What I’m seeing in the investor data I’ve been analyzing continues to shock and amaze me … but I shouldn’t be surprised. In fact it confirms what I expected all along. It’s just shocking to see it so clearly and unmistakably.
Individual investors make a handful of devastating decisions which are responsible for their chronic underperformance. We put too much money into investments that we get excited about and not enough money into our less exciting (and more profitable) investments.
That’s why I’m more convinced than ever that the work I’m doing on volatility based position sizing is the most important work I’ve ever done.
Nothing hits home like real examples of what real people do with their money. Take a look.
The black line is the original performance of the buys and sells of an individual investor. The blue line is what would have happened if this investor put more money into his less volatile stocks and less money into his more volatile and speculative stocks using our volatility based position sizing tool.
On this $434,450 portfolio, the original investments lost over $100,000 from 2007 to 2015. That’s a loss of nearly 25%. Most of the loss, moreover, happened during a massive bull market run.
Simply changing the amount of money invested in each position would have resulted in a gain of nearly $60,000 over the same period of time.
How can it be that simply changing the amount of money we decide to put into an investment have such a dramatic impact on the results? The next two tables show you exactly how it happens.
I’m going to have to dig into a few numbers here. I hope you’ll bear with me. I think that it will be well worth your effort.
This first table shows you the top 10 biggest percentage gaining investments in this portfolio.
As an example, the best investment (rank #1) increased 513.4% in price since it was purchased. This investment had a VQ% of 27.3%. It was a medium risk investment. (This investor happened to be very aggressive, as you’ll see.)
The original position size of this investment was just 0.7% of the total portfolio. Since the total portfolio was $434,450 this means that $3,041 was originally invested. The “resized” investment used 1.5% of the portfolio capital or $6,517. That’s more than double the original investment size.
Hopefully you understand the meaning of each column. Now let’s look at the overall averages of these top 10 best percentage gainers in this portfolio.
The average gain was 142.4%. The average VQ was 26.8%. The investor originally allocated 0.9% of his capital, on average, to each of these investments. If volatility position sizing had been used, then 1.7% of the available funds would have been allocated to each of these investments, on average.
Our algorithm allocated nearly twice as much money to this investor’s best investments (and note that the algorithm did NOT know which investments would be best).
Now let’s look at the top 10 worst percentage gainers in this investor’s portfolio:
Jumping straight down to the last row – the averages – we see that these ten stinkers lost 76.1% on average and had an average VQ of 51.1%! That’s nearly twice the volatility of the top 10 best performing investments (which had 26.8% average VQ).
Moreover, this investor put nearly 3.4% of his portfolio, on average, into each one of these positions whereas our volatility position sizing algorithm put less than 1% of the portfolio capital into each position.
Now I do have to admit that this investor had one big outlier in his portfolio. If you look at his second worst performing investment (rank #2 above) he had originally allocated 23.1% of his portfolio to this investment. That’s about $100,000 of his $434,450 into one investment! Moreover, this particular investment had a VQ% of 60.6%. That is off the charts risky. This investment has fallen 96.5%.
Instead of investing $100,000 into this investment, our algorithm recommended investing just $3,041. Yes, the investment still would have lost 96.5% but that would have only been a loss of about $3,000 instead of a loss of nearly $100,000.
I know that’s a lot of numbers to have thrown at you. My apologies … but I hope that you’re getting the main point.
This investor put the most money into his most volatile and speculative stocks. These stocks ended up performing very poorly. Our volatility position sizing algorithm would have recommended a fraction of the original investment sizes and would have saved this investor a boatload of money.
He also made a disastrous mistake by putting nearly a quarter of his money into a highly volatile stock that ended up losing nearly all of its value.
On the flip side, this investor put less money into what turned out to be his most profitable investments. Our algorithm recommended putting nearly twice as much money into what turned out to be his top 10 winners.
I see this same kind of pattern over and over again. I know that this investor was more aggressive than most of us in terms of investing in very volatile stocks but the overall pattern is the same.
We make emotional decisions about how much money we should put into an investment idea. We put more money into stocks we’re excited about. Sometimes we put waaaayyyy too much money into a stock that we’re really excited about.
Don’t do it. It doesn’t work … and I’ve got the data to prove it.
Both the broad stock market and the US dollar had strong weeks last week. I’ve updated my charts below and included my favorite time cycles on these two assets. We’re not out of the woods yet but both assets are making strong cases for more upside.
Gold and oil remained more or less unchanged. I’m still staying away myself.
My strong chart of the week is O’Reilly Automotive (NASDAQ: ORLY).
After briefly dipping into the Low Risk Zone back in August, ORLY jumped right back out and just broke out to a new high.
I love it when I come across strong performing stocks that I’ve NEVER heard about in the media before. Who the heck talks about the automotive parts business in the media? Borrrrrring. Yet O’Reilly has ripped a gain of over 200% in the past few years and is breakout out to new highs now. Love it.
Wishing you all a great week,
Richard M. Smith, PhD