I finally figured it out…
I was great at buying the right stocks but was a terrible investor.
Just think to yourself: How many times have you bought a stock, then sold it … just to find out that it rose much further?
This happens for a few reasons. And chances are, if you’re anything like me, it’s happened to you a lot in the past.
Let’s put a stop to that right now…
I Trusted My Gut … and Paid the Price
In October 2016, I bought Advanced Micro Devices Inc. (Nasdaq: AMD).
Here’s the thing: This action makes me look like a genius. AMD has gained over 1,000% since I bought into the stock.
But I’m not a genius, and I sold nearly right away…
Here’s why that happened.
I trusted my gut.
The same gut that I trust to tell me right and wrong … or who to be friends with … or what to eat for dinner.
You know, the emotional being in me that makes all of my decisions.
Clearly, that didn’t work out well for me. And you probably have a lot of these types of examples too.
So how is it that we can buy the right stocks, but wind up being terrible investors?
Well, because we are flippant and make quick decisions when we trust our guts.
A Lesson in Behavioral Finance
Do you have a regimented process for understanding exactly when to buy a stock, how much to buy and when to sell it?
I do now, and it all starts with this formula below:
Before I unpack this for you, let me tell you about the findings of two economic Nobel Prize winners in behavioral finance.
You may have heard about Richard Thaler and Daniel Kahneman. These guys are heroes when it comes to their studies around investor psychology, which led to winning the Nobel Prize.
Their first finding was that we are risk-seeking when we’re losing.
This is simple. And I bet you’ve had this happen plenty of times.
I call it “rationalizing your decision after you make it.”
When a stock is falling, you say to yourself:
- “I’m going to buy this on the dip.”
- “This stock will come back, and my break-even price will be lower.”
- “It’s just a paper loss.”
Really, what you’re doing is adding more risk to your position.
You are seeking out more risk by buying more or holding onto a stock that is falling.
Momentum is the single most important factor in investing. MSCI has studied this factor and labeled it one of the most important in reference to a stock rising or falling.
Here’s what that means in plain speak…
When a stock has a confirmed uptrend, it is more likely to rise in the short term.
When a stock has a confirmed downtrend, it is more likely to fall in the short term.
And by buying more of a stock as it’s falling or by waiting for that stock to turn around, you are increasing risk.
You are setting yourself up to lose more money.
So how do you combat that? You cut your losses when the stock is in a confirmed downtrend. Stop the bleeding.
But what Thaler and Kahneman found about winning is even more important to understand.
They found that when a stock we own rises, we are risk-averse when we are winning.
Here’s what that means (and I’m sure you’ve been there with me).
Typically, when a stock is rising, we get excited. We have a winner!
So, we decide to sell our shares to lock in our gains.
Folks, that’s lowering our risk. That’s taking money off the table.
But when a stock is rising and it is in a confirmed uptrend, you are winning. Take some risk, folks!
This is the best time to either ride the winner higher or even add more money to the position to take advantage of its short-term outlook.
1 Number Solves So Many Problems
That leads me to TradeSmith’s discovery of the single most important number in investing … and why it works.
This number is the formula I showed you above for the Volatility Quotient (VQ).
And it solves so many problems that individual investors face today — certainly, people like me, and likely you as well.
It’s a measure of historical and recent volatility in a stock, fund or crypto. And that measurement is really focused on the moves a stock, fund or crypto makes.
Here’s what it tells you (I’ll just refer to stocks, but it covers everything we track):
- When to buy a stock.
- How much of a stock to buy.
- When to sell a stock.
- How risky that stock is.
- The movement you should expect.
And here are the VQs for some popular stocks and indexes:
Ride Your Winners and Cut Your Losers
Let me leave you with a single nugget that may change your investing life forever. It certainly has changed mine…
The two Nobel Prize-winning economists I mentioned earlier essentially are saying: “The trend is your friend. Understand it and take action.”
So if the confirmed trend is up, stay in your stock. Ride the winner!
If the trend is a confirmed downtrend, cut your losses.
The best way to get the most out of a winner and cut the loser (and of course, winners become losers at times) is to deploy a trailing stop.
A trailing stop acts as a point at which you sell a stock (or a fund, crypto, etc.).
When you buy a stock, you decide what your trailing stop is. Most people pick a generic number such as 25%.
That means that from the moment you own a stock, there is a stop-loss number that you will then sell the stock at, and your trailing stop trails the highs that the stock makes.
So if you buy a stock at $100, and it goes down 25% over time and never makes a new high since you purchased it, you sell at $75.
If that stock rises to $200 and never falls 25% from a high, then you’re still in that position and your stop-out point is $150.
So, you ride your winners and cut your losers.
The VQ Can Take Your Investing to the Next Level
No two stocks, funds or cryptos are the same.
But you can use the VQ number to determine exactly what the right stop-loss would be.
Looking at the table I posted above with the VQs of popular stocks, that means your stop loss for Johnson & Johnson (NYSE: JNJ) is about 15%.
But for Tesla Inc. (Nasdaq: TSLA), your stop loss would be around 50%. That’s because Tesla moves around more than three times as much as Johnson & Johnson.
Now, you know that if you were to buy Tesla, you would have to suffer through a lot of thrashing around. But it may be worth it.
Had I followed a 25% trailing stop on my AMD trade, I would have made nearly 50% instead of losing 3.5%.
And had I used a VQ-based trailing stop … well, I could have followed the signals and made over 1,000%!
And I would have known that AMD is risky and moves around a lot.
So the VQ is important. It sets expectations and gives you a framework for making better decisions.
I honestly believe it’s the most important number in investing.
And if you’re serious about improving your returns and taking your wealth to the next level — while also protecting yourself against inevitable market volatility — you don’t want to miss The 4X Stock Accelerator Summit.
You see, on February 25, I’m teaming up with Ian King to reveal how you can generate up to 4X more profits on Ian’s recommendations or any other stocks you own.
I hope you join us! To reserve your spot for this FREE event, simply click here now.
Happy Investing!
Keith Kaplan
CEO, TradeSmith