I want to start today's article with a quick survey.
Don't worry; it's going to be short, only a couple of questions, and you're the only person who is going to know your answers. So improve your investing savvy and answer honestly.
It might just help you make a lot of money - and sleep better at night...
First question: When the markets hit a rough spot this last March, did you start selling your stocks? If the answer to that question is "yes," what methodology did you use to justify your selling?
Second question: If you did sell your stocks, what methodology do you now plan on using to know when it's time to buy again?
Here's a quick hint: Unless you can quickly answer both of those questions without having to think about it, the answer may be "none" or "no methodology."
Don't feel bad; every investor (including yours truly) has, at one point or another, made an investment decision without a clear plan (or methodology behind the decision).
Here's why that can be such a bad idea, and here's how to tap into the tremendous profits out there if you break out...
What Most Investors Do Wrong
According to Barron's, a whopping 85% of all investor "sell" or "exchange" decisions are wrong. Yikes!
The cycle typically looks like this...
The market starts to sell off (for any number of reasons), investors get spooked and sell their stocks right at (or just before) the point of maximum pessimism (which usually is very close to the bottom).
Once they're out of stocks they take their cash and plow it into safe assets like bonds just in time to miss the beginning of the next leg up in stocks. Once their capital is invested in bonds, they have no idea when to shift back into stocks, mainly because of an emotional bias that leaves them too frightened to take on risk.
If that sounds familiar, again, don't worry - you're not alone. Everyone has made this kind of mistake at least once. We'll just make sure it doesn't happen again.
Instead of using market pullbacks as an excuse to bury your head in the sand and catch up on Dancing with the Stars episodes, you can step up your due diligence to create a buy list of your next investment targets.
At first it might seem uncomfortable to be preparing to buy stocks in the face of uncertainty - but don't worry - you're going to be in great company. Warren Buffett, Jim Rogers, and John Templeton all made their fortunes targeting stocks once they were put on sale by market volatility....so let's follow their lead.
Here are two steps you can take that will not only give you an answer to the questions at the top of the this article, but will also let you use market volatility to your advantage, which is exactly what professional traders do every day.
Set Your "Sell" Plan, Before You Buy
The first step: Always make sure you have an exit strategy (or plan regarding when you'll sell) before you hit the "buy" button. This will ensure that you're always making predetermined strategic decisions rather than emotional decisions.
Most people think of trailing stops as a way to protect their downside. While they are great at minimizing losses, they really shine in capturing profits. As your position increases in value, simply tighten up your trailing stop to increase your potential profit.
Strategy Note: Your initial trailing stop and the amount to which you tighten your trailing stop is entirely up to you and should be based on your own risk tolerance. Personally, one of my favorite strategies is to: 1) begin with a 25% trailing stop, 2) once my position is up 30% I like to tighten my stop up to a 19% trailing stop, which makes my stop 5% over my entry price, 3) once my position is up 40% I'll tighten my trailing stop to 15%, 4) and once my position is up 50% I'll settle in with a trailing stop of 12.5% for the remainder of the holding period - or until I get to a 100% gain, which is when I'll start scaling out of the position.
Legendary investor Jesse Livermore summed it up simply and eloquently when he said "you never go broke capturing a profit." Exactly right, and that's why I like to tighten up my trailing stop along the way - especially the first move, which puts my stop 5% over my entry price.
It's worth mentioning, though, that once you tighten up your trailing stop, you do increase the risk of getting stopped out - but I'm totally okay with that because the tighter trailing stop also reduces my odds of letting a winner turn into a loser.
Livermore's second strategy is to sell half of any position once it achieves a 100% or more gain. Professional traders call this "scaling out" of a position. Livermore would refer to this simply as "playing with the house's money" because you effectively take your initial investment off the table and what you're left with is all profit - or the house's money.
The beauty of this strategy is that the freed-up capital created by scaling out of the position can then be used to establish a new position. If you do this a couple of time in a row, your initial allocation of capital can turn into several positions. It's a great way to build multiple positions with a single tranche of capital.
Just like trailing stops, you can choose to start scaling out of a position at any time. The key is that you know, in advance, when you plan on tightening up your trailing stops and when you intend to begin scaling out of a position.
Rebalance Your Profits
Moving on to the second step: rebalancing.
I can't emphasize enough how important it is to stay in the markets - and the best way to remain invested is to use the Money Map Report's 50-40-10 model.
In case you're not familiar with the 50-40-10, it is a risk-parity portfolio structure pioneered by Keith Fitz-Gerald, Chief Investment Strategist for the Money Map Report. Here's a quick rundown...
50% of your assets: invested in what we refer to as "Base Builders," which includes assets such as Vanguard Wellington Fund, sovereign debt, muni bonds, corporate debt, etc.
40% of your assets: invested in what we refer to as "Growth and Income," which are stocks with global exposure to some of the world's largest trends, solid cash flow, rock solid balance sheets, and an above average yield.
10% of your assets: invested in what we refer to as "Rocket Riders", which is where you'll find speculative positions such as small-cap stocks. History suggests that by limiting your speculative positions to just 10% of your overall capital, you maximize your potential return while at the same time keeping your overall risk to a razor-thin level.
Now let's get back to rebalancing.
If you're using a predetermined exit strategy like the example I discussed above (or any other predetermined strategy, for that matter), you will, at some point, find yourself with cash to re-deploy. When that happens, calculate the different allocations between the Base Builders, Growth and Income, and Rocket Riders to find out what portion of your portfolio is overweight and where it's underweight. Deploy your freed-up cash into whatever portion of your portfolio is underweight.
Let me give you a simple real-world example to clarify the above.
For the sake of this example, let's assume your entire portfolio is worth $1,000,000, with the following breakdown: $500,000 (or 50%) is currently in your Base Builders positions, $390,000 (or 39%) is currently in your Growth and Income positions, $100,000 (or 10%) in currently in your Rocket Riders positions, and $10,000 is sitting in cash due to your recent winning trade.
In the example above, both your Base Builders and Rocket Riders are in line, with 50% and 10% of your total portfolio, respectively - but your Growth and Income (at 39%) is a little below your target of 40%, therefore it's "underweight."
In order to bring your 50-40-10 structure back in line, you can redeploy your $10,000 worth of cash into an investment that qualifies as a Growth and Income asset and your portfolio structure will then be back to the desired 50-40-10.
If you don't want to redeploy the cash right away, that's fine. You can also wait for a predetermined time (quarterly, bi-annually, annually, etc.) and then rebalance all of your holdings at one time.
The key here is that it's a predetermined time - not a time based on your discretion, because that could leave you open to emotional biases, which typically work against you.
The beauty of rebalancing is that it takes all the guessing out of the equation because it forces you to sell the assets that have increased in value (and are subsequently overweight) and buy assets that have gone down in price (and are subsequently underweight).
That means you're following the golden rule of investing... buy low, sell high. And profit.