Disposition Of Army – Defensive Investing

May 14, 2013

Investing

Art of War - Defense

http://www.gamedynamo.com/

Art of War Chapter 4 Summary explains the importance of defending existing positions until you can advance them and how you must recognize opportunities, not try to create them.

Translation for investors:

  • Never lose money
  • Patience is a virtue

Asset Allocation

All too often I observe retail investors making a grave mistake with their portfolios. This mistake is improper asset allocation in regards to their investment portfolio. Contrary to popular belief asset allocation is equally important if not more important than the actual stocks you decide to invest in. The most common industry misconception in regards to proper asset allocation is the belief of having numerous stocks in portfolio in order to be ”diversified.” This belief leads investors to believe they can avoid catastrophic losses but this couldn’t be any farther from the truth. It is my belief that investors should focus on investing in the best and largest businesses at the right price instead of diving into numerous stock positions in order to feel a sense of security.
 
 
What is Proper Asset Allocation? – I can almost guarantee at some point in our lives we have known someone (or are guilty ourselves) who put a sizable amount of money into one stock and sustained a catastrophic loss. The headlines, the story, and background of the business or idea sounded great, but at the end of the day the market decided you were wrong! Remember Netflix? We are all familiar with the DVD/Media Streaming service. This stock shot up like a spaceship to the moon based on the revolution of cheap rentals, going from $100 to $300, it almost seemed like you couldn’t lose money. Unfortunately this Cinderella story ended badly, take a look…

NFLX

Trailing Stop Losses

I have a quick question for you, you don’t have to answer, it’s rhetoric. How many people do you know that have had some sort of asset (land, stocks, house, etc) and seen the value of that asset drop significantly only to hope and pray that it goes back up. Time and time again I witness this with family and friends like it’s a broken record. As investors and owners I know it is easy to get attached to your assets as you have spent a considerable amount of time and money acquiring them but the cold hard truth is not all assets are going to be profitable. Additionally when you “wait for things to turn around” you are causing more harm than good, the further into the hole you get the harder it is to climb out. Take a look at this chart that shows how your asset would have to perform in order to get back to break even after a significant loss.

Investment recovery

What is a trailing stop?

Technical Definition - A stop loss order set at a percentage level below the market price for a long stock position. The trailing stop price is adjusted as the price fluctuates.

Practical Definition - A predetermined percentage below your entry price that you are willing to lose. This could be 10%, 15% or 25% whatever you determine this will be your “pack up your bags and move on” price point. In other words, if the price falls below this price point it will set off an automatic trigger to sell. However, we all hope that the price of the stock moves upwards and when/if it does your trailing stop moves upwards as well. This mechanism allows you to do three things:

  1. It allows you to let profits run without selling your position too soon.
  2. Allows you to cut your losses early to prevent catastrophic loss to your portfolio.
  3. Literally takes all the emotion out of investing, which prevents you from making a drastic mistake.

Takeaway

A portfolio that utilizes both the tactics of proper asset allocation and trailing stops will have solid defense against stock market volatility. This will GUARANTEE that you never suffer significant loss to your portfolio. And yes I just guaranteed you that you can prevent significant loss to you portfolio. Here is how!

For this example assume you have a portfolio and at the moment it only holds $100,000 cash. There are two rules and they are absolutely non negotiable!
 
1. Do not place more than 5% of your capital into one position, PERIOD. No excuses
2. Emplace and adhere to a 25% trailing stop loss on ALL positions. No excuses
 
That is it, plain and simple.
 

“If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle”

- Sun Tzu

Based on this example you would have 20 different positions of $5,000 each if you were fully invested. Since you are adhering to a trailing stop of 25% you can lose no more than $1,250 on a  position.  Before you invest a penny you already know that if are wrong (and it will happen) you will lose 1.25% of your portfolio. Now on the highly off chance that we have a catastrophic disaster and all of your positions were to hit their trailing stops after you initially purchased all 20 positions then you would lose 25% of your portfolio. That is the ABSOLUTE WORST that could happen, not a penny more.

Do you currently practice asset allocation in your portfolio? How about trailing stops? Do you think the stocks you choose is more important than proper asset allocation?

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21 Responses to “Disposition Of Army – Defensive Investing”

  1. Troy Says:

    Great post, especially agree with you on the trailing stops. My asset allocation is built on a pretty wide base, although I do concentrate most of my money on a few investments.

    Reply

  2. David Says:

    Asset allocation isn’t nearly covered enough by textbooks etc and the 5% rule is a good one. I do use stop losses and trail them on a discretionary basis and they have saved me from disaster.

    Reply

    • Marvin Says:

      I agree David hardly anyone focuses on asset allocation when that should be one of the corner stones of your portfolio.

      Reply

  3. JC @ Passive Income Pursuit Says:

    I need to start including stop loss orders on some of my more risky positions. I’m not sure if I want to use them on some of the stable ones that I don’t see going anywhere but some of my smaller cap holdings should probably get some stop losses added for a just in case. I tend to shy away from them because when I purchase I try to make sure that I’m getting a really good value of course, things can change so this probably needs to be done.

    With a portfolio that is still growing I’m not too concerned with allocation at this point but I’m working a bit on it through new capital.

    Reply

    • Marvin Says:

      I definitely use trailing stops on my speculative positions as for my dividend positions I’ve found that taking into account the dividends the stock has paid me has given me a signficantly wide trailing stop that could only possibly be hit if we went through another great depression.

      Reply

  4. John S @ Frugal Rules Says:

    Good post Marvin! I wish I had a dollar for every retail investor I have spoken with who thought they were properly diversified by being invested in only 3 or 4 stocks. Then the kicker is to come to find out that they are invested in just those stocks in all of their brokerage accounts. It just makes me want to shake them. I do not currently use trailing stops as I’ve seen too many people use them and get burned. I do use stop losses though and follow the same mentality of keeping it in check so as to not lose my shirt.

    Reply

    • Marvin Says:

      Shake them indeed John! It’s amazing how confident some people are when they are standing on the edge of a cliff.

      I have personally been burned by using trailing stops, right as I stopped out of the position the stock turned higher. It was one of the most painful and frustrating experiences in my life. At the same time however trailing stops have saved me from losing significant amounts of money.

      Reply

  5. moneycone Says:

    If you’ve never set trailing stops, start with a tax deferred account. If a flash crash occurs and your securities get sold, even though you wish to keep them, you’ll pay a steep price in taxes.

    But this was a good read and every investor should consider these before investing.

    Reply

    • Marvin Says:

      Investing in a tax deferred acount could be a good strategy, but I think a 25% trailing loss would typically result in a loss and therefore you wouldn’t need to worry about paying taxes.

      Reply

  6. Martin Says:

    Marvin, this is so cool comparison to the art of war. Smart really. And I love it. It gives me some action thinking into otherwise boring dividend investing. Have you ever played Civilization game? I feel like starting comparing my investing into a battlefield :))

    Reply

    • Marvin Says:

      My name is Marvin Simms and I have been Civilization free for over 3 years! =)
      Seriously that game sucked up so much of my life, a game that I started around 5 pm could easily go into 2 in the morning. Now with a wife and two kids I rarely even get the chance to open up my laptop at home.

      You’re right when you compare investing to a battlefield it makes it much more interesting.

      Reply

      • Martin Says:

        Haha, LOL, but you won’t beat me in Civ playing time. When I was younger palying it many times we started at 5 pm and ended up at 6 am the next day and then we went to school. I hear you. It is amazing game. Let’ do the investing the same way! LOL

        Reply

  7. Greg@Thriftgenuity Says:

    I love the layout of these posts! I do use both asset allocation and stop loss. I feel a bit funny spreading the money out since I am still fairly young and likely have a lot less to spread at this point than others. Nonetheless, I do it for the same reason as others – to mitigate risk.

    Reply

    • Marvin Says:

      Thanks Greg. It is hard starting out in terms of asset allocation I would recommend building your full positions slowly over the course of a year.

      Reply

  8. Laurie @thefrugalfarmer Says:

    I love the way this guy speaks about investing. He puts it in simple terms so that even beginners like me can understand what he’s talking about. Thanks for sharing, Marvin!

    Reply

  9. Integrator Says:

    I need to be more vigilant with maximum asset allocation in any give position. I have some positions that exceed 5%, largely because of capital appreciation. When you start to have more than 100k overall in the portfolio, this is looking for trouble.

    Reply

  10. Michael @ The Student Loan Sherpa Says:

    What percentage of investors would you estimate use trailing stops?

    Reply

  11. Ryan @ RLD Investments Says:

    One of the best pieces of advice I ever got regarding investing was; don’t lose money. It seems pretty obvious but think about it this way. If I have $100, anything I make will be profit. But if I start off with a reckless investment and lose 50%, I now have to have a 100% ROR just to get even. How long do you think it will take me to double my money? Exactly. That’s why having a healthy respect for the potential downside of things is very important to a sound strategy.

    Reply

  12. Tommy B Says:

    This guy is a genius. Thanks for sharing, Marvin!

    Reply

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