An Investment U White Paper Special Report
by Alexander Green, Investment U Chief Investment Strategist
Contributors: David Melnik and Michele Cagan
Investing today is not for the faint of heart. Finding the right stock has never been harder, much less getting truly helpful stock market investment advice. Yet investors keep plunking money down like there’s no tomorrow. Why?
For one thing, the ease of trading is like a siren’s call. No longer is investing a mysterious financial play made by only those in the know. Today, the image of the investor is that of the day trader, an average Joe attempting to amass a fortune from the comfort of his own computer. But ease of investing is only a part of the story…
The real reason we keep pouring money into the markets is that we’ve seen lightning strike before. We were either in on it, and loved the thrill; missed out on it entirely and can’t let that happen again; or even worse, latched onto a tech rocket, rode it to the top, then held on until it crashed back down in a blaze of worthless paper.
Lightning Can Strike Twice… And We Want In
Like you, we know there are winners out there still-but they’re increasingly hard to find. So when we do find a profit rocket, we want to be able to grab on to it with both hands and ride it to the stars. Then, just as importantly, we want to know when to get out-so our profits don’t burn up on re-entry.
That’s why we created ‘Stock Market Investment Advice: The Two Most Profitable Secrets of the World’s Greatest Investors.’
In this special report, you will learn two of the investing secrets shared by more than 99% of the world’s most successful investors — the key to letting you squeeze every cent of profit from your winners and to getting out with your profits intact.
And you’ll learn about a technique used by the world’s greatest investors to take your winning investment and ratchet up the profits.
Sound Stock Market Investment Advice from the Good Doctor
Dr. Van K. Tharp is “coach” to the world’s greatest investors and traders. These superstars come to Dr. Tharp (he has a three-month waiting list according to USA Today) for stock market investment advice that will lift their profits to even higher levels. He was profiled in Jack Schwager’s best-selling book, Market Wizards: Interviews with Top Traders -in fact, Dr. Tharp was the only trading coach included!
For over 20 years, Dr. Tharp accumulated psychological profiles on over 4,000 investors from all around the globe. To maintain current profile data, he conducted many follow-up interviews with them. In addition, he has conducted extensive, in-person interviews with many of the world’s best investors and traders.
The goal of all this work was to find the elements of investing success these superstars had in common.What were the things they all did that helped them pull in far more money than ordinary investors?
If he could isolate those techniques that were shared by the world’s greatest investors, Dr. Tharp believed he could unlock the very essence of investment success.
Remarkably, Dr. Tharp discovered that these great money makers had hardly anything in common. They invested in different kinds of stocks, some liked commodities, others favored precious metals, many dabbled in currencies-and almost all had their unique systems for investing.
And of course this made the two things they did have in common all the more precious…
Dr. Tharp found that out of all the techniques, strategies, and systems these great investors used, only two had strong appeal across the board-but these two were used by a full 99% of these investors. In other words, they disagreed on almost everything else.
Secret #1: Never, Ever Lose Big Money in the Stock Market
Buying stocks is easy. Anybody can do that. The hard part is knowing when to sell. And very few people know how to do that. We’ve all made expensive mistakes-either missing the full upside by selling too soon, or taking a huge loss by holding a falling stock too long.
Let’s face it. Most people don’t know when to sell a falling stock. So they’re frozen into inactivity, saying, “Should I just keep holding and hoping, or should I cut my losses now?” And there’s no reliable crystal ball to tell anyone when a rising stock has peaked.
The problem that causes both these mistakes to happen is simple: Ordinary investors are ruled by emotions.
And the only way you’re ever going to join the highest echelon of the world’s best investors is to strip all emotions out of your decisions.
Here’s our advice on how to do it…
While you’ll never be able to sell at the peak each and every time you invest, or ensure that you never buy a stock that subsequently falls dramatically, there is a secret weapon that is proven to get you the lion’s share of any move.
When you buy a stock, you buy it with the intention to sell it for a profit some time in the future.
In order to do so successfully, you should put as much thought into planning your exit strategy as you put into the research that motivates you to buy the investment in the first place.
We call this our “Trailing Stop Strategy.“
All great traders and investors consistently cut losses short and let their profits run, and Dr. Tharp found that trailing stops are one of the easiest and most effective ways of doing that.
The Best Investment Advice You Never Hear about: The Trailing Stop Strategy
In the stock market, you must have a strategy that makes you methodically cut your losses and let your winners ride. If you follow this rule, you have the best chance of outperforming the markets. If you don’t, your retirement is in trouble.
Our advice is to follow this simple plan: We ride our stocks as high as we can, but if they head for a crash, we have our exit strategy in place to protect us from damage.
Though we have many levels of defense and many reasons we could sell a stock, if our reasons don’t appear before the crash, the Trailing Stop Strategy is our last-ditch measure to save our hard-earned dollars. And, as you’ll see, it works well.
The main element to the trailing stop strategy is a 25% rule. We will sell positions at 25% off their highs. For example, if we buy a stock at $50, and it rises to $100, when do we sell it? When it falls back to $75, or 25% off our high.
So with our Trailing Stop Strategy, when would we have gotten out of the muscle-shirt business? You already know the answer. Remember the shares started at $10 and fell immediately.
Instead of waiting around until they fell to $6 as the business faltered, using your 25% trailing stop, you would have sold out at $7.50. And think of it this way: if the shares fall to $8, you’re only asking for a 25% gain to get back to where they started.
But if the shares fell to $5, you’re asking for a dog of a stock to rise 100%. This only happens once in a blue moon. Not good odds!
Here’s How Our Trailing Stop Strategy Works
If you do hold onto a falling stock too long, the loss will often be far more than just 25%. And all it takes is one big loss to set an investor back for years.
Let’s say you start off with $10,000. A year later you’ve made 25% ($12,500). Same for next year ($15,625), and the next ($19,530). But then after three years of 25% annual gains, the fourth year, you take a loss of 50%. It puts you back below where you started, at $9,766.
Now, let’s say you had a 25% trailing stop during the year you lost 50%. You would have been stopped out at $14,648. Then during the following three years (when you again profited by 25% each year), your holdings would be $28,600 at the end of that entire seven-year stretch.
However, if you didn’t have a 25% trailing stop in place, after the same seven-year period, you would only have $19,073, still below where you were prior to the 50% drop!
Over the seven years of this example, you’d be up 186%. That’s an average return of over 26% per year, much better than you’d think. But pick your own example, and do the math. Look back at your own portfolio. You’ll see that cutting your losses is the key to both getting good overall returns and avoiding lost years.
Examples from Our Files
Let’s begin with a look at Adobe, the innovative software company on the Nasdaq that we once enthusiastically recommended. It zoomed up, with no sizable price correction, for 10 straight months. The stock kept achieving new all-time highs. Along the way we kept adjusting upward our 25% trailing stop. Given that we bought in at $31, we kept locking in higher and higher profits.
When the technology and communications sectors finally began to correct, Adobe corrected along with them. But thanks to our 25% trailing stop, the worst-case result turned out to be a profit of over 81%.
Contrast this approach to the “buy and hold” strategy. The Nasdaq high techs had an amazing run. But when they began to unravel, things got ugly in a hurry. Compare our profit of over 81% to the devastation that occurred among other high-tech stocks during the same 10-month span. Amazon was down 60%, Qualcomm down 63%, Intuit down 66%.
Several companies witnessed declines of as much as 90%, and the “buy and hold” crowd held all the way down. That’s what can happen when you hold a stock investment with no exit strategy. That kind of loss is hard to recover from. Just look at the chart above, and you’ll get a good feel for the kind of long-term damage just one bad stock can do to your portfolio.
Hang on too long… and it could take years to recover your loss.
In reality, most investors who say they’re buying and holding will in fact panic in a bear market, especially a long grinding one. We saw it graphically in the recent “Great Recession.” Don’t let this happen to you: Use a smart exit strategy that lets you capture the majority of any profits-even a doomed one.
The System Is Not Fool-Proof
As good as the trailing stop concept is, it’s not perfect. For one thing, in particularly volatile stocks, you can get stopped out at a price much worse than you had hoped for.
Take Microsoft as an example. As stories circulated that the Justice Department was proposing a court-ordered divestiture of the company, its shares experienced serious volatility. Before the ruling the stock was trading at $79. The next trading day, Monday, the stock opened at $67.
Even if you had a $75 trailing stop in place you would have had to sell at $67 because that was the next available market price to execute the trade.
Once a stop price is triggered, it becomes a “market price” sale, that is a sale at whatever the market will bear. Normally that won’t be a big problem, but sometimes volatility can make your target price impossible to fill, as in the Microsoft example.
Domestic U.S. stock markets do not accept trailing stop orders. And for thinly traded stocks, they don’t even accept “hard” stops. Exchanges outside the U.S. seldom accept any stop orders at all. (Trailing stops move constantly based on the stock price. Normal “hard” stops are put on at a particular price and remain regardless of what the stock does.)
Trailing stops are changed according to what the stock does-the higher it climbs, the higher the trailing stop is moved.
If exchanges won’t accept these orders, there are two alternatives. Both are mental stops, either put on by you or by your broker. Either one of you-or both-must be on top of the situation-always.
Value Trading-When the Trailing Stop Might Work Against You in the Market
By its very nature, value trading can work against the trailing stop. Value trading-the system of buying strong companies at or near historical lows-implies that you may temporarily follow a stock down past a trailing stop before it begins to rebound. With a trailing stop in place, you may never see the rebound.
And this happened to us recently. We recommended Debt Strategies Fund as a good way to play the beaten-down, high- yielding corporate bond sector. At the time, it was priced around $7. But, more importantly, it was yielding over 16% annually.
However, about nine months later, we came full circle with breaking stock market investment advice. We advised members to disregard our trailing stop for this investment. Why? Because at that time, Investment Director Alexander Green valued the income-producing yield more than the price-per-share dip. And he thought the chance for the fund to dive significantly below our trailing stop was remote. So, when the price dipped below our $5.80 trailing stop, we held on.
With no trailing stop strategy, there was no guarantee that we would stop losing money on this investment if the stock continued to slide.
We might have lost 60%, 70% or even more.
The fund behaved like Alex thought it would. The price per share quickly rebounded to over $6 in just a few days.
So we need to carefully consider value trades in light of the trailing stop.
JDS Uniphase: A Perfect Run-Up in the Stock Market
And now we’ve come to our quintessential example of the power of the trailing stop:
Even though the story is over a decade old, it defines the profit-making power of trailing stops like no other. In March of 1999 we heartily recommended JDS Uniphase. We said then that “it would be the company that would create the next great fortune,” and it “is one stock investment that you don’t want to miss.”
We placed the normal 25% trailing stop on it.
It turns out this was sage advice, as the stock had a perfect, even breathtaking, run-up. It rose from our recommended price of $10.95 (split adjusted) to $110.12-a whopping 905.66% in 14 months. But amazingly, during that entire stretch, the stock never had a real pullback in the market.
Without the 25% trailing stop strategy, it would have been tempting to sell some or all of it at 100% or 200%. Had we done that, we would have missed out.
When the stock reached $150 we were still in it, and subtracting 25%, the lowest price we would sell this stock would be $112.50. As it turned out too, $150 was the high point for the stock. Of course we didn’t know this at the time, nor did anyone else. But that’s the great thing about the trailing stop system — it takes the “guesswork” out of trying to determine a stock’s value. We let the market tell us when the run is over.
The trailing stop system always keeps us from losing our shirt and always locks in our profits when a stock has had a significant gain. How many times have you heard of investors saying they made 100%, 200% or more-only to give it all back when the stock corrected? That’s not happening with our system-sure, we may give back a little, but we’re always locking in profits on our winners.
If JDS Uniphase had continued to rise above $150, we would have been along for the ride. But in this case, $150 was the top, and it gives one a great feeling knowing that even if the worst were to happen-a stock collapse-we would have a huge 905%+ profit. That’s the beauty of the 25% trailing stop strategy.
The Rest of the Story: Don’t Buy and Hold
JDS Uniphase also provides a dramatic example of the benefits of our system versus the perils of holding and hoping. As we said above, we took more than 906% profits from this investment. JDS was a grand slam for us.
Unfortunately, for investors who don’t use a trailing stop strategy, JDS is also the perfect example of the “big fish that got away.” From its high of more than $150 per share, the stock went on to plummet by about 97%. That’s the power of a trailing stop strategy — it can mean the difference between taking more than 900% profits and losing 97% of your investment’s value.
Use Daily Prices in Your Stock Market Investment Strategy
We use end-of-day prices for all our calculations, not inter-day prices. You should too. This makes things easier. If a stock has gone to $100, put a mental stop at $75. If, subsequently, the stock closes at or below that $75 level, sell your shares the next day.
Remember, the key is discipline. A trailing stop is a good technique. Stick to it. Choose a broker who understands trailing stops and will do the work for you.
But common sense dictates two investment fundamentals:
- Taking small losses is much better than taking big losses.
- Letting your profits run is much better than cutting them off prematurely.
Using trailing stops is the best first step you can take to greatly improve your portfolio’s return.
Follow this time-tested technique of the world’s greatest investors and your investments will outperform those of your friends, neighbors and even your fund managers.
This is the first step to having a coherent, reliable system that will let you sleep at night and give you the satisfaction of knowing you’re maximizing your profits.
Once you apply trailing stops, you’ll be that much further ahead of the ordinary investor.
Secret #2: Go With “Low Risk”-And Then Let Your Winners Run
The other secret is to always invest in what they call “low-risk” opportunities. Now, as you’ll see, that doesn’t mean their stocks or investments carry no risk or that they’re not expecting very high gains from these investments. Quite the contrary.
After all, we can’t make 30%, 50%, or 70% each year if we have our money in savings accounts or money market funds. Those are low-risk strategies for your money, but they’re also extremely low profit.
For the world’s most successful investors, low risk means entering only into positions where the probability for high profits far exceeds the possibility of losses over the long run.
They invest their money in such a way as to position themselves for maximum profits while-at the very same time-ensuring that their exposure to serious loss is absolutely non-existent.
A High-Profit Tool for Sophisticated Investors
“Position sizing“ is really all about money management. But it’s not the kind you use to make sure you have enough money on hand to pay expenses like the mortgage, household bills, college tuition for your children, car payments, etc.
The money management connected with position sizing is strictly limited to your investment portfolio. And it’s every bit as crucial to your profits as trailing stops and the stocks you choose.
That’s because this management process tells you how much you should invest in your positions so that you’re not risking more than you’re comfortable with. Position sizing also helps you when you decide it’s time to add to your winning investments-a process we’ll discuss in a moment.
Investment Advice in the Form of a Marble Game?
At the many seminars he speaks at each year, Dr. Tharp illustrates the importance of position sizing by having the participants play an investment game using a bag of marbles…
At the start of the marble game, participants are each given $100,000 in play money to seed their portfolio. There are 20 marbles in the bag, each one representing either a losing (black marble) or a winning (white marble) trade. There’s one more interesting variable. Sixty percent of the marbles in the bag are winners while 40% are losers. And each marble is replaced after it is drawn.
One of the winners is a “10 times winner,” and one of the losers is a “5 times loser.”
Now, the odds of winning in this marble game are far higher than the odds you and I face in the markets. Still, when Dr. Tharp conducts this game with his seminar audiences, more than two- thirds of the participants always lose money. And a full one-third go bankrupt!
How is that possible? How can a majority of people lose in a game in which the odds are so heavily in their favor?
The answer is very simple: Those who lose money do so because they have no idea how much they should be investing in any one marble draw. They are playing the game without a “system,” so they’re really doing nothing but gambling. This sort of approach doesn’t win the marble game. And, in the real-world investment game, it won’t lead to long-term wealth.
The key to success they’re missing in the marble game- and the strategy you should use in your portfolio-is position sizing.
Successful Investing Is Emotionless Investing
Just as we saw when we were looking at trailing stops, investors in this marble game lose money because they get caught up in the emotions of investing. During his marble game, Dr. Tharp does just what’s needed to push all the “hot buttons” of his audience…
For example, after 10 pulls from the bag, he’ll ask to see the hands of all those whose play-money portfolios have doubled in value. And a few hands always go up. Of course, when the others in the game see that a few of their fellow participants have hit it big already, worry and envy enter the picture. And what do you think happens?
In an attempt to catch up with the winners, the other participants start increasing their bets. Problem is, when these ill-considered bets turn out to be losers, they’re doomed to failure’ they dig themselves into a hole they can’t get out of.
Now, I’ll show you how you could win in this marble game. It’s the same way you’ll win in the real-life investing game: the game that will determine the level of wealth you’re going to attain in this life. Here’s how you can pursue the very same low- risk ideas the world’s best investors go after…
First of all, I’m assuming that you’ll be following our investment advice and always have 25% trailing stops on your investments. The 25% is our rule; you can chose your own percentage.
The most important thing is that you use it consistently!
Based on this assumption, for your investments to be low-risk, you should be dealing with odds of at least 2-to-1 or 3- to-1 in your favor, and that means you should be expecting returns of between 50% and 75% on your profitable investments.
We arrive at those figures knowing that because you’ll never lose more than 25% on any one investment (you’ll be stopped out at a 25% loss), 50% and 75% gains represent, respectively, 2- to-1 and 3-to-1 odds.
To give you another example, let’s say you invest in a stock that you expect to return only 30% rather than 50% or 75%. To keep your investment low risk (and your odds at 3-to-1), you’d have to change your trailing stop from 25% to 10%.
Whatever your expected profits, here are two “golden rules” you should follow:
1). Know your worst-case scenario to keep from going bankrupt.
2). Determine how much you’re willing to lose in any one investment.
Now we’ll see how you would apply these two golden rules to Dr. Tharp’s marble game in order to come out a winner.
You’d first have to decide how much of your $100,000 you were willing to lose on any one marble pull. Now, because you’re adhering to the 25% trailing stop rule, that decision won’t be difficult for you. You know that 25% is the maximum you’re ever going to lose.
So you would never want to put more than 5% of your money on any one marble, because if you were to pull that 5 times loser out of the bag, you’d hit your stop-loss limit (5% x 5% = 25%).
You’d have to start with a bet of $5,000 (5% of $100,000). But what would you do next? Would you simply continue to bet $5,000 on every marble you pulled from the bag?
Well, because the odds of this game are heavily stacked in your favor, that strategy would probably mean you’d end the game with more money than when you started.So it would be a good strategy — but it’s not the best you can do…
To really optimize the profit on your investments-in the marble game or in real life — you should scale the size of your investments to the amount of total capital you have in your portfolio.
Our Stock Advice: Always Know Exactly How Much to Invest in the Market for Maximum Profit and Comfort
If in the marble game your portfolio grew from the starting $100,000 to $200,000, and you wanted to stick with your 5% rule, then instead of investing $5,000 on your next investment, you’d go with $10,000. Your risk stays the same (a $10,000 investment in a $200,000 portfolio is the same as a $5,000 investment in a $100,000 portfolio), but your potential for profit escalates because you have more money in play.
Similarly, if you happen to start out with some losses, you only risk 5% of what remains in your portfolio.
For your initial investment and for all subsequent investments, you should never take on a bigger risk than you’re comfortable with. And you should have a systematic way of investing that ensures that no matter how the size of your portfolio changes, you’ll continue to maintain that same risk level.
We suggest never having more than 2% of capital at risk in any one position. But remember, that doesn’t mean that you can only invest 2% in any one position; it means you shouldn’t have more than 2% at risk.
To illustrate this 2% rule, let’s look at a $100,000 portfolio. If you follow 25% trailing stops and 2% risk, the maximum you can invest in any one stock at any one time is $8,000. Here’s the formula for figuring that out… [(.02 x 100,000)/.25]. Now here it is “spelled out”: .02 times 100,000 = 2,000, divided by .25 = 8,000.
If you decided you wanted to put less at risk (like 1% of your capital) our formula would be [(.01 x 100,000/.25] and your limit would be $4,000 in any one stock.
The central message here is consistency: Decide on how much you want to risk… and then stick with that number no matter what. Stay with low-risk ideas… have a consistent exit strategy for the stock market… and you’ll begin to make money just like the world’s greatest investors.
Let Your Winners Run — “Scale” Your Way to Ultra-High Profits
As a final, bonus secret technique of the world’s greatest investors, again from Dr. Tharp, I want to tell you about “scaling in” to investments. The basic reasoning behind this technique is that once you’ve found a winner, you absolutely don’t want to sell it. Instead, you want to put more money into it…
So far we’ve seen exactly how your portfolio will benefit from strictly following a Trailing Stop Strategy. And you’ve seen how following position-sizing opportunities keeps your capital safe while letting you rake in the maximum amount of profits available. That’s a perfect combination.
It’s also one that few investors get advice on from their stock brokers. In scaling in, you’ll be using a similar rule to what you learned in our look at trailing stops. Only this time, instead of selling when your stock falls 25%, you’ll be adding to your investment when-and every time-it rises 33%. Now let me pause for a moment to issue a warning…
At about this time, average investors will begin to worry. That’s because, to them, the idea of adding money to a stock that’s rising is every bit as frightening as selling a stock that’s falling. Once again, emotion has come into play, and it threatens to get in the way of your profits.
But by this time, you should be beyond that. You’ve seen how being afraid to sell a falling stock can hurt you, so you understand the negative role emotion can play in investing. What’s more, you should be able to appreciate how investing more money into a rising stock can help you…
One of the best examples that we can use to illustrate the power of scaling in involves the French telecommunications company, Alcatel. When we first recommended this company to members, it traded at a price of $22. We rode the stock all the way up to a 108% gain before selling it on the way down, where we ultimately pocketed 78%.
The fact that we gave back 25% off the stock’s top didn’t bother us a bit. After all, every $10,000 our members invested in Alacatel had blossomed to $17,000 — and this money was safe from any further erosion in the stock’s price.
But here’s how you could have done much, much better with Alcatel. Rather than just sitting back and watching their winning positions climb, the world’s best investors will “feed” their successes more money — so that there’s more capital on the table to take advantage of the high profit that will be thrown off by these winning rides.
And, of course, they always know how much additional capital to add because they’re using the position sizing technique.
As you’ve seen, our advice is to not put more than 1% or 2% into any one stock market investment or 1% in subsequent scale-ins of that investment. In other words, you put 2% in to start the investment, and then if it climbs 33% for you, you add another 1%… another 33%, another 1% goes in, and so on.
I’ll illustrate this principle using a very simplified scenario, but I will use a 2% scale-in to emphasize the effective use of scaling in…
Let’s suppose that after your initial investment in Alcatel (and for the subsequent 14 months) the size of your portfolio was such that 2% equaled $4,000. That would mean that if Alcatel had gone up 33%, you’d be in a position to feed this investment with another $4,000.
As we saw, Alcatel in fact rose 108%. Which means that you would have had opportunities to do three “scale-ins” of $4,000 each. This scenario is played out in the chart above.
By adding $4,000 each time this stock went up 33%, you would have maximized your profit from it for 14 months. So instead of a $10,000 investment growing to a very respectable $17,000, your total stake in Alcatel would have skyrocketed to $43,514.95!
The reason we recommend you wait to do the initial scale-in until your investment has risen a full 33% is that by that point you’re guaranteed never to lose any money on the stock as long as you get out at the trailing stop. Because you’ll be using a 25% trailing stop, the very worst that could happen to you at this point would be for the stock to return back to the point at which you bought it-a wash, in other words.
An Ideal Profit and Safety Scenario Unfolds…
The secrets that Dr. Van Tharp discovered are used by 99% of the world’s most successful investors, and are now yours to apply to your own investments.
At the end of the day, these secrets (i.e. limiting your losses and maximizing your profits) seem to spring from just plain common sense. The problem, of course, is that common sense is an extremely rare commodity in the world of investing.
Many stock market investment advisors, newsletters, mainstream media financial TV shows, and internet “gurus” make a living out of complicating the process with their own forms of investment advice, rather than simplifying it.
After all, the more complicated they make it, the more mysterious it seems. And the more mysterious it seems, the more it can play on the emotions of investors. And the more emotional investors get, the more they’ll turn to these very same self-proclaimed experts for “investment advice.” It’s a vicious circle.
We take a different approach.
It is our hope that you now appreciate the absolute necessity of stripping emotions out of your investment decisions.