An organized approach to investing - The 30/30/30/10 Method
If there is one thing I have learned over the years, it's that there is no "one best way" to invest. Consider:
Jay's Trading Maxim #182: When a person says, "to succeed in investing, you must," what they should be saying is "in order to succeed in investing, I must." What YOU must do may be something entirely different.
If you look around, you will find successful individuals engaged in momentum investing, value investing, dividend investing, trend-following, countertrend trading, stocks, option, futures, and/or ETF trading, and anything and everything in between, i.e., there is no one best way.
The key to developing a successful approach for yourself, I believe, involves the following process:
- Take in as much information as possible
- Take some time to sift and sort your way through it carefully
- Settle on those ideas, principles, and methods that you believe will work best for you (regardless of what anybody else tells you)
- Formulate a plan that utilizes those ideas, principles, and methods (and make sure that "worst-case risk management" is addressed in that plan)
- Starting following your plan and stick to it
- Ruthlessly ignore the headlines and stories and distractions that go on around you
Hint: The above is not easy. But remember, the alternative is simply reacting to every twist and turn in the financial markets.
The ultimate goal (beyond generating consistent returns, of course) is essentially the following:
When someone asks you, "How will you invest in light of the latest geopolitical tensions?" or "How will you invest in light of recent actions by the Fed?", you're answer will always be the same: "The same way I always do. By following my plan."
Jay's Trading Maxim #65: Develop a plan and follow it. Remember, tuning out the "news and noise" of the day will make you a better investor and a happier (albeit slightly more bored) person.
There is no one best way, so what follows is not intended to be a perfect roadmap for everyone. It is merely intended as food for thought as you organize your ideas on how to proceed as an investor, whether you are just starting out, or are looking to improve upon whatever you are doing now.
The 30-30-30-10 Method
First, the short version:
- 30% ALWAYS in the market
- 30% in or out of the market using trend-following method or method(s)
- 30% in "Systems/Strategies" (based on your preferences and research)
- 10% in "Whatever"
The slightly longer version:
30% always in the market
The worst thing is being fully invested and losing large sums of money. Only slightly less bad (at least psychologically) is being 100% out of the market while it roars higher and missing out on making large sums of money. You can avoid this problem by always committing at least 30% to the market at all times. Exactly how you invest that 30% - whether you plow it into mutual funds or index ETFs and forget about it, or if you change the makeup of this portion from time to time is up to you to decide. But, regardless, that portion of the portfolio is always fully invested.
30% in or out of the market using trend-following
The purpose of this portion of the portfolio is not to try to "time the market." The sole purpose is to ensure that you never, ever ride a primary long-term bear market all the way to the bottom fully invested. Because bear markets happen and will continue to do so. To wit:
- Following the 1929 top, the Dow lost -89% in 3 years and took 25 years to fully recover
- Following the 1937 top, the Dow lost -49% in 7 months
- Following the 1966 top, the Dow lost over 40% and took 17 years to fully recover
- Following the 2000 top, the Nasdaq 100 index lost -83% in two years and took 16 years to fully recover
- Following the 2007 top, most major indexes lost 40% to 50% of their value in 18 months
If you think for a moment that another devastating bear market is not out there somewhere and inevitable, you are plain and simply mistaken. The good news is that there is absolutely no need for you to ride to the bottom of the canyon fully invested.
This piece is not a "How To" but rather a set of guidelines. That said, in this case, an example may be helpful. Let's say that I follow three different trend-following methods, and each accounts for 10% of the overall portfolio (hence, 30% total). If a particular trend-following method is bullish, 10% of the portfolio goes into a stock index fund. If the trend-following method is bearish, 10% of the portfolio comes out of the stock index fund.
For example, one simple method is the compare the monthly close for the S&P 500 Index to its 10-month moving average. If SPX closes the current month above the moving average, then 10% is in a stock index fund the next month, and if SPX closes the current month below the moving average, then 10% is in cash (or short-term bonds) the next month. Simple as that. No questions asked.
"The Reality" of trend-following: When a trend-following method gives a sell signal, it means one of two things. Either:
- The market is about to break down, and you are going to save yourself from losses and a whole lot of psychological pain, or
- You are about to experience a "whipsaw," i.e., a situation where you sell at one price and are forced to buy back in at a higher price, thereby creating an opportunity to "kick yourself." But DO NOT kick yourself. Just buy back in and carry on.
Remember these two important points:
- Whipsaws are 100% inevitable with any trend-following strategy (Hey, I don't make the rules)
- You are not using trend-following to try to "time the market." You are using trend-following to avoid getting your head handed to you when the worst-case scenario unfolds - which it inevitably will again.
So, if your trend-following method(s) says "sell," then sell. And if they say to buy back in at a higher price, then do that.
30% in "Systems/Strategies"
At one time or another, every investor dreams of finding a system or strategy that generates a constant flow of riches beyond the dreams of avarice. And then, of course, reality kicks in. Still, systems/strategies - much like trend-following - can be beneficial when done right and for the right reasons.
The real reasons to use systems/strategies are to:
- Remove opinion and emotion from decision-making
- Improve profitability and/or reduce risk and/or improve the overall reward/risk profile of a portfolio
For some examples of systems, see this page on Sentimentrader.com.
Let's say that I use three separate systems, and each accounts for 10% of the overall portfolio (hence, 30% total). If they are not bullish, each can go to cash/bonds (or commodities in certain circumstances). So, at any given point in time, it is theoretically possible that this portion of the portfolio could be 30% in stocks or 30% in cash/bonds (or 10% commodities). Again, this is not some "ideal" roadmap that you should follow, just an example of one possibility.
Ideally, this portfolio portion will be the area than generates "alpha," i.e., market-beating returns. The keys here are:
- Don't settle for just one strategy (because nothing works all the time)
- Don't use too many different strategies (I'm thinking five as an upper limit for the most hard core market intensive person)
- Make sure you can actually follow the strategies you choose (if there is a chance that active trading is involved, honestly answer the question, "can I and will I religiously follow the strategy if it flips from one day to the next?")
- If the nature of the returns for the strategies you choose are not highly correlated, all the better (the goal here is to have the strategies dynamically increase or decrease risk exposure)
- Lastly, remember that "complex" strategies are not necessarily "better" strategies
10% "Whatever"
A vast number of individual investors make one of two mistakes:
- The "What do I know?" mistake: Everyone who follows the markets comes up with "ideas." "Gee, I think that company will be very successful, I should buy their stock" is a common refrain. But in the next breath, the people who make this mistake convince themselves, "Hey, what do I know, I'm no expert - plus I don't want to lose money and look stupid." And so, they take a pass. And somewhere along the way, a stock that they like "goes to the moon" and a huge - potentially life-changing - profit is missed.
- The "I know exactly what I'm doing" mistake: I will illustrate this one with an example. I recently read of a trader who claims he is putting 90% of his money into Bitcoin. This is not an anti-crypto screed. This is simply recognizing that Bitcoin has already had three separate 80+% drawdowns in its relatively brief history. If (when?) it has another decline of this magnitude, this trader will suffer a 72% decline in his investment capital. Beyond the devastating loss of money, a drawdown of that magnitude invariably has a profoundly negative psychological effect on an individual, which can negatively impact their investment decision-making capabilities for a long time. The simple way to avoid making this mistake is to never put yourself in a position to make this mistake. Hence the 10% limit.
Want to trade crypto? Penny stocks? Options? Some hot company that strikes your fancy? Some company whose product you buy and love all the time? Fine. Absolutely. Don't hesitate or fight the urge. Trust your instincts. Go ahead and take the plunge.
BUT DO NOT allocate more than 10% of your investment capital into these activities.
If you are truly good at generating solid investment ideas, you will ultimately amass a great deal of wealth. On the other hand, if you are somewhere between "not so good" and "terrible," you will also figure that out in time. In the meantime, you won't lose your shirt.
Summary
When you are fully invested and the market is roaring you will feel euphoria regarding how "easy" is it to make money. When that bull market starts to falter you will feel frustration and not want to give up on feeling that euphoria again. And when the market is breaking hard you will feel great anxiety as you watch your net worth decline. And finally, when the market plunges to its nadir, you will feel abject fear as you wonder "how low can this go?" That is, unless you adopt a trading plan that takes these emotions out of the equation.
Individuals spend entirely too much wondering and pondering (and guessing) "which way" the market will go next. But the reality is that no one ever really knows for sure. No matter how much time you spend on that endeavor, you ultimately have absolutely no control over the market. The only thing you have control over is you and how you allocate your capital. So make a plan that focuses on this area.
Jay's Trading Maxim #10: The question to ask and answer is NOT "is the market about to rise or fall?" (because no one really knows for sure). The question to ask and answer is "How will I allocate my capital?" ?" (Your answer to that question will actually decide your results.)
This subtle shift of focus can and will profoundly impact your level of long-term investment success.