There is always an inner game being played in your mind no matter what outer game you are playing. How you play this game usually makes the difference between success and failure.” -Tim Gallwey

With all the changes and new additions of the past six months, it’s probably a good time to jump back up to the 50,000 foot level and remind ourselves of the big picture – what it takes to be a successful investor and how TradeStops can help.

It’s been shown again and again that most individual investors badly underperform the broad market averages. Even most professional investors fail to beat the markets. Professionals just tend to do a little “less worse” than the average individual investor.

Yet, it’s my firm conviction that the individual investor has multiple significant advantages over both professional and institutional investors. We’re small and nimble. We’re not under pressure from boards of directors or clients. We can focus on longer time horizons. We can fly under the radar.

What’s been obvious to me for the past 10 years now is that our failure to realize our full potential as investors is mainly due to the behavioral challenges of investing rather than to poor stock picking or lack of good information. Finding the right stock to buy or the right stock picking system is not the answer.

The secrets to investing success are:

  1. Mastering our inner investor;
  2. Managing risk; and
  3. Swinging for the fences on those rare high-conviction opportunities.

Of course, it’s easier said than done. Hence TradeStops.

Getting Started with 25% Trailing Stops

TradeStops was launched in 2005 as a service offering simple percentage trailing stop alerts. Most of our subscribers used TradeStops to track 25% trailing stop alerts on their investments. To this day I remain convinced that a simple 25% trailing stop strategy is a powerful strategy for individual investors.

In fact, applying a 25% trailing stop strategy to my own initial experience as an investor is one of the things that led me to create TradeStops in the first place.

RMS_Equities_2000
The gray line is what happened to me when I first started investing. I took a rocket ride up to gains of 250% in less than a year and an even faster rocket ride down, wiping out all my gains and barely escaping with my original capital. The black line is what would have happened to my portfolio had I made the exact same buys but used a mechanical 25% trailing stop exit strategy instead. I would have had peak gains of over 400% and would have exited all of my positions with banked gains of 150%.

That was compelling evidence! Moreover, I wasn’t the only one. My research showed over and over again that a mechanical 25% trailing stop exit strategy improved the performance of both novice and experienced investors alike.

The real kicker came when I back-tested the performance of my friend and mentor Dr. Steve Sjuggerud. Steve is the godfather of trailing stops as far as I’m concerned. He was pounding the table on the importance of trailing stops way back in early the early 2000’s – a full decade before the rest of the world caught on.

I was stunned to find, when I back-tested Steve’s track record in his flagship newsletter True Wealth, that Steve himself would have dramatically benefited from a mechanical 25% trailing stop strategy. Here’s how that looks on a chart:

how to be successful in the stock market
What was so striking in Steve’s case was that he was already following a 25% trailing stop strategy… but he was primarily using that strategy to get out of his losers. He wasn’t always using it to stay in his winners.

Why Even Simple Percentage Trailing Stops Work

Why does a 25% trailing stop strategy regularly make such a big impact on the real decisions of real investors? Because we’re biased – biased against staying in our winners. Behavioral economists have a fancy name for this bias. They call it the “disposition effect”. I’ve got a simpler way of describing it. We prefer our losers over our winners.

When it comes to investments in which we have profits, we are risk averse. We close out the position, fearing that the profits might get away from us. When it comes to investments in which we have losses, we are risk seeking. We don’t want to take a loss. We hold on. We might even double down to lower our cost basis and try to get back to “break-even” quicker.

The end result? We hold onto our losers and we let go of our winners. In holding onto our losers we leave ourselves open to a few disastrous and debilitating losses. In letting go of our winners, we eliminate the possibility of ever having a few transformative portfolio powering gains.

Kind of simple when you finally understand it, huh?

Discovering Volatility-Tuned Trailing Stops and the Volatility Quotient

Once it was obvious that simple fixed percentage trailing stops could transform individual investor performance, the next obvious question was, “Does a one-size fits all trailing stop make the most sense?”

A couple of years, and tens of thousands of dollars of research later, the concept of the volatility-tuned trailing stop was born. Using this new tool, initially called Smart Trailing Stops, it was now possible to use a tighter trailing stop and take less risk on less volatile stocks like Johnson & Johnson while using a wider stop on more volatile stocks like Tesla and Netflix.

The core question behind Smart Trailing Stop concept was, “How much wiggle room do we need to give this stock in order to not get stopped out by the normal expected volatility of the stock?” While it seems like a common sense idea, it took a long time to develop a robust algorithm that could answer that question for any stock and that consistently improved performance across a wide array of back-tested portfolios.

Eventually I realized that this idea of the “normal expected volatility of a stock” had much broader benefits than just answering the question of where to place a stop loss. In fact, I realized that it was so important that I gave it a name – the Volatility Quotient or VQ. Here’s a list of recent VQ’s on widely owned equities:

list of widely held stocks1
 Certainly this VQ% idea is helpful in identifying what level of trailing stop we should use on these stocks but every time I look at one of these lists I’m struck by how extraordinarily valuable it is just to have a number that tells me how “risky” each of these stocks is. I always knew that TSLA was riskier than JNJ but I never had a number that I could put on that gut instinct. Now I do… and I know that even just looking at a list like this makes me a better and more informed investor – ready to make more intelligent and less emotional decisions.

That’s priceless.

Put More Money into Safe Stocks and Less Money into Risky Stocks

If I could give just two pieces of advice to every investor I would say:
Find a way to make sure that you hold onto your winners instead of your losers.

  • Take equal risk on your investments, instead of putting an equal amount of money into each investment.

I’d be hard pressed to say which piece of advice would be the more valuable.

We already saw how the VQ helps us to address the first issue. Somewhat surprisingly, it also gives us a simple answer to the second question.

Here’s how it works.

As a starting point, take 1% of your investable capital and divide it by VQ%. For example, if you have a $100,000 portfolio, then 1% of your investable capital is $1,000. The current VQ% on JNJ is 11.3%. If you divide $1,000 by 11.3% you get $8,850.

If we do that for all 10 of the equities in the above list and use their respective VQ’s, we easily come up with the following approximate position sizes for risking $1,000 on each investment:

list of widely held stocks2
There are, of course, possible nuances to this approach but the core idea is simple – put more money into the JNJ’s of the world and less money into the TSLA’s. The VQ provides us with an easy way to get started doing that.

For those of you out there that might experience a twinge of disappointment at the notion of putting less money into exciting stocks like Netflix and Tesla, I’ve got news for you. The real secret to reaping huge gains in disruptive technology stocks is in making sure that you can stomach the inevitable wild ride.

If you put $10,000 into Netflix and then throw in the towel when its normal volatility has resulted in a loss of $3,000 and you just can’t take it anymore… is that an exciting investment? Well, it certainly is one kind of excitement. On the other hand, if you invest $2,315 in Netflix and weather the predictable storm because you’re comfortably positioned and Netflix finally takes off for the races … what could that potentially do for your portfolio?

You can still enjoy the thrill of investing in disruptive and game-changing companies like Netflix. Just make sure that you do so in your personal risk comfort zone. Using VQ% to position size for equal risk allows you to do so.

Still More to Come

That’s a good start at reminding ourselves how far we’ve come in the past ten years with TradeStops. We have really covered the foundational issues of what makes TradeStops so valuable for individual investors.

Next week I’ll finish up with:

  • The evolution of Smart Trailing Stops:
  • When to get back in after you’ve been stopped out;
  • How to get in at low risk entry points;
  • Dr. Smith’s Indicator; and
  • Next steps.

I hope that it’s been helpful to keep in mind the big picture of why we do what we do at TradeStops.

To the growth of your wealth and your peace of mind,

richard's signature
Richard M. Smith, PhD
CEO, TradeSmith
Founder, TradeStops.com