Volatility Based Investing

Dear TradeStops Subscriber,

Sometimes the biggest secrets are hidden right out in the open. That’s certainly the case with investing.

The financial markets are so full of smoke and mirrors (many of which were designed to part investors and their money) that it’s easy to hide real value out in the open. Most people will never notice it. And if you cover your open secret with the slightest whiff of mathematics you’re secret is safe from nearly everyone.

Take, for example, my two volatility-based investment tools – volatility trailing stops and volatility position sizing. These tools are easy to use, available to all subscribers and are extremely powerful.

Let me show you a few examples of what I mean.

I recently was able to analyze the performance of a couple of anonymous individual investors. Each of these investors had five years or more of trade history and a substantial amount of buy and sell transactions over the history of the portfolio.

I took the historical buys and sells of each of these individual investors and applied two simple strategies – VQ trailing stops and VQ position sizing.

VQ is my acronym for my proprietary Volatility Quotient – the most important number that I believe investors need to know about any of their investments. It tells you how much uncertainty or noise there is in your stocks. More conservative stocks like J&J have lower VQs (currently 11.3%) while more speculative / less certain stocks like Tesla have higher VQs (currently 42.2%). I’ve written about VQ extensively before, most recently here.

In the following studies I used VQ both as the basis of a trailing stop strategy as well as for position sizing. For the trailing stop I set the initial stop VQ% below the entry price. For position sizing, I took the available capital in each portfolio and distributed it across the investments so that more capital was in the less risky positions and less capital was in the more risky positions.

These VQ based tools are both available in every version of TradeStops.

I’ll let the results speak for themselves.

 

Both of these individual investors managed respectable returns over the past six to eight years. They did better than most. Both of them, however, could have improved their returns by using VQ Trailing Stops and VQ Position Sizing.

Investor 1 could have improved overall returns from 98% to 132%. Investor 2 could have improved overall returns from 142% to 206%. Those are both significant improvements!

Let’s take a look at some of the reasons that my simple VQ based portfolio management strategy outperformed the original strategies.

First of all, there is the all too common story of not staying with our winners. There are numerous examples of these investors prematurely exiting investments while the VQ trailing stop strategy would have stayed in the investment for big gains.

Here are a half dozen examples across both portfolios illustrating what is, in my opinion, the single biggest reason that most investors fail to realize their full potential.

In each chart I’ve indicated where the investor took profits versus sticking with a VQ trailing stop strategy (shown in red).

 

 

 

 

 

Sobering, isn’t it? So much for our wise judgements about when it’s time to sell.

The second biggest contributor to underperformance in these portfolios is not knowing when to sell a stock that is going down.

This first example of an unnecessary loss is particularly painful because the investor actually had paper-profits of over 100% before finally throwing in the towel for a loss of over 50%. Ouch! The VQ trailing stop strategy, however, exited with gains of over 50%.

Example #2 of an unnecessary loss is not quite as painful but it’s still pretty tough. In this position the investor got in around $35, saw paper-profits of over 70%, could have stopped out for a gain of about 35% and eventually bailed out at about breakeven.

Besides the disappointing performance here, think of all of the likely anxiety these investors experienced fretting over when to sell.

While it’s easy to visually illustrate how a VQ trailing stop strategy can impact performance, it’s not quite as easy to show the impact of VQ based position sizing on individual trades. In the charts below, however, I’ve added a blue line which shows how much improvement was added to each portfolio just by using VQ position sizing.

 

The blue lines in the above two charts were created by using the exact same entries and exits as the original investor but simply putting more money into lower risk stocks and less money into higher risk stocks using VQ based position sizing. It never ceases to amaze me that something as simple as adjusting position size for volatility can so consistently produce improved returns.

I hope that these two case-studies inspire you to follow a simple disciplined investment strategy like my VQ trailing stops + VQ position sizing strategy. They certainly inspire me.

To the growth of your wealth,

CEO, TadeSmith