This week I’m writing to you from Las Vegas again where I’m talking about TradeStops with the attendees of the 2015 annual investor conference of the American Association of Individual Investors (AAII).

The Real TradeStops Story

One of the most striking things about the conference so far is how many speakers are talking about behavioral finance. I’ve been to about half a dozen talks now and literally every speaker has talked about things like confirmation bias (making your decision first and then favoring information that confirms your decision) and recency bias (the tendency to overweight recent events).

The keynote speaker that opened the conference was Carl Richards, the New York Times columnist and author of The Behavior Gap. The “neuro-economist” Dr. Richard Peterson, founder of MarketPsych, LLC and author of Inside the Investor’s Brain was another featured speaker.

It’s great to see behavioral finance really starting to enter mainstream consciousness—it’s important stuff.

Another thing that’s been interesting is to listen to myself introduce TradeStops to individual investors that have never heard of us before. I’ve probably given my stump speech now to about 100 different individual investors (one by one) who have come up to our booth or whom I’ve chased down in the aisles encouraging them to come and hear me speak on Monday.

I know that you all know TradeStops pretty well by now, but I’ve found this “beginner’s mind” experience to be very useful myself and I wanted to share it with you today – I hope that you will find it useful as well.

So please permit me to re-introduce you to TradeStops and share with you the TradeStops story.

The tale is below,

Richard_Signature
Richard M. Smith, PhD
CEO, TradeSmith
Founder, TradeStops.com

The Story of TradeStops – as told to attendees of the AAII conference

TradeStops is an online portfolio and risk management service that helps you make more money with the stocks you already own or are thinking of buying.

We don’t pick stocks for you. You bring your own investment ideas. You enter your data into TradeStops (you can download it from your online broker or enter it manually) and then use our tools to monitor and manage your investments.

What we noticed is that most investors have plenty of ideas as to what to buy but very little idea of how to manage the investments that capture their interest.

We help investors answer questions like:

  • How much should I buy?
  • When should I sell?
  • When is a good time to get into an investment I’m interested in?
  • Is a new investment idea a good fit for my portfolio?
    • Does it increase my diversification?
    • Does it reduce the overall volatility of my portfolio?

These are critically important questions that have to be answered about every investment. Many investors don’t have answers to these questions.

TradeStops was launched over ten years ago. We started out by just tracking percentage trailing stops on individual stocks. Most of our subscribers used 25% trailing stops.

I personally came to understand how powerful trailing stops were because I saw how in my own investing I kept nursing my losers and closing out my winners. I would hold onto my losers, often double down on my losers and hold onto them until I couldn’t take it anymore or until they went to zero. On the other hand, I was quick to take my profits.

That’s all well and good but if you’re only taking small profits while suffering a few large losses, that’s not going to work out too well.

In essence, I noticed that I was un-limiting my losses and limiting my gains.

Trailing stops are a mechanical strategy that reverses this unfortunate bias we have. Trailing Stops limit our losses and un-limit our gains!

I started using trailing stops in my own investing and it made a big difference. I figured that other investors would appreciate an easy to use trailing stop tracking service as well.

After TradeStops was up and running for a few years, I set out to see if I could figure out how to identify a unique optimal trailing stop loss level on any stock. It didn’t make sense to me that trailing stops should be one size fits all.

After a couple of years of research, we did figure out an algorithm for using historical volatility to determine what the best level of trailing stop was for any stock.

On Johnson and Johnson, for example, the optimal trailing stop is about 12%. For Tesla, on the other hand, it’s about 42%.

If you use a 25% trailing stop on Johnson and Johnson, you’re giving back too much of your gains. You don’t need to take that much risk.

On the other hand, if you use a 25% trailing stop on Tesla, you’re almost guaranteed to get stopped out of Tesla. Tesla can more 10 or 15 percent in a day. Using a 25% trailing stop isn’t enough for Tesla.

Make sense?

Eventually I realized that this “optimal trailing stop” idea was a bigger idea than just where to put your stop loss. I saw how it impacted investors when they saw the “42%” risk figure for Tesla.

It would put them back on their heels. I could see them start thinking … trying to figure out what it means that Tesla has a 42% risk factor.

Finally, they would say, “Wow. Does that mean that if I invest $10,000 in Tesla that I might have to live through a $4,200 drawdown? I have to be willing to take that much risk?”

Exactly.

That led me to start using this volatility factor as a basis for deciding how much money to invest in a stock based on how volatile the stock is.

Think about it. On a low risk stock like J&J, your risk is only 12%. If you’re willing to risk $1,000 on J&J (i.e., lose $1,000 if you’re wrong about J&J) then you can invest about $9,000 in J&J. If J&J falls 12% then your $9,000 position will have lost about $1,000.

On the other hand, if you want to risk $1,000 on Tesla, then you can only invest about $2,400 in Tesla. If your $2,400 investment in Tesla falls 42%, you lost about $1,000.

My research has shown that using this volatility and risk based approach to position sizing is incredibly powerful.

In fact, I recently completed a study of 40 different real portfolios from real investors. These 40 portfolios covered the period from about 2008 to 2015. They consisted of real buys and sells and real position sizes.

The average gain across these 40 portfolios on their own was about 6.7%.

I then back-tested these portfolios by ONLY changing the amount of money invested in each position. I didn’t change which stocks they bought. I didn’t change when they entered or when they exited.

All that I changed was how much was invested in each position. I used my volatility based position sizing algorithm to allocate more of the available capital to low risk stocks and less of the capital to high risk stocks.

After making this one small change the average gain across these 40 portfolios leapt from 6.7% to 12.0%. That’s a phenomenal difference of nearly 80%.

What I’ve noticed over the years as I have studied real portfolios of real investors (and observed myself as an investor) is that most investors tend to some reasonable winners and some reasonable losers and a few crazy losers.

The net effect of such outcomes is a negative experience.

TradeStops was created to help investors get rid of their few crazy losers and replace them with a few crazy winners. That’s how you succeed as an investor.

We started out over ten years ago with simple percentage trailing stops and have since evolved an online suite of algorithms and services to help investors make more money with the investments that they already own.

If you’re managing a portfolio of investments of even $25,000 or more, TradeStops is an absolute no-brainer. One disaster averted or one winner expanded will more than pay for a lifetime of TradeStops.

To the best of my knowledge no other suite of services exists that is as easy to use and that is as effective in making a real difference in the real outcomes experienced by self-directed investors.