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I have little doubt that I will lose the strategy lab contest. I will probably lose because I'm not the best stock picker, and of course there's only one winner. But another, smaller factor that will ensure my doom is a focus on risk management. The funny thing about this is that it's not real money, but try not to think about that for now. Instead, close your eyes with me and think about risk. Actually, you'll need open your eyes again to read this. Sorry about that.
The fine print of every investment commercial is "Past returns do not guarantee future performance." But when the market waves are rough, there's always a chorus of people saying, basically, "Don't worry, the market always comes back because it always has in the past." So which is true? I say both.
The key is, which past? And which market? It is true that there are always good stocks out there, and over long periods of time stocks in general usually do well. However, I take friendly issue with the current leader of the SLO contest when she says we should not worry so much about our financial system, but rather "take a look at the financial history of this country, beginning in the 1800s with the tulip bulb bubble." I mean this in a tone of happy banter (and she will probably beat me like a drum in this contest, proving my ignorance) but doesn't the tulip bulb craze show that bubbles can be more extreme and irrational than most people realize at the time? Think about it--tulips! How much is an average tulip worth these days? (By the way, wasn't this in Holland in the 1600s? Maybe she lives in Holland; if so, apologies.)
Just having fun here, but the point (that she does make later on) is that you need to be very selective as you navigate the market. I know people who bought tech stocks on the way down in 2000, and they are still angry about it. This does not mean we should go to the other extreme and be completely bearish (now I'm picking on you, Mr. Bearly Solvent!). It just means that whatever your time horizons and investing preferences are, you should consider the art of risk management. As Keynes said, "The market can stay irrational longer than you can stay solvent." Good stuff, Maynard.
Recently, I read the book When Genius Failed: The Rise and Fall of Long-Term Capital Management. The story really opened my eyes to how leveraged up bets on seemingly safe investments can be disastrous to financial institutions and, as a result, individual investors. This type of risk (and risk unwind) is playing out again right now, and it can deal a blow to any portfolio. If an institution gets a margin call, they will sell what they can to meet it. If they can't sell what they want, they'll sell what they can--tech stocks, energy stocks, whatever--fundamentals be damned. Risk management simply means being ready for the market's ups and downs.
There is no question the current market is in a precarious position, and no one knows how far up or down we go from here. There are pundits on both sides. It certainly doesn't seem like a bull market to me, so I'm being extra careful even with my fake money. Therefore, I've had a third to a half of my portfolio in cash the entire time (much to the chagrin of marketocracy's compliance rules). I have some short positions related to financials (SKF) and real estate (SRS) and some long positions related to video games (ATVI) and energy (SJT). Nothing too fancy. When I got lucky and Take-Two (TTWO) got a buyout offer, I took the gains. When I got nervous that the ag commodities (DBA) were getting too much hype, I sold. Whether the market has been up or down, I've done okay. That is risk management.
Why will I lose the contest? Well, as I've been watching the leaderboard, I've noticed that when the market is down big, the bearish portfolios do better than me. When the market is up, the bullish portfolios do better. Such is life. But I have a decent chance of beating the market averages, and maybe even some of the Strategy Lab professionals (I find it astounding that only "The Amateur" has any short exposure). More importantly, by applying some risk management to my real and imaginary portfolios, I find myself sleeping very well at night. With my eyes closed.
[This article simultaneously published on my personal blog, www.thestocksurfer.blogspot.com.]
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Comments (2)
Great post. I have to say, I am very torn in this contest. I'd like to be near the top so I take risks here that I do not take in my real portfolios but I don't want to just be chasing shorts or momentum stocks the entire time. That's not to say I don't get good ideas here or don't own anything in both, I do. But, was asked questions of the week, I always think in the time frame of the game and usually sound very bearish while I might actually hold that stock in my IRAs. I mean the difference between 6 months and 20 years is astounding on what risk you are willing to take. I guess I'm just exploring what I could try to do to create short term gains.
Uncle John
Posted by Uncle John | March 6, 2008 5:58 PM
Good Post. I couldn't agree with you more. People who do a good job of risk management rarely wins short time trading competitions. To win this type of competitions, you need to chase the hottest thing out there :)
Posted by Raju Dantuluri | March 7, 2008 11:02 PM