The #1 Investing Rule (by Nasdaq)

Why the #1 Rule is the #1 Rule
But You Still Have to Take Some Heat

With the market having hit a pothole last Wednesday and Thursday, it’s a good time to review what I consider the #1 rule for growth stock investors–cutting losses short. Interestingly, I remember a conversation I had back in 2003 with Carlton Lutts, our founder and a great investor, asking him what he thought was the most important “rule or tool” (as we call it in-house) and he said it was letting winners run. That was classic Carlton; without some big winners you’re never going to make any big money in the market, which I totally agree with. But I still think that protecting capital is the first step, at least for the vast majority of investors.

No matter what rule you’re talking about, though, most investors only learn to follow it after being burned a few times. I can’t tell you how many emails I’ve gotten from subscribers that say something like “Man, it took me a few years to really appreciate it, but after riding a bunch of stocks down 50% or 60%, I’ve finally learned to let stuff go quickly when it’s not working out.” As an advisor, that warms my heart because cutting losses is really the quickest and easiest thing you can do to improve your results. I’ve seen it dozens of times.

However, in this Wealth Advisory, I wanted to explain why cutting losses is so vital … but also why taking the idea to an extreme can be counterproductive. And, of course, I’ll also tie in some dos and don’ts when it comes to setting your loss limit.

But first, let’s start with why cutting losses is important. It all revolves around the Loss Curve, which displays just how unfair investing really is:

The bottom row refers to the size of the loss, while the left hand values refer to the amount needed to gain to get back to break-even.

Simply put, the more you lose—whether it’s a single trade or the value of your overall portfolio—the harder it is to get back to break-even, never mind set new highs. A 10% loss isn’t hard to recover from, relatively speaking; if your $10,000 turns into $9,000 (a 10% drop), you have to make 11.1% on that remaining money to get back to even.

Yet as the losses steepen, so does the recovery necessary to get your money back. A 20% drop means you have to make 25% on what’s left to get back to even; if you hold onto a 25% loser, it’s going to take 33% to return to where you were; a 33% drop requires a 50% gain; and a 50% loss means you have to double your money … again, just to get back to where you started. And from there, the numbers only get more daunting!

Now, if you’re a value investor who owns 25, 30 or 35 stocks, maybe the occasional big loss isn’t a big deal. But if you run a concentrated portfolio like I do (generally between 8 and 12 stocks when fully invested), a couple of 40% or 50% losers can be devastating, not just to your overall account value but possibly more damaging-to your psyche.

My experience is that investors who don’t routinely watch their risk and cut losses short spend a lot of time and energy simply trying to get back to some previous high-water mark in their portfolio. The classic example was 2008, which caused such major losses that most investors are still no wealthier than they were back in 2007; more than five years later many are just wishing to get back to that prior peak. But even in lesser downturns, too many investors let their portfolio fade by 15%, 20% or more, usually because they hold on to some stinkers, failing to get out when they should.

Of course, there are other reasons investors struggle (including poor stock selection, which I wrote about in my last Wealth Advisory), but I think the unwillingness to admit they’re wrong and take small losses is the #1 reason many investors put up poor returns. And that’s why cutting losses short is my #1 rule for growth stock investing.

Now, I’ve been writing about the value of cutting losses since I started at Cabot in June 1999, and thankfully many of you have listened, adjusted and benefited. But soon after somebody converts to making sure no loss gets out of control, I often get an email like this:

“OK Mike, I hear you loud and clear about cutting losses; in fact, I haven’t taken a loss of more than 10% during the past few months. Yet my overall portfolio has done nothing but head south during that time–it seems like all my trades end up in losses, even though I own some good stocks. Help!”

I often go back and forth for a bit and maybe chat on the phone to get a better idea of what he’s doing wrong. And eight times out of 10, the answer is that, instead of being numb to losses like they were before, they’ve become hypersensitive to them!

The classic example is the investor who does some research, likes a story and chart, and goes ahead and takes the plunge. Then, two days later, some analyst downgrades the stock or the market has a nasty selloff, and the stock falls a few points and he bails out; the stock didn’t hit his loss limit, but he gets nervous and sells.

Another pitfall is what I call the square-peg-round-hole problem when it comes to loss limits. Some investors will buy Home Depot, a relatively steady stock, and use a 10% loss limit. But then they’ll buy Netflix and use the same 10% loss limit … even though the latter stock is two or three times as volatile as Home Depot! The result is that many investors will get knocked out on what is effectively “noise”-the stock didn’t really do anything abnormal, but it forced the buyer out.

Both of these problems boil down to one fact: In the stock market, you have to be willing to take some heat. Nobody is going to be able to buy stocks that simply go up, up, up as soon as they take a position. Sure, you’ll occasionally catch a tiger by the tail, but as any trend-following investor during the past two years can tell you, there will be plenty of times a stock bobs-and-weaves for two or three weeks before getting moving.

Right about now, you might be completely confused; in the first section I told you that cutting losses is rule #1, but right now, I’m telling you sometimes people get into trouble by cutting losses too tightly. But the solution isn’t convoluted; the idea is to plan where your loss limit will be BEFORE you make the trade (and, secondarily, how you’re going to trail a mental stop) … but then be comfortable losing that amount if necessary, unless something clearly changes (market timing turns negative, etc.).

Many investors tell themselves they’re comfortable losing 10% or 12% or whatever the number is, but then once the stock falls 5% they’re panicking and want out. It’s kind of like the casual casino player who brings a wad of $700 to gamble with, but as soon as he’s down $250 after a bad run at craps, he heads to the bar … often just before the table turns hot. I can tell you that’s a big no-no, as you’ll end up owning a bunch of winners but will actually lose money on the trades because you forced yourself out too early.

Honestly, I could write for hours about things like stop placements, portfolio management and the like; in fact, I’m thinking one of my main presentations at the Cabot Investors Conference this August (email me for details) will be about those topics. For now, though, suffice to say that it’s vital to cut ALL losses short if you’re running a concentrated portfolio … but to also give stocks room to breathe for a few weeks as long as they don’t trip your pre-determined loss limit.

 

Morgan Stanley, Goldman Declare Global Recession Under Way

Goldman Sachs Group Inc. and Morgan Stanley economists joined the rush on Wall Street to declare that the coronavirus has triggered a global recession, with the debate now focusing on its likely length and depth.

A day after President Donald Trump conceded the U.S. slump alone is set to be “a bad one,” economists threw away their forecasts that the world could avoid tumbling into recession for the first time since the financial crisis.

 
 
 

Morgan Stanley’s team, led by Chetan Ahya, said a worldwide recession is now its “base case,” with growth expected to fall to 0.9% this year. At Goldman Sachs, Jan Hatzius and colleagues predict a weakening of growth to 1.25%. S&P Global added its voice to the chorus with a report expecting that growth would range 1% to 1.5%.

 
relates to Morgan Stanley, Goldman Declare Global Recession Under Way

Such slumps would not be as painful as the 0.8% contraction of 2009, as measured by the International Monetary Fund, but they would be worse than the downturns of 2001 and the early 1990s. Both Morgan Stanley and Goldman Sachs anticipate a rebound in the second half, but warn that the risk remains of even greater economic pain.

The projections will apply further pressure on policy makers to do more to limit the health emergency and to deliver stimulus that helps companies and consumers through the shock and then drives a rebound in demand afterward.

What’ Bloomberg’s Economists Say…

“We are downgrading our forecast for China’s 2020 growth. Our previous forecast for the year was growth at 5.2%. Our new forecast is 1.4%. That includes a 11% contraction in the first quarter.”

— Chang Shu, David Qu and Tom Orlik

For more, click here

Data already show the virus’s effects: Investor confidence in the German economy plummeted to levels last seen during the European debt crisis, while U.S. retail sales fell the most in a year in February even before coronavirus containment measures began rippling through the economy.

Read more: Retail, Factory Data Show Fainter U.S. Economic Pulse Pre-Virus

American jobless claims for the week ending March 14, due for release Thursday, will probably jump to the second-highest level this year, according to the median estimate in a Bloomberg survey, and are likely to rise further in coming weeks.

Although the Federal Reserve and fellow central banks have been active in loosening monetary policy, most governments have been slower to respond and are only now crafting fiscal packages that may still fail to pacify worried investors.

Global Easing in 2020

Central banks across the world have cut interest rates this year

“While the policy response will provide downside protection, the underlying damage from both Covid-19’s impact and tighter financial conditions will deliver a material shock to the global economy,” Morgan Stanley’s economists said.

The outlook could darken even further if the virus lasts longer than anticipated, or wields greater economic pain — given factories, schools, restaurants and shops are closing around the world. A freezing up of markets or a continued sluggishness by governments to act are also regarded as threats.

Elsewhere on Wall Street, strategists are laying out what governments should be doing.

At JPMorgan Chase & Co., John Normand advocated developed economies repeating their handiwork of the crisis when they delivered fiscal stimulus worth 1% to 2% of gross domestic product. George Saravelos, a currency strategist at Deutsche Bank AG, said governments may also need to step in to guarantee support for households and companies.

Economists have been ratcheting back U.S. growth estimates for first half

In Washington, Treasury Secretary Steven Mnuchin said the administration is pushing to send direct payments to Americans within two weeks, sending stocks higher at midday. He also said individual taxpayers can get a deadline extension.

READ MORE

S&P Global also said Tuesday that the severity of the blow from the outbreak means the world’s largest economy is entering recession, if not already in one. The hit to consumer spending and business investment, plus the oil price damage to energy infrastructure investment likely means a 1% contraction in first quarter and 6% contraction in the second, U.S. Chief Economist Beth Ann Bovino said in a note.

Predictions for the U.S. still vary wildly, with some guessing activity could even decline as much 10% on an annualized basis in the three months through June. Goldman Sachs is penciling in a 5% dive after zero growth in the first quarter.

Example of an Investment Pie Chart

Financial Pie Chart, Investment Pie Chart, Pie Chart, How to use a pie chart while investing, Typical Investment Pie Chart, 401K Pie Chart

Don’t Trust a Pie Chart to Test Investment Diversification

When the next market downturn comes, many investors who think they’re protected may be surprised. Merely being invested in different types of stocks and bonds isn’t good enough anymore.

It is hard not to be confident. But with confidence also comes complacency … and now is definitely not the time to be complacent. We meet with investors every day and ask some basic questions to identify whether I can provide any value to the current situation.

“What is your current strategy to help mitigate investment losses?”
“Can you show me some specific examples of diversity within your portfolio?”
“What is the maximum loss of money you can tolerate at this point in your life?”

These are just a few examples of how I learn about potential client priorities as well as the missing elements in their existing plans. Most investors point to a “pie chart” found on the first few pages of their quarterly statements. Sometimes they have several statements from several different companies, each with their own pie chart.

The Pie Chart Problem

What do all those slices of pie really mean? Do more pies, and more slices, imply greater diversity?

It is important to understand that diversification isn’t designed to boost returns. Unfortunately, for many investors, the pie chart can be misleading. The goal of “diversification” is to select different asset classes whose returns haven’t historically moved in the same direction and to the same degree; and, ideally, assets whose returns typically move in opposite directions. This way, even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much. Thus, you can potentially offset some of the impact that a poorly performing asset class can have on an overall portfolio. Another way to describe true diversification is correlation. We want to own asset classes that are not directly correlated.

Unfortunately, even though a pie chart may make it look like an investor is safely diversified, it’s probably not the case. They are probably much more correlated to the market than they realize. Making matters worse, investors with multiple different families of mutual funds often own the exact same companies across the different families. We call this phenomenon “stock overlap” or “stock intersection.” You may own 10 different mutual funds, but the largest holdings in each fund are the same companies.

There was a fascinating study done in the late 1970s by Elton and Gruber. They concluded that a portfolio’s diversity stopped improving once you had more than 30 different securities. In other words, increasing from one or two securities up to 30 had a big improvement. Increasing from 30 all the way up to 1,000 different securities didn’t materially improve the portfolio’s diversity.

Consider that the next time you open up your quarterly statement. How many mutual funds do you really own? How many individual stocks are inside all of those mutual funds?

How about overseas? Again, Morningstar data shows that back in the 1980s there was a low correlation (0.47) between U.S. equities and international equities. That correlation has steadily increased to 0.54 in the 1990s all the way up to 0.88 in the 2000s.

The biggest challenge for most investors is finding an adviser with extensive experience.  If your portfolio is market based, and you are hoping your “pie chart” is going to save the day, now is not the time to be complacent. Dedicate some time and meet with one of our independent financial advisors with experience working with all asset classes.

Reasons ETFs Are Better Than Stocks

Reasons ETFs Are Better Than Stocks

When it comes to financial situations, everybody’s story is different. Investors have a plethora of information and investment choices at their finger tips. ETFs are relatively the new kid on the financial block but have quickly gained recognition as a must have investment vehicle.  There are some significant advantages to ETFs as compared to stocks and mutual funds for investors to consider.

ETFs Give Instant Diversification

ETFs provide instant diversification relative to individual stocks. It would be challenging to have a properly diversified portfolio with 10 individual stocks, but relatively simple with the same number of ETFs.   For example, purchasing an ETF that tracks a financial services index gives you ownership in a basket of financial stocks versus a single company.
As the old cliché goes, you do not want to put all your eggs into one basket. An ETF can guard against volatility (to a point) if certain stocks within the ETF fall. This removal of company-specific risk is the biggest draw for most ETF investors over owning individual stocks.

Less Due Diligence

Most ETFs contain dozens of stocks. It would require weeks for an individual investor to complete proper due diligence on each of those companies, and that is one of the advantages of ETF investing. Since the importance and impact of any one stock is relatively small, our investment team can spend their time researching which sectors and markets are poised to perform and make investment choices without being bogged down by an overwhelming amount of initial and ongoing corporate due diligence.

ETF Portfolio Benefits

ETFs are baskets of individual securities much like mutual funds but with two key differences. First, ETFs can be freely traded like stocks, while mutual fund transactions don’t occur until the market closes. Second, expense ratios tend to be lower than those of mutual funds because many ETFs are passively managed vehicles tied to an underlying index or market sector. Mutual funds, on the other hand, are more often actively managed. Because actively managed funds don’t commonly beat the performance of indices, ETFs arguably makes a better alternative to actively managed, higher-cost mutual funds.

Might Be Cheaper

ETFs can be cheaper to own and trade when compared to stocks or mutual funds. Research Financial Strategies offers a popular portfolio model of ETFs that trade commission-free. That gives them a positive cost advantage relative to individual stocks. Many ETFs, particularly index-type ETFs, have lower annual expenses than comparable mutual funds and can be cheaper to hold.
Read more: See ETFs vs Mutual Funds

No Minimums

Although it is possible to discover mutual funds with low minimum initial investment requirements, ETFs have no such requirements at all.

Invest In Hard-to-access Markets

Obtaining, storing and long term owning gold is a difficult task for most individual investors; owning a gold ETF is simple. Not only does a ETF bypass the bid-ask spreads of retail gold and the expense of rolling over futures contracts, but it has no security or storage requirements. Likewise, investors can access commodities like copper, precious metals, timberland and so on through the convenient forms of ETFs.

 

The Bottom Line

There is no such thing as a perfect investment. Still, ETFs do stand apart as an investment category with some real positives for individual and corporate investors. As a cost-effective way of achieving a broadly-diversified portfolio including hard-to-own (but worthwhile) assets, ETFs are hard to beat. Accordingly, investor will most likely find that ETFs can play a useful role in place of a portfolio of mutual funds, stocks and bonds.

Target Date Retirement Funds

Retirement Advisor

Target Date Retirement Funds

Most target-date fund managers won’t even invest in their own funds.
Should you?

Making investment decisions for retirement can be a daunting exercise for most people.  Future retirees will need to make a variety of choices, including how to balance the desire to increase their investment returns vs. the risk of losing money.
That being said, future retirees must also keep in mind that inflation may reduce the purchasing power of retirement savings and a spouse or partner may live longer in retirement than expected.  Realizing these facts, a number of mutual fund companies who participate in 401K plans offer “target date retirement funds,” sometimes referred to as “target date funds” or “lifecycle funds.”

Target date funds, which are usually mutual funds, hold a mix of stocks, bonds, and other investments. Over time, the mix gradually shifts according to the fund’s investment strategy. Target date funds are designed to be long-term investments for individuals with particular retirement dates in mind. The name of the fund often refers to its target date. For example, you might see funds with names like “Portfolio 2030,” “Retirement Fund 2030,” or “Target 2030″ that are designed for individuals who intend to retire in or near the year 2030.  Most target date funds are designed so that the fund’s mix of investments will automatically change to become more conservative as you approach the target date. Typically, the funds shift over time from a mix with mostly stock investments in the beginning to a mix weighted more toward bonds.

Most Target-Date Fund Managers Won’t Even Invest In Their Own Funds!!
Morningstar recently reported the stunning fact that “…only three (target-date mutual fund) managers invest more than $1 million of their personal assets in the target-date mutual funds of the series they manage. More than half of the industry’s target-date series are run by mutual fund managers who have made no investments in the target-date funds they oversee”.
Ponder that statistic for a moment. If the majority of fund management won’t even invest in their own target-date retirement funds….why should you?

read more: The Drawbacks Of Target Date Mutual Funds

Target date funds are becoming a staple option through employer sponsored 401K plans. More and more 401K plans use these funds as the default investment for plan participants who have not selected their investments under the plan.  Once you select a target date fund, the managers of the fund make all the decisions about asset allocation.

"...Their Returns May Be Very Disappointing"

“Target-date funds don’t necessarily mirror the performance of the larger stock and bond markets. Instead, their returns depend on the mix of their individual portfolios, and in some years, their returns may be very disappointing.”   – NewYorkTimes.com

Evaluating a Target Date Retirement Fund

As with any investment, evaluate a target date fund carefully before investing. The target date may be a useful starting point in selecting a fund, but you should not rely solely on the date when choosing a fund or deciding to remain invested in one.  You should consider the fund’s asset allocation over the whole life of the fund and at its most conservative investment mix, as well as the fund’s risk level, performance, and fees.  This information is available in the fund’s prospectus.

As noted above, funds with the same target date may have different investment strategies and levels of risk.  These variations may occur before the target date, and also at the target date and after it.  Some target date funds may not reach their most conservative investment mix until 20 or 30 years after the target date, as shown in Example 1 below.  Others may reach their most conservative investment mix at the target date or soon after.

For The Fiscally Apathetic

Target-date retirement funds tend to be pretty conservative in nature. These funds were designed not so much to make you rich as to keep your investments relatively safe.
Comfortable, but too cautious for many younger investors especially.  It is basically the “set it & forget it” retirement investment choice for the fiscally apathetic.

Target date funds also may have different investment results and may charge different fees, even with the same target date.  Often a target date fund invests in other mutual funds, and fees may be charged by both the target date fund and the other funds.  Keep in mind that a fund with high costs must perform better than a low-cost fund to generate the same returns for you.  Even small differences in fees can translate into large differences in returns over time.

You should also consider how a target date fund fits in with your other investments.  If you have other stock, bond, or mutual fund investments, you should carefully examine your overall asset allocation.

In summary, before investing in a target date fund:

  • Consider your investment style.  Do you want to play an active role in managing your investments, or do you prefer the more hands-off approach of a target date fund?  Keep in mind, however, that even with a target date fund, it is important to monitor the fund’s investments over time.
  • Look at the fund’s prospectus to see where the fund will invest your money.  Do you understand the strategy and risks of the fund, or of any underlying mutual funds held as investments?
  • Understand how the investments will change over time.  Are you comfortable with the fund’s investment mix over time? In particular, make sure you understand when the fund will reach its most conservative investment mix and whether that will occur at or after the target date. Does your level of risk tolerance match how aggressive or conservative it is?
  • Take into account when you will access the money in the fund.  How does the fund’s investment mix at the target date and thereafter fit with your plans for the future, whether they are to withdraw your money at retirement, or to continue to invest?
  • Examine the fund’s fees.  Do you understand the costs for both the target date fund and for any mutual funds in which the target date fund invests?
  • Consult a financial advisor.  Don’t fall into the trap of selecting the easy fund choice. Research Financial Advisors can help you select the proper investments to guide you towards a successful retirement.

Both before and after investing in a target date fund, consider carefully whether the fund is right for you. It might not be.

So, should you invest in your employer’s 401K account if you’re confused and looking for help with your retirement?
Consulting with a professional investment advisor at Research Financial Strategies will help you to make important 401K decisions.  
Research Financial Strategies offers ongoing management (401K advisor) of your employer 401K or government TSP.
Our years of experience will help navigate your 401K toward your retirement goals.
Contact us for a 401K 2nd opinion

read more:  The drawbacks of target-date mutual funds

 

Source:  www.investor.gov

 

 

 

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