Short-termism

June 14, 2021

After investing in mutual funds for several years, I began trying to earn an exceptionally high return of 30% in future years by trading profitable stocks in short periods of time. Could I outperform the stock market with short term trading? 

Short-termism is the habit of selling securities in the stock market after brief periods of ownership less than one year.  My short-termism is summarized in figure 1 for the past thirteen years.  According to the gold and green bar graphs, more short term than long term sales were made during the first ten years.  The gold dashed line shows a steady decline of 3-year moving averages for short term sales after the eighth year.  By the thirteenth year, the average number of short term sales fell below the average number of long-term sales (green dashed line).  The portfolio’s average number of year-end securities (blue dashed line) varied between 17 and 20 after the fifth year.   

Figure 1 legend.  The annual numbers of short-term sales (gold bars), long-term sales (green bars), and year-end holdings (blue bars) are represented by the height of the bars.  Dashed lines represent those numbers as 3-year moving averages. Each moving average is an average of the previous 3 years.

I compared my portfolio to the stock market using the “percentage return” measurement shown below in figure 2.  Heights of the bar graphs for the portfolio (blue) and stock market (black) changed according to the percentage change in market prices between the start and finish of the year.  Goal lines for “30%” and “-30%” represent exceptional gains and losses. At the end of 2008 (“year 1”) the portfolio lost 60% of its starting value compared to the market’s 37% loss.  During year 2, my successful trading in the resurgent stock market lifted the portfolio’s percentage return by 54%.  But successful trading had nothing to do with the portfolio’s 123% return in year 3.  Instead, I made a one-time transfer of additional stocks into the portfolio from another investment account.  Thereafter, with the exception of year 11, the stock market outperformed the portfolio as indicated by higher percentage returns.  Short term sales (gold bars) accounted for the portfolio returns of years 1, 2, and 5, but otherwise failed to account for the portfolio returns [nor did long term sales (green bars); unsold securities usually accounted for most of the percentage returns]. 

Figure 2 legend.  “Percentage return” of the “portfolio” and “market” represents the change in total value for each entity at the beginning (value1) and end (value2) of one year [return = 100(value2 – value1)/value1].  “Percentage return” of sales represents the net profits of “short-term sales” and “long-term sales” earned during the year as percentages of total portfolio value at the end of the year.  The investment goal of 30% return is represented by the upper black line.   

Figure 3 (below) clearly shows that my portfolio failed to achieve the goals of earning a 30% CAGR and outperforming the stock market.  The portfolio’s thirteen-year CAGR of 7.9% was 1.9 percentage points below the stock market’s 9.8% CAGR and 22.1 percentage points below the desired 30% CAGR.  In terms of cash value, a $1,000 sample of baseline investment ultimately grew to $2,690 in the portfolio (blue line) compared to $3,370 in the stock market (black line).  At the stated “30% target” growth rate (dashed line), every $1,000 invested at baseline would theoretically grow to $4,000 in merely 5 years.  The portfolio’s final surge in the last two years came from reinvesting 80% of the total value into an index fund that tracks the stock market.

Figure 3 legend.  “Multiple” is the ratio of year-end value to baseline value.  Baselines of the “Portfolio” and “Market” occurred at the close of trading in 1979 (time 0).  Year-end value of the “Market” was reported by the Standard and Poors 500 Total Return Index. Multiples below 1.0 are losses and above 1.0 are gains.

Short-termism wasn’t the only reason I failed to earn a 30% annual return, but I believe it is the main explanation; here’s why:

  1. Fluctuating prices in the market prevent accurate timing of returns. Technical analysis of stock prices doesn’t guarantee accurate timing of trades.
  2. The fundamental analysis of stocks for short term trading is costly in terms of time spent on research and subscription fees for research reports.  
  3. Frequent stock purchases can be an overwhelming task without the aid of an effective screening program and computer-assisted analyses.  A problem with screening programs is the slow turnover of attractive stocks over a period of months rather than weeks.  I began to run out of new ideas after a few months.  
  4. A portfolio with too few or too many stocks is unlikely to beat the market.  Underperformance of one or more stocks among a few securities incurs the burden of recovering losses before earning high returns.  Too many stocks likely dilute the returns.
  5. I lost the opportunity to earn higher returns by selling good stocks too soon.  Behavior analysts offer the opinion that long term buy-and-hold strategies offer a better chance of earning annual returns than short term sales strategies.  
  6. Investing in distressed companies at low prices incurs an extended period of time needed for the company to recover its financial health and desired growth of earnings.
  7. Cash is necessary to purchase new securities, but too much cash dilutes the profits from short-term trading [please see “cash penalty” in the Appendix].

Conclusion.  Bad choices and hurried trading most likely explain my subpar performance.  The worst choice was purchasing shares of LEH (the listing of Lehman Brothers Holdings Inc. in the New York Stock Exchange) in year 1 when respected analysts warned against investing in such a deeply indebted company [more explanation in the Appendix].  And, hurried trading is a risky business due to unpredictable pricings and unexpected market declines.  It’s less risky to purchase undervalued stocks of good companies and wait for however long it takes to sell those stocks at overvalued prices.  A collection of healthy stocks protects from the inevitable decline of some companies. 

Appendix: My trading behavior

30% goal.  A compounded monthly return of 2.25% should yield a 30% annual return, which produces a compound annual growth rate (“CAGR”) of 30% when repeated for a period of years.  

Assumptions:

  • net monthly returns of 2.25%
  • Every sale is promptly replaced by a security that continues earning a monthly return of 2.25%.
  • Negligible ‘cash penalty’ [cash penalty: every dollar of uninvested cash doubles the required monthly return from the same amount of invested cash].

My strategy was to sell stocks above cost by analyzing price charts.  Frequent trading produced mixed results during the first two years (figure 2).  Several trades earned sizable short term profits, notably stocks listed as GOOG (19%) and SOHU (14%).  Other trades earned disasterous short term losses, notably LEH (-27%), SOL (-26%), and NVDA (-35%).  The 2008 Recession occurred during this time period and undoubtedly contributed to my 60% loss in year 1.  Year 1 ended with a portfolio of 4 stocks and $15 (~0%) in cash.  During year 2, successful trading in a resurgent stock market lifted the portfolio’s annual return by 54%.  The year-end portfolio held 27% cash and 73% securities which were comprised of stocks and one real estate investment trust (REIT).

[case history #1, LEH: My worst investment occurred in 2008 when I ignored the signs of a troubled company named Lehman Brothers Holdings Inc. to purchase its stock at several levels of declining share prices.  Instead of a profitable rebound, the declining stock was delisted from the market when the company filed for bankruptcy.  I felt demoralized by the end of 2008]

[case history #2, GOOG & NVDA: Had I kept these stocks for thirteen years, my final returns-on-investment would be 283% (GOOG) and 3,415% (NVDA).

In year 3, the one-time transfer of stocks from another account boosted my portfolio’s return by 123%.  My intent was to acquire additional cash from short term sales in order to buy interesting securities such as exchange traded funds (ETFs).  The ETFs offered a layer of protection against corporate bankruptcies and stock delistings.  Short term trading of securities continued during years 3-5 with the inclusion of sector ETFs and leveraged ETFs. The portfolio held 19% cash, 34% stocks, and 47% ETFs at the end of year 5.

My revised goal in year 6 was to consistently outperform the market by combining market-matching returns using ETFs with above-market returns using stocks.  I would do so with an 80% investment in ETFs and 20% investment in stocks.  Promising stocks from foreign countries were added to the portfolio and leveraged ETFs were abandoned. The remaining ETFs were distributed among four different asset classes: 30% stocks, 30% REITs, 20% investment grade bonds, and 20% gold bullion.  The occasionally rebalanced ETFs offered good protection at modest returns that underperformed the stock market.     

In year 12, I sold the diversified group of ETFs to reinvest in a single broad-market ETF that mimicked the U.S. stock market.  I no longer needed to rebalance the portfolio, with the added advantage of automatically reinvesting the fund’s dividends.  The new ETF enabled the portfolio to match the stock market’s resurgence in years 12-13 (figures 2,3).  The portfolio held 3% cash, 16% stocks, and 81% single-ETF at the end of year 13.

Copyright © 2021 Douglas R. Knight 


2020

January 18, 2021

The SmallTrades Portfolio holds cash, one exchange-traded fund (ETF), and a folder of stocks (figure 1).  

Figure 1.

Strategy

The SmallTrades investment goal is to earn an annual rate of return —as measured by percentage change of market value over the year— which surpasses the performance of the benchmark Standard & Poors 500 Stock Index.  In figure 1, one index-ETF creates 80% of the Portfolio’s market value with an expectation of matching the benchmark’s rate of return.  The stocks contribute 20% of the market value with an expectation of outperforming the benchmark’s rate of return.  

Performance

During 2020, the SmallTrades Portfolio earned an 18.2% rate of return compared to the Standard & Poors 500 Index’s 18.4% rate of return, thus matching the benchmark’s performance. In figure 2, the 12-year trend of performance was considerably better for the benchmark than the portfolio.  The benchmark’s 9.8% compound annual growth rate (CAGR) exceeds the portfolio’s 2.8% CAGR.  Portfolio mismanagement explains its underperformance. 

Figure 2. The unit value is a ratio of final-to-initial value. In this chart, the initial value was measured on 12/31/2007. Unit values less than 1.00 represent a loss and greater than 1.00 represent a gain.

In figure 3, the 7-year trend of performance was considerably better for the benchmark compared to the portfolio.  The ETF performance coincided with that of the portfolio, indicating that the ETF is the major determinant of portfolio performance.  

Figure 3. The unit value is a ratio of final-to-initial value. In this chart, the initial value was measured on 12/31/2013. Unit values less than 1.00 represent a loss and greater than 1.00 represent a gain.

Discussion

The “Great Recession” of 2007-08 devastated the Economy and the stock market as well as my portfolio.  The effect of the “Recession” is seen in figure 2.  The portfolio’s benchmark recovered higher and faster than it’s market value. 

The stock market declined in the last quarter of 2018, which caused corresponding declines in market value of the portfolio’s ETFs and stocks (figure 3).  That was a wakeup call to revise my investment strategy in 2019.  First, I replaced the 4-sector group of ETFs (discussed in AR2018) with the current large-cap ETF (SCHW in fig 1).  Second, I stopped using stop-loss orders to protect from losses and started using limit orders to capture large gains.  The stop-loss orders focused on minimizing losses in a volatile market rather than seeking long-term gains.  The result was a dramatic increase in performance of the portfolio, ETF, and stocks in 2019.  The stock market crash of March 2020 and the Pandemic of 2020 combined to level the stock performance during 2020.  I might have done better with different stocks, but that’s wishful thinking.  Fortunately, the performace of the ETF protected the growth of my portfolio.  My plan is to continue seeking long-term gains.

Copyright © 2021 Douglas R. Knight


2019

January 5, 2020

The SmallTrades Portfolio holds cash plus an exchange-traded fund (ETF) and a folder of stocks (figure 1).

SmallTrades Portfolio, 2019

Figure 1 displays 2019’s year-end composition of the SmallTrades Portfolio. COLUMN HEADINGS: “Ticker” is the trading symbol of the “Security” as listed in the U.S stock exchange.  “Mkt Cap” stands for ‘market capitalization’, which is the total market value for all tradable shares of a given security.  “Allocation” is the percentage market value of each holding relative to the market value of all holdings in the Portfolio.  “Strategy” is the investment strategy.  STRATEGY: “Passive” strategy relies on the ETF’s computers to track the value of a selected market index.  “Drip” signifies the automatic reinvestment of dividends earned from long term investments in ETFs and stocks.  “Growth” stocks are expected to earn long term capital gains.  “Swing” stocks are expected to earn short- or long term capital gains based on a pre-defined range of price growth.

Strategy

The investment goal of the Portfolio is to earn an annual rate-of-return that surpasses the performance of the benchmark Standard & Poors 500 Stock Index.  One index-ETF dominates the Portfolio’s return with an expectation of matching the benchmark’s rate of return.  A subordinate folder of selected stocks is expected to outperform the benchmark’s annual rate-of-return.

Performance

The Portfolio earned a 29.7% total rate-of-return during calendar year 2019.  Although the Standard & Poors 500 Index earned a higher rate of 31.5% in 2019, I’m pleased with the Portfolio’s performance for these reasons:

  1. 2019 was the first year that the Portfolio’s market value surpassed the initial market value at year-end 2007 (figure 2).  As reported in an earlier post, the market value declined in 2008 due to mismanagement, then took 12 years to recover by the process of employing trial-and-error strategies of management. The strategies gradually improved to the current idea of using an index-ETF to earn the benchmark return and supplementing that return with a subfolder of growth stocks.
  2. Converting 2018’s diversified ETF folder to 2019’s single ETF successfully raised the ETF folder’s market value by 33.9% in a single year (figure 3).
  3. Revising both the investment strategy and the composition of 2018’s stock folder raised its market value by 54.9% (figure 3).

 

2008-19 portfolios

Figure 2.

 

2014-19 stocks & ETFs

Figure 3.

Copyright © 2020 Douglas R. Knight

 

 

 

 

 

 


Model Portfolios, updated

January 23, 2019

Portfolio Visualizer is a highly rated online tool for designing investments (ref. 1). I used it to backtest the model portfolios listed in the following chart:

models

Legend: The top row shows the trading symbols of six index funds selected to build the model portfolios in rows 2-5.  The portfolios were backtested from December 2018 to January 2010.  $1.00 was initially invested in each portfolio and allowed to grow in value to the final balances shown in the righthand column.  The performance benchmark is Standard&Poors 500 TR Index in row 6.

Four-sector models in rows 2-4 represented diversified investments in stocks (VT, VTI), real estate investment trusts (VNQ), investment grade U.S. bonds (AGG), and gold bullion (GLD).  Several observations:

  • Four-sector models outperformed the bond market as determined by comparing their balances to the $1.32 that would result from investing only in AGG.
  • Portfolio performance was affected by the percentages of the index funds. The final balance of  four-sector models increased with the total percentage of stocks (VT, VTI) and real estate (VNQ) investments. 
  • Four-sector models underperformed the benchmark.

The one-sector model in row 5 held diversified investments in U.S. stocks. SCHX is a proxy for U.S. large-cap stocks and VTI is a proxy for all U.S. stocks. Among models, only the final balance of this model surpassed that of the benchmark in row 6.

Applications

Four-sector models are ideal portfolios for making short term investments of 1-5 year time periods. The goal of four-sector models is to improve safety by reducing the downside risk of investing in one sector.

The one-sector model of diversified U.S. stocks is ideal for making long term investments of 10 or more years.

Plan

Last year’s SmallTrades Portfolio, in 2018, was a four-sector portfolio that underperformed the benchmark.  In 2019, the new SmallTrades Portfolio will hold a group of actively managed stocks plus the passively managed Schwab U.S. Large-Cap ETF (SCHX). The initial allocation will be 20% stocks and 80% SCHX.

Thesis: SCHX is designed and tested to match the performance of the benchmark. Successful management of the stocks will raise the portfolio’s total performance above that of the benchmark.

References

  1. Vikram Chandrasekhar, 2016.  What is the best tool to backtest a portfolio online?

Math

The total return of a portfolio is estimated by the following formula:

RT = aRA + bRB+ cRC + dRD

For example, what is the estimated total return for the following portfolio?;  

25% VT + 25% VNQ + 25% AGG + 25% GLD

  • a, b, c, and d = 0.25.
  • RA = 7.19%, RB = 10.21%, RC = 3.13%, and RD = 1.37%.
  • RT = 0.25*7.19% + 0.25*10.21%+ 0.25*3.13% + 0.25*1.37% = 1.80% + 2.55% + 0.78% + 0.34% = 5.47%

By comparison, the Portfolio Visualizer  reported RT = 5.93% with a final balance of $1.68.  

Copyright © 2019 Douglas R. Knight 


2018

January 19, 2019
Once again, the SmallTrades Portfolio failed to outperform 
the Standards & Poor 500 TR Index ('benchmark'). In 2019, I
will replace five exchange-traded funds (ETFs) with a single ETF.

The SmallTrades Portfolio is actively managed within a tax-protected Roth IRA.  No cash has been added or removed from the account since the time of inception in 2007.  Figure 1 describes the portfolio and its investment strategy:

portfolio 2018 v3

Fig. 1. The holdings as of 12/31/2018.

The following strategies are used to earn capital gains:

  • The passive strategy is to collect dividends and capital gains from exchange-traded index funds (ETFs).  Each ETF is ‘passively’ managed to match the performance of a market index rather than ‘actively’ managed to outperform or underperform a market index.
  • The swing strategy is to buy the stock at a low price (‘bargain’) and sell it at a high price, however long the price-swing happens to occur.
  • The growth strategy is to purchase a reasonably priced stock and hold it until the company stops growing over several-to-many years.  The stock price should increase with the company’s profit.
  • The drip strategy is to buy a reasonably priced stock to collect dividends and reinvest them in additional shares of stock.  The beneficial effect of ‘drip’ increases as the stock survives several market cycles.

2018 Performance

Figure 2 shows the changes in value for every $1 invested in the Portfolio (solid blue line) and Benchmark (dashed blue line) after 12/31/2007.  The market value of the benchmark was consistently higher than that of the portfolio.

invested $ portfolio

Fig. 2.

 

In 2013, I replaced the Portfolio‘s mutual funds with ETFs that match the performance of 4 market sectors based on a model portfolio of global stocks, U.S. real estate investment trusts (REITs), U.S. bonds, and gold bullion.  I rebalanced the ETFs as needed and continued to actively manage a group of stocks.  Figure 3 shows annual fluctuations of the stock values (solid red line) and ETF values (dashed red line) as if $1 were invested in each group on 12/31/2013.

invested $ stocks

Fig. 3.

The benchmark (solid blue line) underperformed the stocks and outperformed the ETFs until 2018, when the benchmark surpassed both groups of investments (Fig. 3).

Why?

Several events in 2018 worked against the portfolio.

  • The U.S. stock market lost its collective annual earnings in the last quarter of 2018.  Most stocks declined in value.
  • Stop-loss trading orders triggered steep losses from 5 stocks in the portfolio.  Four were high-risk investments in small companies that failed to generate returns.  One investment was a large company with steadily declining earnings.
  • The 4-sector model portfolio predicted that the portfolio’s ETFs would collectively grow by nearly 9% every year, but instead they grew at half that rate, 4.4% annually.  The databases for the model portfolio were outdated (limited to the time period of 1997-2011) and have not been updated.

Plan

The new SmallTrades Portfolio will hold one index fund, the Schwab U.S. Large-Cap ETF (i.e., SCHX), and a group of stocks.  The SCHX is designed and tested to match the performance of the benchmark (more information in Model Portfolios, updated). The stocks will initially comprise 20% of the portfolio’s market value and they will be actively managed to outperform the SCHX.  Consequently, the portfolio’s growth should outperform the benchmark’s growth.

Copyright © 2019 Douglas R. Knight


2017

January 1, 2018

My SmallTrades Portfolio holds stocks and broad-market index ETFs (chart 1).

chart 1. SmallTrades Portfolio in 2017.

Chart 2 shows the diversification of ETFs as measured by percentages of year-end market values among ETF classes.

chart 2. Diversification of ETFs in 2017.

Chart 3 shows the diversification of stocks among 8 market sectors as measured by percentages of year-end market value for each stock sector and the ETFs.

Chart 3. Distribution of stocks and ETFs by market sectors.

Chart 4 shows the distribution of stocks according to market capitalization.

Chart 4. Combined market capitalizations.

Performance

My investment goal is to outperform the “Benchmark” Standard & Poors 500 Total Return Index, yet my portfolio has never outperformed the Benchmark (chart 5).

Chart 5. Portfolio performance.

Chart 5 shows growth trends for the benchmark (blue dashed line) and portfolio (solid blue line) since 2007 [the benchmark represents a passively managed, buy-and-hold investment; my portfolio is an actively managed investment].  On the Y axis, a unit value of $1.00 was assigned to both the total market value of the Portfolio and the Benchmark on December 31, 2007. Ratios of subsequent market- and benchmark values to the 2007 baseline are displayed line plots on the chart.

In 2014, my investment policy was modified to buy stocks of good companies and hold them for the long term. Chart 6 shows the result of my stock investments (red line) compared to the Benchmark Index (blue line) and ETF investments (red dashed line). The unit value of $1.00 was calculated on December 31, 2013. Since then, the stock group clearly outperformed the Benchmark and ETFs.

Chart 6. Stock and ETF performances.

Risk Management of ETFs

Broad-market index ETFs are primarily protected against stock losses by the passive management of investment portfolios which mimic the composition and performace of reputable market indices.

ETFs are secondarily protected by rebalancing significant allocation errors as described in the SmallTrades Portfolio’s strategies for risk management. In theory, a significant drift of asset classes occurs when one asset class surpasses a 24-28% allocation error. My preferred allocation of ETF market values is 30% stocks, 30% REITs, 20% bonds, and 20% gold bullion.

A perfect allocation of ETFs would result in 0% allocation error.  Furthermore, allocation errors would reflect disproportional gains or losses of market value.  Chart 7 shows the year-end allocation errors (blue bars) and error limits (red dashed lines) of my ETFs. There was growth of the Global Stocks ETF and decline of the remaining ETFs. Any allocation error that exceeds an error limit (red dashed line) should trigger trades that rebalance the ETFs to the preferred allocation.  My ETFs were not rebalanced in 2017.

Chart 7. ETF allocation errors in 2017.

Risk management of Stocks

My stocks are primarily protected against risks of steep loss by diversification of the market sectors, as illustrated in the preceding chart 3. The second line of defense is stop-loss orders.  In keeping with the investment goal of holding good stocks for the long run, I set ‘stops’ at a wide margin to prevent recent market fluctuations from triggering an unwanted sale.

Plan

The SmallTades Portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. In 2017, I failed to sell large cap stocks in order to buy good small cap and mid cap stocks. Consequently, 60% of the total market capitalization of my stock portfolio was in the Large Cap category.  In 2018, I would like to reduce the Large Cap category to 40% total market capitalization and boost the market capitalization of small- and mid cap stocks issued by good companies with potential growth of earnings.

Portfolio history

  1. On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in a Roth account.
  2. During 2007-2010 the actively managed mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’.  Four mistakes led to a big loss:
  3. mistake #1: after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of the company’s large debt and lost $45,000 during Lehman’s decline to bankruptcy.
  4. mistake #2: substantial long term profits from good companies were lost by selling holdings for short term profits. My strategy was to earn a quick 30% in the first year and re-invest in the next winners. It was too difficult to identify the next winners.
  5. mistake #3: day-trading was a game of chance that I played and managed to break even; meanwhile, good stocks grew in value.
  6. mistake #4: a trial of investing in leveraged ETFs resulted in losses due to negative compounding.
  7. I abandoned the goal of a 30% annual return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad-market index ETFs and 20% stocks for the long term. ‘Good’ companies attract and retain investors for many years. I will search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, partiicipating in an investment club, using stock screeners, and attending investor conferences. Then I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
  8. Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since my retirement income didn’t depend on making withdrawals from the SmallTrades Portfolio, I increased my ETF exposures to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.

Stop losing value from a declining price

March 4, 2017

background

The market value of your stock equals your principal (i.e., the amount you invested) plus any profit or loss from price fluctuation. The market price that moves below what you paid to purchase the stock will produce a loss of principal if you sell the investment. Here are several risk factors that may drive stock prices downward:

  1. Company performance. ‘Good’ companies attract investors. Conversely, ‘distressed’ companies repel investors.
  2. Industry performance. Business cycles can affect the sales of products from an entire industry. For example, sales of new automobiles declined during the Recession of 2008.
  3. Market cycles. Aside from business performance, the entire stock market is subject to periods of declining prices due to massive selloffs by investors.

The risk of an extreme loss can be prevented by setting a stop-loss price (“stop”) to sell part or all of your shares.

ways of setting the stop

The systematic way is quite simple. If the market value is below your invested principal, then select an absolute loss or a fraction of the principal. Examples:

  1. Absolute loss. Suppose you invest $5,000 in 100 shares of stock (i.e., $50/share) and you can tolerate a loss of $1,000 should the price start to fall. Regardless of future prices, you choose to stop the decline at $1,000 below the original $5,000 value. In this example, the stop would be $40/share [stop = (value – loss)/shares = ($5,000 – $1,000)/100].
  2. Fraction of value. Suppose you can tolerate a 10% loss from an investment originally valued at $5,000 for 100 shares.  Ten percent is one-tenth of 100, which is equivalent to a decimal number of 0.10. The stop would be $45/share [stop = (1.00 – decimal)*value/shares = (1.00 – 0.10)*$5,000/100].

The technical way is based on the stock’s historical prices. If you want to minimize the chance of a sale, set the stop at the lowest price from the past 5-10 years. Beware that setting the stop at a historical low may incur a steep loss. Other ways involve the more complicated analyses of trendlines, moving-average lines, or price statistics.

Another way is to adjust the price gap (gap = market price – stop) to the growth of capital gains. As the market price increases over time, choose a narrow gap to protect the capital gain or a wide gap to reduce the chance of a trade. Generally speaking, widening the price gap will reduce the chance of a trade at the risk of incurring a bigger loss.

add a limit price (“limit”) for extra protection

A brokerage firm will enforce your stop order for 30-90 days depending on the firm’s trading platform. The firm’s computer activates the order when the latest market price reaches the stop. The order is then filled at the next available price. In a chaotic market, the price could plunge below your stop to an exceptionally low value at the next available trade, resulting in a bigger loss than you planned. You might be able to prevent this result by setting a limit slightly below the stop. The trading order would be filled somewhere within the stop-limit price zone unless the transaction is cancelled, unfilled, when the next available price dips below the limit. The limit helps protect the extent of your loss.

who should worry about an extreme loss?

Nobody’s immune, but long-time investors have the least concern. Investment strategies such as dollar-cost-averaging and automatic-dividend-reinvestment plans will help protect against damages from periodic bear markets. Short- and intermediate-time investors are at greater risk for incurring an extreme loss from market down-cycles. For example, families who are saving to pay college fees or to buy a home risk big losses from a bear market.

conclusion

Stop orders are used to set the price for buying or selling exchange-traded products such as stocks, ETFs, and REITs. This article discussed the use of a stop-limit order to sell a stock in a declining market. Brokerage firms may restrict the duration of stop-limit orders to 30-90 days after which the order is cancelled without a transaction until you renew the order. Periodic renewals allow you to reconsider your strategy in light of the prevailing price trend. In a downtrend, simply renew the order. In an uptrend, you may wish to protect a growing profit by resetting the stop-limit order to higher prices. Click on this link to skimming a profit for another perspective on protecting a growing profit.

Copyright © 2017 Douglas R. Knight


2016

January 14, 2017

My SmallTrades portfolio holds stocks and four classes of exchange-traded index funds (ETFs).

chart 1

chart 1

Investment plan

The goal is to outperform a reputable benchmark, the Standard & Poors 500 Total Return Index, on a sustained basis.  The ETFs are diversified and rebalanced in order to partially offset the losses of a declining market. A small group of stocks are used to boost the investment returns.

Performance

In FY2016 the portfolio’s market value increased by 8.3% due to a 9.1% gain in stock value and 8.1% gain in ETF value. Charts 2 and 3 illustrate the nominal (solid lines) and real (dashed lines) growth in unit value for shares of the portfolio, ETF group, stock group, and benchmark. The number of shares for each entity was the initial market value divided by $1 of U.S. currency.  Assume that the initial unit value of $1 was a real value unaffected by inflation.

Chart 2 shows the pattern of unit-value growth for the benchmark (black lines) and portfolio (blue lines) since December 31, 2007.

chart 2

chart 2

The unit value of both entities declined in year 2008 and began to recover in year 2009. The benchmark (black lines) recovered in year 2011 while the portfolio (blue lines) is still struggling to recover [notes 1,2]. The effect of inflation was to devalue real growth (broken lines) compared to nominal growth (solid lines). The real unit value signifies the purchasing power of the investment. The investment has greater purchasing power than uninvested money when the real unit value exceeds $1.

Chart 3 shows the result of implementing the current investment goal [note 2] with a small group of stocks (red lines) and large group of ETFs (blue lines). In chart 3, the initial unit value was re-calculated on December 31, 2013.

chart 3

chart 3

Since 2013 the stock group clearly outperformed the benchmark (black lines) and ETF group. The success of the Stock group is attributed to investing in ‘good’ companies for the long term [note 3].

Stock group

Chart 4 shows the market sector and market cap diversity of the stock group defined in chart 1.

chart 4

chart 4

Several stock trades were made during FY2016 to improve the chance for success.
Closings:

  • Alibaba Group (BABA), for 10% capital gain, to exit the Chinese market.
  • Geely Automobile (GELYF), for 14% capital gain, to exit the Chinese market.
  • Corning Inc. (GLW) for no gain.
  • iRobot Corp. (IRBT) for 10% capital gain.
  • ITC Holdings (ITC) for 14% capital gain, due to the stock’s delisting.
  • Stericycle (SRCL) for 34% capital loss, to stop further loss.

Purchases:

  • Biogen (BIIB), an innovative biotechnology firm.
  • Cal-Maine (CALM), a leading producer of shelled eggs.
  • Express Scripts Holdings (ESRX), a large mail order pharmacy
  • Royal Bank of Canada (RY), a well-capitalized bank.

ETF group

Chart 5 shows the distribution of asset classes among the ETFs. All asset classes drifted from an allocation plan of 30% stocks, 30% REITs, 20% bonds, and 20% gold [note 4].

5-etf-distribution

chart 5

The SmallTrades portfolio’s primary strategy for risk management is holding a large group of diversified ETFs that are rebalanced to correct a significant allocation error. In theory, a significant drift of asset classes occurs when one asset class surpasses a 28% allocation error.  At the end of FY2016, the existing allocation errors (blue bars) were within 24% error limits (red dashed lines) as illustrated in Chart 6.

chart 6

chart 6

Chart 6 reflects the portfolio’s response to an incline in equity markets compared to decline of the bond and gold markets. History has shown that a decline in equity markets tends to be offset by a rise in the bond and gold markets.

Plan for FY2017

The SmallTades portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. I would like to own fewer large cap stocks in favor of small- and mid-cap stocks issued by good companies with potential growth of earnings.

Notes

  1. On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in the Roth account. During 2007-2010 the mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’. Several mistakes led to a big loss:  A) after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of that company’s large debt and lost $45,000 during its decline to bankruptcy.  B) substantial long term profits from good companies were lost by selling holdings for short term profits. I was trying to earn a quick 30% annual rate of return and immediately re-invest in the next set of winners. It was too difficult to identify the next winners.  C) day trading also prevented a 30% return.  It was a game of chance that I played without a strategy and I was fortunate to break even.  D) a trial of investing in leveraged ETFs resulted in losses due to negative compounding.  Leveraged ETFs were very high-risk investments that I made without a sound strategy.
  2. I abandoned the goal of a 30% annual rate of return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad market ETFs and 20% stocks for the long term.
  3. ‘Good’ companies attract and retain investors for many years. I search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, participating in investment club discussions, using stock screeners, and attending investor conferences.  I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
  4. Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since I don’t depend on making withdrawals from the SmallTrades Portfolio, I increased my exposure to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.

Copyright © 2017 Douglas R. Knight


Beta is the incline of a straight line

December 10, 2016

Beta (which is symbolized as β) is the incline of a straight line. Mathematicians would say the same thing another way, that beta is the slope of a regression line. Either way, β describes the tendency of investment returns to move with market returns. The investment is a security (e.g., stock, bond, mutual fund) that has a unit price. The market is a trading place for a large group of securities. The combined value of all securities is measured by a market index.

Returns

Trading causes security prices to change during the passage of time, a process called price movement. Calculations of β require price movements to be measured as percentage returns. In table 1, the daily closing prices of a security and its market index are listed under the column heading “close”. Percentage daily changes in closing price are listed under the column heading “Return %”.   Equation 1 is the formula used to calculate a return:

Return % = 100 x (current price – past price) / past price  (equation 1)

Notice in table 1 that all prices are a positive number and that the market’s close is bigger than the investment’s close. However, the calculated returns are positive and negative numbers of similar size. The positive and negative returns represent up and down movements of prices. Table 1 has 3 pairs of investment and market returns with corresponding dates.

table-1

Beta (β)

β may be calculated directly from a table of returns, but it’s more meaningful to analyze a scatter plot of returns. The scatter plot in figure 1 has a solid blue line derived from 5 years of daily returns represented by more than a thousand black dots. Each dot has a pair of corresponding returns on each axis.

fig-1
The blue line offers the single-best comparison of investment returns to market returns. The incline of the blue line is β, which is calculated as a ratio of the lengths AC and BC of the dashed lines. Since AC and BC have equal point spreads of 5%, β is 1.00, which means that the investment and its market TENDED to move together at the same rate of return.

Notice that the black dots are closely aligned to the blue line, therefore excluding the random movement of returns. Consequently, the blue line is highly predictive of this particular investment’s past performance.

Significance

β is a measurement that literally means for every percent of market return, the percent investment return TENDED to change by the factor of β.  This is illustrated in figure 2.

fig-2
The colored performance lines in figure 2 represent different investments. Each line offers the single-best comparison of investment returns to market returns. For the sake of graphic clarity, a large cluster of paired returns was not plotted as data points.

At β = 1.00 (black dashed line) the investment and market TENDED to move together at the same rate. At β >1.00 (yellow line), the investment performance was amplified by trading activity in the market. The yellow line’s β infers that the investment’s return was 1.72 times the market’s return. At β <1.00 (green line), the investment performance was diminished by market activity. The green line infers that the investment’s return was 0.86 times the market’s return. At β <0 (red line), the investment performance was reversed by market activity. The red line infers that the investment’s return was -3.86 times the market’s return.

Thus, β is a ‘pretend’ multiplier of market performance. Higher β ‘amplified’ the market performance, lower β ‘diminished’ the market performance, and negative β ‘reversed’ the market performance.

Risk

Risk is the chance for a capital gain and capital loss. Betas greater than 1.00 tend to be riskier investments and those lower than 1.00 tend to be safer investments compared to performance of the market. Negative β infers a reversal of investment outcomes compared to market outcomes.

Summary and advice

β is a statistic for past performance that describes the tendency of investment returns to move with market returns. When comparing the β of different investments, be sure to verify the time periods and market index used by the analyst. β is typically measured with weekly or monthly returns for the past 3-5 years.

Copyright © 2016 Douglas R. Knight


Choosing an ETF

August 16, 2016

Investing in an exchange-traded fund (ETF) begins with screening many funds to identify a few candidates, then rating the candidates. My preferred open-source screeners are XTF.com and ETF.com, both of which have inclusion criteria for selecting desirable ETFs and exclusion criteria for rejecting undesirable ETFs.  Aim to find a reputable low-cost ETF that best matches the performance of its category.

Asset class

Assets are potential sources of income to investors.  Consequently, an asset class is a group of assets that earn income the same way.  The ETF portfolio holds assets consistent with the fund’s investment strategy, which is either to copy a market index by process of passive management or compete with a market index by process of active management. The index measures the performance of an asset market.

Competing ETFs are typically grouped in one of the following asset classes:

  1. EQUITY is a share of ownership claimed through the purchase of a company’s stock. Equity ETFs earn capital gains and dividends from stocks.
  2. REIT.  The real estate investment trust (REIT) is a company that owns and manages income-producing real estate. The REIT earns money from rent, mortgage interest, or other real estate investments. At least 90% of the REIT’s taxable income must be given to shareholders in the form of dividends. REIT ETFs earn capital gains and dividends from REITs.
  3. FIXED INCOME securities pay an expected amount of interest (e.g., bonds) or dividends (e.g., preferred stock).
  4. COMMODITIES are raw materials sold in markets for use in making finished products. Commodities are sold for cash or traded in futures contracts.
  5. CURRENCY is a system of money in the form of cash or notes. The currency market trades different currencies to profit from trading fees and differences in interest rates.

Inclusions

The following inclusion criteria direct the search for reputable candidate funds desired by most individual investors:

  1. Passively managed ETFs typically charge lower fees than actively managed ETFs and likely outperform actively managed funds over long time-periods.
  2. U.S. listed ETFs comply with SEC regulations, U.S. stock exchange rules, and the U.S. tax code.
  3. One of these Asset classes: Equity (stocks), REIT (real estate), or Fixed Income (bonds).

Refine your inclusion criteria by selecting reputable indices and desired market categories.

Exclusions

The following criteria should be excluded by all but the most adventurous investors!

  1. Exchange-traded notes (ETNs) are not ETFs.
  2. Closed-end funds (CEFs) are not ETFs.
  3. Leverage and inverse ETFs are very tricky investments.
  4. Actively managed ETFs charge higher fees in order to create porfolios that outperform or underperform a market index.
  5. These asset classes:
    Alternatives (imitation hedge funds)
    Asset Allocation (actively managed mix of assets)
    Multi-Asset/Hybrid (diversified asset classes)
    Volatility (exposure to volatile market)
    Commodities (potential tax burdens)
    Currency (potential tax burdens)

Reputable index

All ETFs compete on the basis of an Index they use to design an investment portfolio. Some Indices make better measurements of market performance than others. Beware that some Indices measure untested markets. Generally speaking, the best-in-class ETFs use reputable market indices. One way of choosing a reputable index is by selecting a long-standing, oft-quoted Index provider or Index name.

Index providers are companies that specialize in measuring market performance and selling the information to financial institutions. Table 1 provides a sample of reputable Index providers.

Table1

Category and Index names

Asset Classes have unique categories. Each category may be measured in a variety of indices listed in Tables 2-4.

table2

 

table3

 

table4

Rating the candidates

By now you should have several ETFs that could satisfy your investment goal. Verify that they belong to the same category, then assess their suitability based on the following critera:

  1. Net assets, Total assets, Assets Under Management (AUM), or Market cap AT LEAST $1 BILLION.
  2. Inception date AT LEAST 5 YEARS AGO
  3. Expense ratio BELOW 1%, LOWER IS BETTER AMONG COMPETITORS
  4. Legal structure PREFERABLY “OEIC” OR “UIT” (table 5)
  5. Number of holdings CONSISTENT WITH THE MARKET INDEX.
  6. Tracking error, LOWER IS BETTER AMONG COMPETITORS
  7. Premium (Discount), LOWER IS BETTER AMONG COMPETITORS

The finishing touch

It’s a good idea to review the Annual Report of your selected ETF.  Your potential tax burden is determined by the ETF’s legal structure, its portfolio turnover, and your tax accountant’s hourly fees.

table5

Copyright © 2016 Douglas R. Knight


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