A Base for Taking Risks

On my blog I talk a lot about investing in the stock markets and assuming risk in exchange for positive returns over time. In this world, things can feel advanced and overwhelming very quickly. Particularly for newer readers.

While it is fun to explore the deep dives of investment strategies and better ways to invest, sometimes we forget about the basics. A base for investing—being in a position where we can take risks.

I often get emails from newer investors who will ask questions about the various investing styles I explore. (And some that I don't.) Is Dual Momentum a good choice for them? Should they stick with static index investing instead? Is adding leverage to a portfolio too aggressive for them?

While I enjoy the interaction, it is always difficult to answer these emails. I'm not a professional financial advisor and don't hold myself out to be one. I'm a regular guy who is interested in the markets, is moderately well read when it comes to investing, have experienced some decent success, and am continuously learning myself.

But more importantly, everyone's personal situation is different. A retiree who needs stability and tax-friendly income requires a different portfolio from my own. Someone who is starting out but has a shaky job and a lot of debt is also in a much different category of responsible risk taking.

Speaking from personal experience, my ability to invest carefully with appropriate risk and the right mental mindset was advanced when my personal financial situation stabilized. It is very tough to invest properly when cash is low, money is tight, and debt is high.

When I had little money and a big mortgage, I was tempted to go for home runs, treating investing little different from a lottery ticket. The problem is these big wins rarely happen. In the worst cases the more likely large losses can scare a person away from the markets forever.

Very few people get rich with 5x, 10x, or 100x baggers on risky forms of investing (penny stocks, cryptocurrencies, options, etc.). Even fewer stay rich.

Sticky wealth is wealth amassed carefully and methodically over a long time with a lot of hard work.

A Firm Foundation

Like everything else in life, investing begins with a firm foundation. Before taking on risk and putting money into the markets, have everything else in your financial world tightened up.

Pay off debt. Debt is a major financial risk factor today. Way too many people carry enormous debt loads that bog them down. Deep down, most regret the choices that led them into debt. I cannot emphasize enough how important it is to buckle up and do everything in your power to pay off debts. Take a second job, work overtime, live with mom and dad or in a low-cost roommate situation, spend nothing, sacrifice, do whatever it takes.

Never invest if you are carrying credit card debt or have personal loan or an unsecured line of credit balance. Paying these debts off aggressively can provide you with a guaranteed after tax return of 7 to 25 percent. It can also save you a huge amount of stress.

That said, a modest mortgage is okay to carry while investing. Your interest rates are likely to be low and the payments should not be overwhelming.

Cut expenses. Having low living expenses can provide substantial peace of mind. It is also likely to simplify your life. While a million websites will moan about spending on lattes and avocado, the best places to save money are the big expenses.

Downsizing your house, going down to one (or none) fuel efficient vehicle, getting rid of pricey toys like motorbikes or ATVs, selling the vacation cabin or time-share, and taking modest vacations are perfect ways to live better and save money. Way too many people have no money but think it is normal to live like millionaires. It's not.

Earn a decent income. It doesn't need to be a huge six figure take. In Canada I peg the healthy number at C$70,000 gross per year. In the U.S. this could be closer to $50,000. That's only a bit above average for a full-time skilled worker. In some areas of the country it will need to be higher, in others the number can be lower.

Many younger people follow the herds into Toronto, Vancouver, San Francisco, LA, NYC, or Seattle. For most a much better bet is a city like Edmonton, Winnipeg, Montreal, Dallas, Atlanta, Charlotte, or Phoenix. Or the hundreds of very livable smaller cities with low cost-of-living. You would be amazed how location can drastically improve your odds of building wealth and financial independence.

Save money. This is a big one and is the culmination of the prior three points. You should be in a situation where your monthly income consistently exceeds your monthly expenses. Nothing is worse for your portfolio than being in a situation where you put in a dollar and pull out 50 cents two weeks later.

This includes investing for financial independence but pulling money out to "invest" in a kitchen upgrade or "invest" in more reliable car. Investing is for the long-term. It should be kept completely separate from saving for a larger purchase, even if that purchase adds a bit of value to your home.

Build a cash cushion. I like to maintain a decent cash balance in our chequing account. Depending on the time of month, when income comes in and expenses go out, our chequing account will bounce from around $3,000 to $7,000. This provides a nice cushion to cover any spending needs without worrying about overdraft or credit card balances.

We use credit cards for most daily spending to defer the bill for up to a month and a half. Free short-term loans, free purchase protection, and free travel rewards are awesome! But I make sure I can pay it off in full every month.

I'm not a big fan of maintaining large emergency funds because odds are you will never need to use them if you manage your finances properly. Instead, get a personal line of credit set up at your bank. Don't use it unless you are in a financial emergency. Save and invest the rest of your money so it is working for you, not the bank.

Risk and Investing

When most people think about risk and investing, they focus on how risky their investments are. They might even dwell on the risk of losing money when investing—a virtual guarantee at some point in everyone's investing journey.

I prefer to look at the entire picture of risk. This includes investing but it adds in your personal situation (which in many ways is more important). A commissioned real estate salesperson is in a much riskier situation than a power lineman at the utility company. Even if the sales lady drives a BMW and wears nice clothes (or maybe because of that).

A shaky relationship with one very spendy partner is much riskier than a stable partnership of two frugal individuals. A family with a large house and a large mortgage is much more fragile than a family that rents a smaller house or rowhouse.

These ideas extend to a multitude of other factors: high debt compared with no debt, dual versus single income families, old versus young, kids or no kids, level of flexibility in pursuing the best work opportunities, renting or owning, biking and the occasional Uber versus multiple vehicles. The list goes on.

A young, dual income, no debt, apartment renting, no child, biking couple has the capability of taking on high leverage in their portfolio while still being lower risk overall. Flip the situation and invest in GICs and you are still setting yourself up for a major financial wipeout.

Set yourself up for success in your personal situation. Then let the markets do the rest of the work.

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Trend Investing in Choppy Markets

Well... since last January being a trend investor has not been especially fun. U.S. markets have been stopped three times. The international equity markets haven't been doing too well at all; they more or less broke down near the end of January 2018, most countries have dropped substantially, and, based on my momentum scoring, they are on the slide again despite the signs of optimism earlier this year.

Only U.S. stocks have made new highs since January 2018, but even there it has been a range-bound and choppy market. New highs haven't carried the momentum we like to see in a strong market. We have also seen a pick up in volatility.

Take a look at the size of the weekly bars in the red areas compared to the black area.

Credit: TheRichMoose.com, StockCharts.com
Right-click to expand image.

These factors spell trouble for any trend investor. Trend investing performs the best in smooth uptrending markets or in longer downtrending markets. We go with the uptrend and capitalize with leverage where we can. In a long downtrend we sit on the sidelines in cash or bonds and watch the markets burn.

These types of market conditions in stocks are not rare. This is, after all, why trend investing works. Great recent examples of clean uptrends are from March 2016 through January 2018. Or before that from January 2012 through September 2014. These are two year holding periods where trend investors capitalized. In my own account I generated a 68 percent return in the latest period.

On the downside, we all remember October 2007 to March 2009. I had no money back then, so it didn't really affect me. But the S&P 500 fell 55 percent. The trend investor using my model would be off by just 13 percent. For those interested, we're more than halfway there already in 2019.

We see a more recent picture of the protection that trend investing offers by looking outside of the United States. Emerging markets fell around 27 percent from January to December 2018. A trend investor would have been down 14 percent.

Stretching back, emerging markets are down more than 25 percent since 2007. Not a profitable investment for a buy-and-hold investor patiently waiting—with their money tied up—for more than a decade. The trend investor would be roughly flat in their emerging markets trading during the same time period, but could have profited over the years by putting their money to better use when the trend model prescribed no allocation to emerging markets (often for many months at a time).

Of course this is all without factoring in leverage—which rewards handsomely but also punishes cruelly.

The Big Picture

Trend investing offers a good long-term outcome considering there is no crystal ball. We only know what happened yesterday, last week, or in the past years. That's the data a trend investor can use to try get a long-term, but certainly not easy, edge in the portfolio.

As a trend investor, it's important to recognize different market conditions. Markets which are expected to be good for your style and markets which are not. In choppy markets—the markets of today—you will lose money. That's what happens when stocks are not trending well.

Too often we hear from the boisterous crowds employing hindsight bias and capitalizing on narrow time frames. Of course with a crystal ball we would have invested (with ample leverage) in emerging markets from 2004 to 2007, went to long-term bonds until March 2009, then put all of our money in U.S. tech stocks until today. But no one did.

As humans using their superior discretion it's more likely that in 2007 they were diving greedily into emerging markets. By 2009 they were exhausted by the losses and switched to cash. And this past year they are finally buying tech stocks on the dips hoping to catch the rise of Netflix, Uber, Lyft, and Amazon (after all, even Mr. Buffett is buying it now).

Stick with the trend. Ignore the noise. With a lot of patience, a little alignment of the stars, a few whipsaw trades, and a bit of leverage I'm pretty confident I'll be much wealthier ten or twenty years from now. You should be too.

Trend investing may be the only quantifiable, repeatable, and diversifiable way to invest in a broad range of markets with a long-term edge.

Comments & Questions

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Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.