Build your own index fund using blockchains

Another tool (in beta) for better managing money on your own, Prism lets you setup an index on your own. From  the post How Blockchains Will Disrupt Mutual Funds…You Build Your Own at Never Stop Marketing:

Prism is the world’s first trustless platform for creating portfolios of assets.

Designed and built by ShapeShift, Prism uses smart contracts deployed on the Ethereum network to bring custom portfolio management to everyone.

You can create and rebalance your own portfolio, as well as browse the public portfolios of others and follow them.

So that is exactly what I did.

Now, my one issue with the site (at the moment) is the relative limited number of coins that it supports. I had hoped to create a broader index of coins, but there are only about 25 or so coins (if you have ever used ShapeShift, you will see the exact same coins).

Look outside public markets for true diversification

From a post on diversifying from The Humbe Dollar, based on Harry Markowitz’s 1952 research paper on the subject.

For instance, he explained that the number of stocks you hold is far less important than the number of types of stocks you own. A portfolio of 60 stocks might appear to be diversified. But if all 60 are technology stocks, there is still quite a bit of risk. Today, this might seem like commonsense, but at the time it was a major revelation.

Markowitz ultimately won a Nobel Prize for his work, and there’s no question it was brilliant. Today, however, there’s even more you can do to manage risk in your financial life. Here are five ideas to help you think more comprehensively about diversification:

Diversify your tax rates
Diversify your investment products
Diversify your financial relationships
Diversify the timing of your purchases.
Diversify the timing of your sales.

While this post at the Humble Dollar focuses on public market investments, diversifying can be taken much further. With easier access to alternative investments, it’s easier than ever to diversify among a large number of investment products. The trick is doing so feasibly and with proper risk management.

via Five Ways to Diversify – HumbleDollar at HumbleDollar

Dollar cost averaging with stop loss orders?

More on stop loss orders, which are called The Most Important Trading Tactic in this article from The Balance. The idea of stop-losses is great. In practice, I’m less convinced.

The optimal degree of the stop-loss price is different for every investor, and sometimes may be as low as a few percent. For others the level could be as great as 30 percent, sometimes even larger. For example, some investors may set their stop-loss price at 70 cents for shares which were bought at $1. Whatever level each person chooses represents their total downside risk.

An effective strategy to protect against downside, and preserve potential gains, is to use multiple stop-loss prices.  For example, you may commit to selling a portion of the shares at one price, then another part at an even lower level.  Using our example once more, when the shares hit $2.85, you may have established a mental stop-loss at $2.50 for one-third of the shares, then another at $2.00 for the remaining two-thirds.

Tips for successfully using stop loss orders

A few highlights from the post 10 Great Tips For Using Stop Loss Orders Successfully at StockTrader.com.

1. Never use stop loss orders for active trading. For investors that watch their screens all day and are involved in day trading a stop loss order serves little purpose.

4. For the original placement always give the stock atleast 5% of space to avoid market maker abuse. If the stock is trading at $100, a stop loss should be no higher than $95 initially as intraday price swings may cause the order to trigger prematurely

9. Set the trigger price at common price increments. Prices like $100 or $60.50 are far more common to be traded at than $123.47. By placing the trigger price at a common increment there is a smaller chance of the stock “trading through” the order trigger.

Stop limits kicked in on nearly my entire portfolio this week as the market has dropped relatively significantly across the board. A few stocks have popped back above my selling positions, though overall it’s saved me from a lot of losses. I’m still unsure if this is the best practice moving forward, since some gains were lost and some items sold at “flash crash” type prices, possibly engineered by Wall Street in some way.

Findings from 3 research papers on stop losses

From a 2015 post at Quant Investing, a look at 3 research papers on the use of stop losses.

Study 1: When do stop loss rules stop losses?

What they also found was that the stop-out periods were relatively evenly spread over the 54 year period they tested. This shows you that the stop-loss was not just triggered by a small number of large market movements (crashes).

Study 2: Stop Losses, Trailing, and Buy & Hold compared

Trailing better than traditional
Only at the 5% and 10% loss levels did the traditional stop-loss perform better than the trailing stop-loss. At all other loss levels the trailing stop loss out performed, most notably at the 20% loss level where it performed 27.47% better over the 11 year period.

Study 3: Stop Losses in Momentum Investing

The stop-loss momentum strategy also completely avoided the crash risks of the original momentum strategy as the following table convincingly shows.

Click image to enlarge

Note that if you followed a stop loss strategy you would have made a small profit when the momentum only strategy lost nearly 50% and 40%.

The studies actually convinced the author to change is opinion on stop losses:

This has been a rather long article to come to a very clear and simple conclusion: Stop-loss strategies work

As you have seen:

  • When applied to a 54 year period a simple stop-loss strategy provided higher returns while at the same time lowering losses substantially
  • A trailing stop loss is better than a traditional (loss from purchase price) stop-loss strategy
  • The best trailing stop-loss percentage to use is either 15% or 20%
  • If you use a pure momentum strategy a stop loss strategy can help you to completely avoid market crashes, and even earn you a small profit while the market loses 50%
  • Stop-loss strategies lowers wild down movements in the value of your portfolio, substantially increasing your risk adjusted returns

via Truths about stop-losses that nobody wants to believe at Quant Investing for Value, Momentum, Quality and Growth stocks

Being too cautious can be costly in investing

Ben Carlson on the false narrative of all-time highs resulting in a crash. There’s a lot of talk about the market being ready for a correction simply because things are going well.

Here, Carlson quotes a myth from his own book, publishedin 2013:

Of course, stocks can fall from all-time highs, but hitting an all-time high isn’t necessarily the trigger that causes them to fall. Since 1950, there have been over 1,100 all-time highs reached on the S&P 500. That’s good enough for almost 7 percent of all trading days or roughly one out of every 15 days that the market is open. Here is the breakdown by decade that shows how often the S&P 500 hits a new high level:

He then goes on to give some numbers on what’s happened since then:

Since new highs were hit in 2013 there have been 201 new ATHs in total. This year alone there have already been 13 new all-time highs on the S&P 500, the same number that was seen in the entire decade of the 2000s. It’s not even the end of January.

Stocks are already up almost 8% this year and that’s after 9 straight years of gains (with 7 of those annual returns in double-digit territory). It’s been almost 20 months since we saw a 5% correction.

A good reminder that being cautious can be costly too. Rad his post All-Time Highs, Risk & Consequences at A Welath of Common Sense.

Stick to familiar companies

Good reminder from Howard Lindzon to stick to what you know when it comes to investing. Buffett stresses this in his investment philosophy as well.

Valeant never interested me on the way up. Pharmaceuticals and biotechs are too complicated for me to understand. Wall Street and greedy executives take advantage of these complications.

via Dirty Money and Pharmapalooza at Howard Lindzon

Factors to Consider before Selling

Continuing with our portfolio adjustments today and some more thoughts on portfolio allocation and risk ratios, which are highly dependent on target prices.

A target price is good for weighing risk/reward, but shouldn’t be used for decision making in terms of when to sell. Investments need to be reassessed before any of those decisions can be made.  When we review individual stock investments, we consider a number of different factors.

As trend followers, we begin with reviewing the themes we’re following. If our outlook has changed on a particular trend, we’d look to get out of any positions that play into that trend.

However, we rarely change the trends we follow (we look for long term themes/trends) so that’s not often the case. Assuming the stock fits into our current themes, we look at the individual stock from both a fundamental and technical standpoint. We prefer undervalued businesses, but are more concerned with momentum over the previous 3/6/12 months. It’s tough to go against the crowd for a long period anyway.

Assuming we still like the business, we then assign a new target price and set a new stop loss to get a new risk ratio. These target prices tend to be realistic and optimistic, as we’ve already determined that we believe strongly in the theme and are now looking for the best case scenarios. Regardless of the new risk ratio, no action is taken until reviewing the entire portfolio.

After updating all holdings, we  can then review how each stock plays into the portfolio as a whole. At times, we may see the need to add some risk by exchange particularly low reward positions for stocks with greater upside. By assigning both a target and stop loss price, it’s possible to quickly get a best/worst case scenario for the portfolio as a whole, making these decisions much easier than when looking at a stock in isolation.

 

NOTE: Howard Lindzon’s post about someone asking when to sell $600k worth of Bitcoin inspired my thinking about all the other factors that go into deciding when to sell outside of price. M

Thoughts on Market Timing & Crashes

There’s been a lot of talk of markets being very expensive lately. This includes US stock markets, crypto, international stocks, venture capital, and many other markets. With everything being expensive, many have come to the natural inclination that a downturn must be imminent. The thought has certainly crossed my mind recently while working on our theme-based stock portfolio.

At some point, there will be a correction to all of these expensive markets. There’s no doubt about that. The problem comes in trying to guess when that may be, how far up it still has to go, and how far down it may tumble. Without knowing those three, there’s really no way to gauge when to enter or exit an investment. Of course, it’s not exactly easy to guess.

Some extremely successful investment managers like Jeremy Grantham and Howard Marks seem to think the markets are extremely risky, and have changed their portfolios accordingly. Many others, including Buffett, believe it’s foolish to try to time general market cycles, citing the risk in giving up potential huge gains while awaiting the impending crash.

We lean more towards the second line of thought, believing that the right investment can withstand negative shocks, at least to a better extent than the market as a whole, and that trying to guess what the market as a whole will do is a futile exercise. This thought process applies to our investments in public markets, as well as our private alternative investments.

Relating to the stock market, the style of ignoring market conditions works best when selecting individual companies rather than widespread market index funds. The more finite the selection (industry etf, specific stock), the greater the potential for either superior or inferior performance compared to the market as a whole, in the event of a widespread downturn.

As we work to build our theme-based portfolio, we are specifically looking for companies we believe provide room for significant upside while having a perceived lower downside compared to the market as a whole.

 

HELPFUL READING

10 things investors can expect in 2018 – Ben Carlson
When things don’t make any sense – Ben Carlson
Stock Trends for 2018 – Chris Perruna
Bracing Yourself for a Possible Near-Term Melt-Up  – Jeremy Grantham
How to Survive a Melt Up – Ben Carlson

 

Building a Stock Market Portfolio by Theme

Even with alternative investing in mind, many investors, including ourselves, keep some amount of capital in public market investments. There’s potential for considerable upside, though typically less than alternative investments. There’s no control of the investment, both in the sense that you can’t control the company’s performance nor how the market reacts, which may or not be in line with the company’s performance.  Though the higher liquidity is nice both as a piece of mind and potential to get out of bad investments quickly.

There’s a number of ways to go about constructing a portfolio. From a basic perspective that including roboadvisors, human advisors, handpicking index funds, and handpicking individual stocks. Of course, it’s also possible to use some combination of these styles.

Personally, I’m not a big fan of losing control of where my money goes, such as the case with index funds. There are a number of companies with which I’d prefer not to be associated with, either for business or personal reasons, so I’d rather handpick individual companies, much like I do with individual alternative investments. In some cases, this isn’t feasible due to a lack of knowledge of individual businesses or difficulty in investing in specific businesses.

Actively selecting individual securities is a mostly outdated style, though the tools and info make it easier than ever to be informed and to act (buy/sell). For us, it’s about investing in good companies in trending areas ripe for growth. The themes were following for 2018 include:

  • fintech – technology is completely changing finance. this includes roboadvisors but is much more than that including payments, funding, etc.
  • crypto – it may be a bubble yet that could still grow significantly before it pops. regardless, there’s new technology and it will have major implications. many existing public companies are already involved.
  • marijuana – things may be volatile in the U.S. under Trump/Sessions. Still seems inevitable at some point in future that this will be federally legal. For now, Canada offers some options as it’s scheduled to be federally legal there in july.
  • ecommerce – this has grown every quarter for over 13 years as a percentage of total retail sales. amazon is the leader, still growing but largely outside of retail. more and more business is done online.
  • automation – things are getting automated, jobs are changing. it’s inevitable. companies that take advantage of this will will.
  • cyber security – more attacks likely in the coming years. security becoming a bigger concern to companies. more resources being allocated to security.
  • technology – there’s a general pro-technology consumer market that wants the next device constantly. this may not always be the case but for now people willing to give significant resources (time, money) to technology. recently, there’s been some pullback in terms of news stories, but usage and spending hasn’t diminished at all.
  • non-meat foods – includes organic produce, healthy grains, and meat-replacement solutions
  • pro-women – companies that are very pro-women will benefit from both publicizing their message and making their organization very fair and open
  • china – huge and growing middle class market.

The next step is to find companies working in these themes. They may not be 100% focused, but should a leader in that area, giving them room for substantial growth as the market grows. We’ll look more at individual selections in a later post.