Repeat Until Broke

by gilch4 min read13th Aug 20203 comments

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Financial InvestingWorld Optimization
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Part 2 of the Inefficient Markets sequence.

[Educational purposes only! I am not your financial advisor! Read part 1 first.]

Knowledge, learned in the wrong order, can be dangerous. Before I teach you how to trade, I will teach you The Three Laws of Averting Ruin. To learn how to not lose money, you must first understand how you lose money, and then not do that.

They say the basic idea in trading is to buy low and sell high. (Not necessarily in that order.) Then you have more money than you started with.

It sounds so simple. But it isn't that easy in practice.

You see a stock on its way up on the chart. The company must be doing something right, right? You put in your order and BUY some of the action. It goes up a bit more the next day. You're feeling pretty good. Then it turns around and dips below your starting price. But you believe in the company. This is temporary. It falls some more the next day. You're in denial. You hold on. It gets worse. This company sucks! SELL!

You jumped out at the bottom. The stock recovers. You bought high and sold low. You have less money than you started with. You'd have been better off buying and holding, riding out the storm.

And you do it all over again the next week.

You seem to get greedy near the peaks and fearful near the troughs.

Maybe you get a little smarter and switch to a paper account. Or maybe not. Maybe sell when it's going up and buy when it's going down? It doesn't seem to matter. Alas, reversed stupidity is not intelligence; it's never that easy. It's like the market is out to get you. "This is impossible!" you say. Trading is just not for you.

You're doing it wrong.

The First Law of Averting Ruin

DON'T PANIC!

The man who prospers in a gold rush isn't the man who works hardest digging; it's the man who sold him the shovels. Be the wiser man.

About the fastest way I know of to lose money trading is by trading too much too quickly. Every time you trade, you pay your broker commission. Every time you trade, someone is taking the other side of the deal. If you want the trade NOW, you're taking the offer of someone else who was waiting for a slightly better deal. There is always a spread between the bid and the ask that is not in your favor. If there weren't, the trade would have already happened.

A trade has costs, and they are certain. A trade may eventually have profits, but they are not certain. If you give up on a trade before it has enough time to work, then only costs remain.

Who is digging, and who is selling the shovels?

Emotions are not necessarily irrational. But when you are trading, they are.

The markets are too abstracted from your caveman instincts or your everyday experience. Maybe someday, when you are very experienced, you will be able to trust your gut when trading. But maybe not even then. Markets change. You certainly can't now.

Don't misunderstand, the First Law of Averting Ruin is not a law of physics. "DON'T PANIC" is not a magical talisman that will protect you from harm. It is not about guessing the teacher's password. It's a pithy mnemonic device. If the iron approaches your face, and you believe it is cool, and it is hot, the Way opposes your calm.

The point is not to be in denial, as if that could help. It's not about suppressing your emotions when you have them; it's about taking your emotions out of the picture in the first place. Your System 1 does not know how to trade, so you must use a different system. I don't just mean your system 2, I mean that you must trade systematically. You will develop rules in advance while you can still think rationally, and then you will follow them instead of your emotions. Ideally, you will program a computer to follow the rules for you, and then all you have to do is write the rules and make certain the computer is working. But you can do the trades yourself, as long as you follow your system.

A system will have rules set up in advance to get you in and out. You know when to take profits, and when to cut losses. You DON'T PANIC because you have a contingency plan set up to handle surprises.

A Very Basic System

Buy low/sell high is not quite the right way to think about it.

Suppose you put half of your account in a stock index exchange-traded fund SPY, for example [an example, not financial advice!] and the other half of your account in a bond ETF, like TLT.

There is a noticeable negative correlation between these assets. This is because when stocks aren't doing well, people move their money into the less volatile bonds. It's a "safe haven" asset.

Contingency: Suppose SPY goes up a fair amount while TLT falls a bit. Your portfolio value is now weighted 60% SPY and 40% TLT. If you rebalance to 50/50, you must BUY TLT low, and SELL SPY high.

Contingency: Suppose the stock market drops a bit more quickly than people expected it might. They get scared and move to safe havens, so bonds go up. Your portfolio is now weighted 40% SPY and 60% TLT. If you rebalance to 50/50, you must BUY SPY low, and SELL TLT high.

Notice that by using two assets instead of one, and a simple balancing rule, you are buying low and selling high, but when you tried to guess what an individual asset would do, you couldn't.

A surprising insight about the market: it's easier to predict the relative performance of two assets than one asset alone. There are deep reasons for this.

Contingency: Suppose SPY crashes really hard. Now even the brokers get scared and require more collateral from their customers who like to take risky bets with borrowed money. They all have to sell their bonds at once to cover their margin, so TLT also crashes. (This happened recently during the corona crash.) Someone who knows not the Laws may get scared and bug out. You DON'T PANIC. There is nothing fundamentally wrong with the bonds right now. Jumping off at the bottom is a sure way to lose money. Once the bonds have been liquidated by the traders that needed fast cash, they recover very quickly, because they're in demand as a safe haven asset. Rebalance. You sell some TLT high and get some SPY on sale.

Contingency: Stocks and bonds both go down and diverge a little bit. You're not quite at 50/50. You DON'T PANIC because you don't need to do anything. Don't be afraid to trade when your system calls for it, or when you hit a trigger (that you set in advance) that proves your assumptions wrong, but don't overdo it either. Trading always costs money, it just sometimes makes more than it costs. Wait for it to diverge more. How much? Decide in advance. It depends on a lot of factors. What are your costs? How granular are shares compared to your account size? This is one of those decisions that doesn't have to be too exact. 10% is probably reasonable.

Congingency: They both go up. Profit. They both do appreciate over time, so both going up at once must happen more than the reverse.

This is a stupid-simple trading plan. It's not even a bad plan, in that it's way better than not investing at all, or trading emotionally. Maybe you already have a plan at least this good. But we can do so much better.

Remember

System 1 can't trade. You need a new system. Make a system you can trust, and then trust in your system. Don't jump off at the bottom. Don't trade too much. You must have a plan for surprises, so you DON'T PANIC.

The Second Law is up next.

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