11 Practices for Lasting Investment Success - (2/3)
"How do you know when to sell your investments?" I once asked a student trainee. I personally love coaching trainees at my workplace, seeing their potential to become great investment advisers after they graduate from school.
"I set a price target and sell when it is reached!" the young lad said confidently.
"Okay, so what happens if after you buy in, the price just keeps falling?" I asked.
"I'll average down by buying more at that lower price!"
"And what if you run out of spare funds and the price just keeps falling or staying down?"
"Well..." he said, stammering.
Knowing when to sell your investments is crucial for every investor. If there's one thing you can take away from this part 2 of 3 series, it's on how you should decide to sell.
Yet like other pursuits in life, before we understand how, we need to understand why. Many people start thinking about why they should sell their investments only after they have started falling. That's not good!
Every great investor considers under what conditions they will sell their investments before they even enter. And they know clearly why they want to have this consideration beforehand.
So why is it important you have this as your practice too? Let's find out from these next 4 practices needed for lasting investment success.
4. Always Think One Step Ahead
In part 1, we learned that the steadily moving tortoise beats the hare - this means it is extremely crucial we have planned actions just in case our decisions turn out wrong so that we can continue reaping returns over time no matter what (instead of getting kicked out of the game). To do so, we need to always think ahead. If scenario A happens, what will we do? If scenario B happens, what's the plan?
Too many possibilities? To avoid overwhelm, drop everything and just make sure that even in the worst-case scenario you can still do one or two things to navigate yourself back into profit. This is the top priority.
So how do we come up with this action plan? Well, first we have to know what not to do. The last thing we want to plan for is an action that makes us stray away from our original working investment strategy. Remember (from part 1 again) that we want to make our strategies work instead of dabbling.
Therefore our next action step must keep to the same original working principles that we first base our investments on. If our next steps fall back on such working principles, we give our investments a good chance of eventually working. If we stray away from them, we leave things entirely to luck.
What are some working investment principles then, you may ask? Well, there are too many examples. In the context of quantitative investing, this means you do not deviate from your model. If it was a good model, it would have already been based on sound principles when it was first created, so just stick to it.
What about buy-and-hold strategies? Well, many principles apply, but not to worry. There are only two "motherhood" principles we must pay attention to - effective diversification and rebalancing.
5. Diversify Effectively
The last time I mentioned diversification to a couple, the gentleman looked bored. He probably heard this a million times. He picked up his ice latte, trying to hide his bored expression with his drink. But his wife sitting beside him looked delighted. "It's always good to have more things to spread our investments about," she said, trying to encourage her hubby.
Well, the advising did take me a little longer to complete that evening, because both individuals held these 2 common misconceptions about diversification that needed to be addressed:
Buying into more things definitely lowers your risk.
Diversifying always lowers your returns.
These are not wrong ideas. It's just that they are almost always misunderstood.
Here's how. Diversification is not about buying into different things. It's not just that. The key is that these things must be able to move differently, especially when your view of the market turns out wrong.
Let's take for example a buy-and-hold portfolio of stocks that buys into CapitaLand, DBS, Mapletree, Singtel, and other Singapore blue chip stocks and REITs, because your view is that the Singapore market will go up, or at least consistently pay out at its current dividend rate, for the next 5 years. What happens when the time your view turns out wrong eventually arrives? All your stocks and REITs would likely fall steeply together. This defeats the purpose of diversification, doesn't it? This way of diversification does not lower your risk much at all.
When we diversify, we need to diversify across things that behave differently. Use bonds, gold, defensive sectors, and even cash as an asset class. If you have a whole other strategy that also goes up in the long run and yet performs differently during bad times, even better - run it together (*coughs* VRP in Multi-Strategy)! Diversifying across things that move differently is a must.
But you might ask - doesn't this lower my returns? To use things like bonds and gold more in place of stocks? Well, that would only be true if your plan was to hold a similar allocation to everything for a long... long time. No, that's not the way.
We need planned flexibility in our diversification. For example, since market crises tend to occur only once every 5-8 years (sometimes longer), for our buy-and-hold portfolios, nothing stops us from having a plan that holds equity as the largest portion of our portfolio for most periods of time, providing us good returns.
Yet at the same time, we must prepare beforehand to adjust our equity weightage towards the other asset classes, especially in cases when the probability of market crisis rises. How strictly the rules are defined for the investor to detect and carry this out depends on his/her chosen strategy. Different strategies have different strengths and weaknesses. In quant strategies, these rules and triggers are all embedded into the model.
More importantly, no matter what the strategy, we should all have the deliberate intention to have different things in our portfolio and move our money across them, otherwise it is all for naught. There is no single mythical allocation formula that works like a miracle for 20 straight years without needing any adjustments. Even index funds that track the S&P500 can fall -50% and take 5 whole years to recover. The NASDAQ took 15 years to recover after the DotCom bubble burst.
Many investors struggle with this because we all hope everything we put our money into makes us +1000% over time without us having to touch them. But while effective diversification is pre-planned, it must also be flexible.
"Be like water..." said the late Bruce Lee. Water doesn't change its own properties, yet it can take on any shape or form to adapt to the container that newly holds it. It's the same for investing. The wise are masterful at adapting to change.
"Da Wei, you've got to tell me when to sell, okay? I trust you!" Derrick says.
"Derrick, your Nio stock has earned enough, We're not at the peak and there's no clear sign it will drop substantially, but let's just exit Nio first. There are more attractive stocks we could use," was my answer to this client.
"Ah... but Nio's such a good company! Its stock has been doing so well and its electric cars stand out. I think it'll be fine if I hold on to it for many years," he said.
"No, we've got to go," I insisted. "Let's exit."
"Why? Since you said there's no clear reason Nio would drop..."
I said to him, "It's not a matter of what we think or what has happened. It's all about committing to good habits."
Such is the case for rebalancing.
When it comes to when to buy and sell, a very significant part of the consideration is due to the vital practice of rebalancing. The importance of rebalancing is often misunderstood though. Some investors think that rebalancing is important because it helps us take profits when the market is up and buy at lower prices when the market is down. Others argue that rebalancing just helps you buy losers and sell winners, doing little to increase returns vs. just buying and holding.
While both viewpoints seem reasonable, neither are entirely convincing. Yet would you be surprised if I told you dutiful rebalancing somehow counters every investor's natural tendency to buy high and sell low? Turns out investors who commit to regular rebalancing have a habit to fall back on which breaks them out of the cycle of investor emotion! It might not help you significantly beat the market, but it sure reduces the chances of you making emotional errors and losing to it.
How do we rebalance dutifully then? First, we need to diversify effectively to have things to rebalance into. Then we need to have thought a step ahead on what to do if a particular portion of the portfolio moves to a certain extent, say -20% or +20%, and then make our trades, including selling, as pre-planned accordingly. These are essentially the two practices above. In quant investing, these are again embedded into the model.
Rebalancing is a crucial habit for every investor. Don't underestimate it! It helps us in surprising ways more often than not.
7. Acknowledge Good Luck, Appreciate Forced Exits
As we finish up part 2 of this series, I want to pose you this question. Have you had investments that did surprisingly poorly and others that did surprisingly well?
Interestingly, as we do rebalancing there will be times when we take profits from surprise, 'bonus returns'. These can come from positive hype for our stocks or things like sudden mergers and acquisitions. Acknowledge these as good luck and commit your partial/full sales where necessary. Let them benefit you, and let’s all remain in humility.
On the other hand, sometimes we may have investments we, unfortunately, need to exit at a loss, say a stock whose company lost its operating license, or a sector that will not have its usual edge for a while due to a pandemic. These are situations of forced exits, which happen every now and then for the investor.
These are all part and parcel of investing. Nobody has a perfect streak of luck. Appreciate these forced exits, for they are essential in making temporary your losses so that you can move towards an honest recovery sooner rather than later.
All great investors acknowledge luck, both good and bad. This helps make great investors great, for good responses can only follow after acknowledgment.
If you've read till here, great job! By now you should be more equipped than ever.
But we're not done yet. To complete the picture, great investors also focus on skill, are discerning, plan their finances well, and cherish one more little thing. Stay tuned for part 3!
(This article has been edited for AllQuant’s audience. The original version is on my LinkedIn.)
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