Losses Are Truth

In the past week, I had the pleasure of taking small losses on two of my positions. I say pleasure, not because I necessarily enjoy losing money, but rather because it keeps me real.

I am no savant with all the answers, I take positions that end in a loss, I am human.

All I can do is manage my losses. I can control the severity and impact of losses on my overall portfolio. And this is exactly what I did... very well in both positions.

Both of these positions on which I took a small loss were in the form of long-dated put options, so the risk control was precise and very effective. It's a perfect example of why I love options more and more with each trade.

I followed my signals on the entry, but the market reversed. This means I had to exit the position. Simple as that.

The first position was a long-dated put option on IYR—a U.S. real estate ETF—which had a strike price of $75. I opened my position on December 18, one day after this sector experienced a pretty good drop.

By Christmas Day I looked like a true genius as my trade was “in the money” and up over 50 percent. However, as we know, the broader U.S. stock market turned around and has come back strongly since that time and IYR was no different. The signal changed and I exited my position for a small loss of a few thousand dollars.

A similar experience occurred with my long-dated put option trade on UNG—the U.S. natural gas ETF. I chose a strike price of $25 on a long-dated put option on December 18, once again betting that UNG would fall in value.

Again, as we rung in the new year this position was well “in the money” with a 60 percent gain. This week, however, natural gas prices jumped and I had to exit. I dropped the position for a tiny loss and moved on.

In total, I closed these positions for a loss that was far less than the maximum amount of money I am willing to risk on each trade. I simply followed my signals and I got stopped out. The cash is now in the bank and ready to deploy on a new trade.

Fear of Taking Losses

The events of this week got me thinking about the sentiment which I read so often on the internet and hear so often from my peers. I’m talking about the fear of crystallizing losses. The idea that a loss is not a loss unless it is realized—by that I mean the position is closed.

The fact is that a loss is a loss whether it is realized or not. Your equity has dropped. Your net worth is lower.

Riding a position down to extinction is not going to keep your from being poorer just because you refuse to sell. There is a vast graveyard of worthless stock certificates in the nation's dusty attics.

But this concept goes well beyond the world of stocks and financial investments. It can be your over-leveraged house (which is not an investment), it can be your dismal job, it can even be a relationship with a toxic individual.

When the facts change, or when you're in too deep, you need to take a step back, analyze the situation, and get out. Cutting your losses is critical to moving forward.

Keeping an Eye Ahead

When you really analyze the big picture, you realize that the past doesn’t matter. That doesn't mean we should behave in a manner that's oblivious to the past.

As people, we can certainly learn from the past. We can try avoid repeating the past mistakes we make or those we observe others making. But we shouldn't tie ourselves to the past. Instead, we should always look forward to the opportunities that lie ahead to improve our well-being.

For the investor in us the concept is no different. We use trading systems to try avoid the catastrophic errors made by ourselves or others, but we ultimately look forward.

That means the best way to manage your money each day is by trying to make sure you are invested in those assets which are likely to be the most profitable going forward. Investing is about making profits after all.

Everyday, or every week, or every month, depending on your particular trading strategy, you need to scour the investing universe for the best place to invest your money today. Figure out how to control the risk and place your bets.

I could easily be wrong on the trades I made. IYR and UNG might stop their upswings and once again begin to fall. That’s okay! Provided the risk parameters are right, I will get right back into the trade themes and try again.

The key is that I am willing to change my mind when the evidence shows me that I’m wrong. Even after I was initially right!

If you have losses, realize them quickly, try keep them as small as possible, and move forward.

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Lifecycle Investing for Reduced Risk

Lifecycle investing is an under-utilized strategy that can significantly increase your long-term wealth while reducing your risk.

While the strategy is more geared towards younger investors at the start of their saving and investing journey, an older investor can use Lifecycle Investing if they shrink the timelines to suit their risk tolerance and target allocation by retirement.

While I don't believe Lifecycle Investing is tied to any one particular investment approach, in this post I will explore the strategy in the context of a fixed allocation stock and bond portfolio such as the Couch Potato portfolio. The researchers use this benchmark in their own analysis.

Standard Allocation Portfolio

In a standard Couch Potato style portfolio, the investor will typically choose an allocation that suits their long-term risk tolerance.

Generally, the investor assumes the stock portion can drop about 50 percent in value in a market downturn. There is a paired assumption that bonds will be stable or increase slightly if stocks are falling in value (slight inverse correlation).

This investment approach is mathematically simple to understand. Better yet, it is easy for an investor to manage their portfolio with minimal thought put into the strategy.

While the relative effects of the drawdowns are "managed" carefully based on expected impacts of stocks and bonds on the portfolio, the gross effects are not considered. I believe this is a statistical error often misunderstood by investors and investment managers.

Drawbacks of Standard Allocation Portfolios

We've all seen the upwards sloping curve of a compound interest chart:

Source: TheRichMoose.com

The total monetary impact of investment performance in the first decades of the strategy are very minimal since there is not a lot of money invested in this stage.

However, in the final third of the curve, the impact of investment performance is exponentially higher. Poor performance at this stage will significantly restrict portfolio value at retirement while great performance is going to make the investor very wealthy.

This effectively means an investor in a static allocation portfolio model is entirely dependent on the investment performance of the stock market in the final decade before retirement. The final third of the investing journey is where all of the gross impact of investing is realized.

To simplify, if you only have $10,000 invested, a 30 percent annual return is worth just $3,000. If you have $500,000 invested, a 30 percent return is worth $150,000. The relative performance is the same, the gross impact is very different!

The same impacts are present on the downside. Losing 50 percent of a $10,000 portfolio means a total loss of just $5,000. That's the equivalent of a month's gross income for the average investor. Losing 50 percent of a $500,000 portfolio means a total loss of $250,000—several years worth of gross salary.

There are strategies which attempt to address this discrepancy between relative impacts (percent of portfolio changes) and gross impacts (total dollar value changes).

The overall method is simple: invest aggressively in your early years and reduce risk as your portfolio grows.

Target Retirement Investing

The less risky strategy to address the gross impact issue is often called Target Retirement Investing.

Early in their investing path, the investor chooses a heavy allocation to stocks—typically 90 percent stocks or higher. The idea is that stocks provide higher returns than bonds, but are also more risky than bonds. As each portfolio contribution has a high impact on the total portfolio, the large swings characteristic of stocks have less impact.

However, the investor will slowly shift the portfolio towards more bonds over time. By retirement, an investor may have an allocation of just 40 percent stocks to reflect the decreased capacity for risk in retirement.

This approach has been popularized by Vanguard (U.S.) who offers managed index funds following the target retirement date approach. These funds are particularly appealing to investors in defined contribution pension plans where it may be more difficult to change investments regularly.

The drawback of Target Retirement Investing is that the impacts are still quite subdued. The overall return of a portfolio with 90 percent stocks is actually not that different from a portfolio of 50 percent stocks over ten or twenty year periods.

Lifecycle Investing Strategy

The Lifecycle Investing strategy takes a much more aggressive approach to address the gross impact issue of stock returns on portfolios.

Although arguments can be made that this research isn't new, the Lifecycle Investing Strategy has been popularized in recent years by the authors of this working academic paper: Lifecycle Investing and Leverage. It is worth a read for anyone interested in this strategy.

In the paper, Professors Ayres and Nalebuff advocate investment allocation based on a mathematical model using liquid current savings (S) and the present discounted value of future savings (W). The investor targets stock exposure equal to 88 percent of S+W.

There are three stages which could roughly be summarized as follows:

  1. Stage 1 (age 20 to mid-30's): Invest entirely in stocks leveraged up 2:1 for the entire period.
  2. Stage 2 (mid-30s to 65): Slowly deleverage by paying off margin debt, then begin accumulating bonds to your desired retirement asset allocation.
  3. Stage 3 (retirement 65+): Invest at your desired allocation based on long-term risk tolerance. While I believe it is overly aggressive for most, the authors suggest 88 percent stocks is ideal.

This investment process tilts the standard portfolio value slope quite significantly. First, it shifts more of the gross portfolio impacts to the earlier decades. Second, it allows you to reduce risk as your approach retirement without sacrificing overall returns or your ability to retire.

The theory is that your portfolio growth looks a lot smoother over the entire investment period:

Source: TheRichMoose.com

Or, under ideal conditions, returns are tilted toward centre peak earning years, then tapering down somewhat as the investor approaches retirement:

Source: TheRichMoose.com

The calculation that Ayres and Nalebuff use actually recommends leverage use greater than 2:1 during the earliest phases of investing; however, they suggest 2:1 should be the maximum leverage due to market restrictions and risk of loss.

I would argue this is no longer a concern given the 3x leveraged ETFs on the market. Following this method, a young investor can easily put all of their money in 3x leveraged ETFs and slowly pull back their leverage ratio in Stage 2 by purchasing short-term bond ETFs.

Using 3x leveraged ETFs (or simulating these returns with LEAPS options) would often allow the investor to begin tapering back leverage—Stage 2 of the process—earlier in their investment journey.

Under this method, an investor would roughly match a 100 percent stock portfolio when they hold 35 percent leveraged ETFs and 65 percent short-term bonds. For 60 percent stocks, the investor could alternatively hold 20 percent 3x leveraged ETFs and 80 percent short-term bonds.

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.