Risk Tolerant Personal Investing Strategies

Key Ideas

I would like to discuss two key-ideas that fundamentally alters the investment strategies of individual investors and would make investors pay more attention to risk and also make them evaluate their strengths in stock-picking as well as investment skills. The ideas are as follows:

1. The structure of stock portfolio currently presented by trading firms and extensively used by individual investors is fundamentally flawed and needs to be redesigned. We present a new design for stock portfolio.
2. Most of the investors are great buyers when it comes to timing the “buy-side” of the trading using various statistics, and also there are great and well-proven concepts like “dollar-cost averaging” for buy-side trading. These strategies are simple, well-understood by average investors and reduce the risk significantly for buy-side trading and also lower the cost-average of the various stock positions. But there are very few strategies or disciplines available for individual investors for lowering the sell-side risk. The ones available may be very sophisticated and is not easily understood by average investors, which brings into question, whether an average individual who has a profession in non-finance fields can really invest on their own? We present a simple and an easily understood strategy (and a discipline) for sell-side, which we call it as an equivalent of “dollar-cost averaging” strategy for sell-side trading.

Stock Portfolio Flaws and New Portfolio Design

A typical stock portfolio from a trading firm looks as follows:

Symbol	Last Trade	Change $	Change %	Day's Gain	Qty	Price Paid	Total Gain $	Total Gain %	Market Val
C	3.385	0.08	2.27%	26.25	350	$4.25	-312.57	-20.88	1,184.75
ETFC	1.84	0.08	4.55%	80	1,000	$3.67	-1,844.99	-50.07	1,840.00
WMT	54.62	1.17	2.19%	351	300	$53.24	404.46	2.53	16,386.00

The portfolio makes the investors focus on all the “colors” and “red color” jumps out. This affects the emotions of the investors in various ways, and subsequently affects all their decisions. It is important to note that the red and green color only shows the past performance and doesn’t reflect what will happen next week, next month or whenever one needs the money in the future. The fact that this particular investor say, John Doe, paid $53.24 per-share for Wal-Mart or $3.67 per- share of E*TRADE has no material impact on how the stock will perform in six months or year from now. No one else cares and one person’s cost basis has no bearing on the company performance. The cost-basis does contribute to the notion of support level, which in turn affects the technical trading. But that’s the problem to begin with. The portfolio highlights significantly the past performance facts and what has happened to the entire principal from the time it was invested. Sure, the information has value in understanding the tax consequences, and has value in understanding how the investment decisions are working out. But that is not the message reaching most of the investors and the “red” colors and more importantly “green” colors affect their emotions and lead them to make various decisions that significantly hurt their investments and make them take serious risks. Most of the investors when they look at the portfolio –focus on red and greens – red more than the green – do one of the following:

• Red color causes serious emotional reaction and they try to correct by more of the same – averaging it down. If they average it down based on future projection/performance, then it is a good strategy. But, the portfolio structure doesn’t help them do serious analysis of projected return and what the future holds. There is no information to help with projected return and it is wrong.
• Red color sometimes causes so much heart burn they take huge loss and completely get out of the stock. They generally don’t even take a look at that stock for a while. Again this is based on past return and there is no help from the portfolio design what they should do.
• Green color on the other hand makes them feel good and complacent. Here again they tend to ignore what the future holds and it is the fault of the portfolio as it doesn’t help them point to appropriate future course. For example, they could be sitting on a huge profit and most forecast may point to significant downside, and it is not reflected in the portfolio. Many investors could have bailed out during dot-com bubble if the portfolio pointed out what is in store for $400 stocks.

Bottom line, every day is a new beginning and the current market value of the portfolio is the total asset the investor has. It is real; it belongs to them; and something they own. It doesn’t matter where they started, but they have to hold on to what they have currently very tightly, protect it and grow it to a value they want and when they want in the future. There is too much focus on the past and it makes the investors spend lot of time ruminating on the losses, or if there is gain making them feel good about what they did. There is nothing in the portfolio to advise them when to sell or what to sell or whether to sell. Even if it is there, it is not highlighted significantly compared to the past performance, which is quite useless. The past performance only shows how well your buy-side strategy is working, but there is no help for sell-side strategy. This is significantly different from how companies operate their business. The companies take actual numbers in past-sales and generate forecasts and actually do planning for what to do next. Past-sales reflect past performance, but planning is all about future. Every quarter they generate a new plan or make adjustments to their existing plan, and most of the decisions about investments are based on “projected revenue” and “projected gross margin”. They have processes such as financial planning, sales and operational planning, budgeting, and involve various inputs such as statistical forecasting, Just in time manufacturing, manufacturing forecast, marketing and sales forecast, etc. This is tough business, forecasting is hard and it is tough to predict the future, and many companies succeed or fail depending on how well they deal with their forecasts and inventories. If the companies with all their investments in sophisticated planning processes are struggling or innovating all the time to deal with their projected revenue for the future, how can an individual investor hope to do better? Also they have many choices to deal with. But if an individual investor decides to take control of all their investments and thinks he/she can trade in the market, they are actually saying they know better than the institutional investors who presumably (or expected to) do research, forecast, etc.

The good companies having invested in good processes and used their best knowledge to come up with projections for the coming quarters and year, adjust their mix percentages in various product lines – increase investments in some, decrease or stop investments in others. There is a sell-side strategy going on here by looking at projections and the past sales at the same time.

So, it is important that individual investors adopt a similar strategy with their assets. They need to look at the projections of their stocks, and have a well defined sell-side strategy. The portfolio design should enable them to do this. Here is a suggestion for the new portfolio design:

Symbol	Last Trade	Qty	Projected Price (1 year from now)	Projected Gain $	Projected Gain %	Current Market Value	Projected Market Value (1 year from now)
C	3.385	350	$4.25	302.75	25.55%	1,184.75	1487.5
ETFC	1.84	1,000	$1.5	-340	-18.47%	1,840.00	1500
WMT	54.62	300	$48	-1986	-12.12%	16,386.00	14400

The new portfolio tells us what the value of the assets one year from now. The critical information is the column that shows “project price (1 year from now)”. It is important for ANY investor to have a portfolio such as above and make appropriate decisions. When I mention this to my friends, their immediate reaction is, “how do we know the price?” My response is, if they cannot project the price of a stock they hold, then they have no business to invest on their own and take serious risk on their entire asset. This “projected price” information could be garnered from various resources such as analyst estimates, companies own estimates and then doing your own estimate. This is similar to what I described about as “planning process” i.e., what companies do on a routine basis each quarter and each day. Every day, many planners in many companies, stake their job in decisions on what to make and how much to make. They consume various data streams and make their best decisions. This is because life is about future and we all should have a proper planning for all the assets and proper reasoning for why we are sticking with some assets. The projected price and projected gain reflects our research, reasoning and confidence. The portfolio should fill in default values based on the best analyst research and also let user enter a value on his/her own – this is like doing personal planning and doing what-if analysis on their investment strategies.

The above portfolio ignores the “dividend” aspect to simplify the discussion. One could add the dividend and reflect that in the “projected price”.

In the above portfolio, the projection says that there is no real upside to stick with Wal-Mart. This view will help the investor to come up with a sell-side strategy or at least make them think about selling. The original portfolio on the other hand, shows a gain for Wal-Mart and may lead the investors to be complacent and stay with the stock for the next year suffering 12% loss. So, it might be time to do some selling and do market research for new stocks to move into. The structure of portfolio should primarily give data about future projections, and make the investors think about future growth.

Periodic Selling or Sell-Side Equivalent of Dollar-Cost Averaging for Buy-Side

The second idea we present is about how to create a recurring habit of selling similar to recurring dollar-cost averaging strategy for buy-side. We also talk about insurance concept – after all many of us invest significant assets (retirement and other savings) in stock.

Let us consider other purchasing people do apart from stock assets. Most of us these days do significant market research using internet before buying and look for sales, whether it is $200 cameras or $30 book or $600 laptop. We try to save $5 to $10 on shipping costs or drive 50 miles to outlet malls to save $3 on jeans. The management of personal money when it comes to necessary and discretionary items is very diligent and purposeful about finding the best price. Moreover, many folks take extended warranty on $200 cameras or $500 laptop or $20,000 car. But when it comes to trading and investment, many investors lose thousands of dollars and also leave $50,000 to $500,000 in stocks with no protection against moderate to significant downside. They don’t show the same concern they have for $200 camera towards their retirement assets, where the stakes are much bigger. This is the biggest irony of investing. People act as if it is not their money or when they lose thousands of dollars, they either hide it (from spouse and families) or find some strange reasoning to convince their mind and thought processes that what they are doing is fine or dive further deep into crisis by taking further stake in falling assets.

Basic question is why you would protect your car and cameras, but not one of your significant assets. In fact, cars and cameras are less likely to fail than the volatile stock market as we are beginning to see boom and bust cycle more often in recent years. This question is more relevant when investors fall for ads from trading companies like E*Trade and Charles-Schwab who encourage investors to manage funds on their own. We need to ask similar questions to fund managers also. Here we focus on strategies of insurance and also developing periodic sell-side habits.

We will focus on individual investors – mostly middle-class families. As a start let’s ask, why do we invest and what type of resources we are investing. There has to be goal for investments and most of us invest for retirement living and saving for education for children. The investors from middle-class families invest in 401(K), children’s Education IRA, mutual funds, and additional available assets in trading firms. Some investors roll over their IRA’s and 401(K) into rollover IRA where they trade their retirement investment on their own. So, the stake is pretty high and if these investments turn sour, the quality of retirement lifestyle is at risk and also education of children is at risk. Basic problem is investors don’t think about this day-in and day-out, and get into bad habit which causes significant risk, and they tend to reflect on it only after huge loss. In the last couple of meltdown (year 2000 and year 2008), we heard so many sad stories of people losing most of their retirement investments with age also not on their side to recoup the losses.

So, what should they do? There are many sophisticated insurance strategies available (straddles, call option, put option, covered call, etc.). Many investors do not use these strategies and do not understand them. Also, these strategies do cost in terms of trading expenses. This is again another problem with individual investments. Any other job we undertake, we try to understand the full scope of the work involved and put our best effort forward. In the case investing, many investors jump headlong using only very primitive strategies and they don’t spend time to learn all the tools available.

We present a simple strategy here based on the “covered call”, which is relatively safe and is one of the trades allowed in IRA as generally IRA’s do not allow you to rely on margins.

Going back to the original question, why do we invest and what do we want from it? Let’s state the problem as follows:

The investors want 10% return on their investments with very little risk (there is always non-zero percentage risk in any investment) and significant protection against the assets. The percentage return can vary by investor.

We now present one strategy that lets the investors achieve the above goal.

1. Suppose you are investing $50,000 and want a 10% return for the year. Your expected return percentage can vary, and the math below needs to change accordingly.
2. This implies that you need to make $5,000 for the year. Or $1,250 for a quarter.
3. Next step is to pick stocks. In this section, we are focused on insurance and developing a sell-side discipline. We simply suggest that the investors be diligent in their research and pick stable, solid and proven stocks (also I like to say the companies they are proud of being an owner and want to participate in their effort to help civilization) like Wal Mart, Target, GE, JNJ, etc. or one of your favorites. It is important to lower the risk at every level. So, these stocks are important to pick and please use well-proven buy-side methods for that and we don’t recommend any specific method. Many investors are good buyers and they can time well or use dollar cost average.
4. To make $1,250 for the quarter, we are going to write covered calls. We do it one quarter at a time. It is important to give sufficient time for the covered call and quarter is a good window as it doesn’t intrude with your regular life and profession. The goal of writing covered-call is to get a fixed-return, force selling as a way to establish recurring sell trades, and lower the cost-basis of the underlying stock to improve the risk tolerance.
5. The other important point is to write covered calls below the price you bought. This gives more money; lowers cost-basis significantly, increases the chance of selling, and also increases the range of protection. Suppose you are buying Wal-Mart (WMT) at $47 today. The march 08 calls for $47.5 gives you a premium of $2.67 dollar. This is 5% already and we need to only make 2.5% for the quarter. The march 08 calls for $45 gives you $4.10. This is below the price you bought. But it protects your principal for a larger range. Suppose the covered call is executed, then the return is $47 - $45 + $4.10 = $2.10, which is again 4.4%. I would pick $45 call over $47.5. The $45 calls cover your principal up to $47 - $4.10 = $42.9 i.e., as long as the WMT stays above $42.9, you made money. This is where it is important to pick stocks that are stable or you wouldn’t mind holding onto them. You would think WMT is a dead stock, but you can see it gives good returns. The $47.5 calls cover your principal only up to $47 - $2.67, i.e., around $44.5. So, it is not as good as $45 call. So, one may ask why not write $40 calls? There is a sweet spot at which the premium disappears. So, you need to pick.
6. It is important to note that the covered-call amount gets credited immediately i.e., we don’t need to wait for the end of quarter. This money could be put to good use immediately.
7. We didn’t talk about the dividend that WMT pays. That’s additional return.
8. If the stock gets called, it is forced-sell and makes the investor revisit their investment planning every quarter similar to what companies do. This forced quarterly review is a good habit to have. The landscape could have changed and they can do new research to pick new stocks using “projected revenue” and “project margin” portfolio or stay with the same set of stocks.

Case Analysis:

• WMT price above the call price of $45. It gets called. It is ok and I have to admit I cannot understand why the investors fret about the fact that the covered-call was executed. Yes, we are limiting our up-side potential, but with a good protection and up-front collection of the return money. This is the “periodic-selling” I am talking about and is the equivalent of “dollar-cost” averaging on the buy side. You are achieving your goal, and made your $1,250 for the quarter. It is important to focus on the “goal” and “fixed” return. You are left with cash. You can buy WMT again, and write calls again on WMT or go back to “investment research” and do something else for $1,250.
• WMT price above $42.9 – the cut off for the principal and below $45. Here again you made your money. You are left with WMT stock. You can turn around and write more covered calls for next quarter to make $1250 again.
• WMT price below $42.9 to, say $40, i.e., it fell from $47 to $40. Here you lose only the principal between $42.9 and $40. You are not losing the $7. This is the worst case and the risk you are taking. This is totally depending on the type of stocks you pick. There are more things you can do here. But let’s say we take the hit here. The stock is still there and you made the $1,250. You can turn around and write more covered calls. If the stock is falling from $47 to $40 (almost 15% drop) in one quarter, then you picked a very volatile stock and with covered call you reduced your loss to 6% as opposed to 15%. This is definitely a better choice than simply sitting on a stock and not doing anything. Moreover, as individual investor if the market is falling, it is tough to react and most investors would incur this loss.
• The stock jumps to very high value and this is very unusual and it depends on the stock we pick. It is rare for a well-established company and if there is such a huge jump, then there is equal chance it could go down also. Here again the call would get executed and we will achieve the quarterly goal, but we lose the upside. We should learn to ignore this. In the long run, with the well established discipline of aiming for a fixed return, it will pay off. We all talk about dollar cost averaging as a good strategy. This is for the “buy” side, where we keep buying. If we don’t sell, then we just ride the wave and hit bottom. The covered calls are the equivalent of dollar-cost averaging on the sell side. It gives you a discipline to sell on a regular basis and also make money from the volatility of the market.

Dividend Stocks

One of my friend asked about strategy of investing in dividend stocks. The yearly dividend reduces the cost basis every year. For example, at one point Philip Morris used to pay $3.20, a year. If you had bought the stock around $60, then in 20 years your cost basis would become zero. How you use the cash from dividend is another story and we wont deal with that here. This is a good strategy and there is not much reason to think about sell side issues here. You can earn dividend and write covered calls too. I guess this is "value investing" and the fact that the companies generate enough cash every quarter to pay out dividend indicates good health. The relevant question is what do you when you own growth stocks that do not pay dividend or pay very little dividend. All the gains are in paper and your cost basis does not go down and the paper gains can easily disappear. The covered calls for growth stock is equivalent to getting dividend and they help to reduce the cost basis.

Conclusion and Feedback

Personally I lost lot of money in the last two meltdowns. Luckily age is on my side and I have a good education and a good job (touch wood). But it is heart breaking to see people close to retirement playing with their investment without any plan and protection against risk. I learnt a lot and narrowed down my lessons to these two strategies. Now these strategies are paying off well for me and I call myself a disciplined (very important quality to have), rigorous in my research and a good investor. I know there are 100’s of books available for investing, but when I mention these ideas to my friends, they are all surprised at how simple and useful these two ideas are. So, I decided to write them down and share with others as I am sure would be useful for others. Please poke holes in these strategies and if you have adopted similar strategies before, please share your thoughts.