Clouds of Doubt Percolate Over Europe

Reuters:
After another week of confusion and turmoil in Europe, investors are ditching whatever hopes they once had for a conclusive solution to the debt crisis.
That may foreshadow a gloomy holiday season in markets, especially if wary investors opt to reduce risk in their portfolios and take refuge in US Treasuries and the dollar.
Just weeks after it seemed leaders had drafted a master plan to solve the crisis, doubts rose about whether Greece would back a 130 billion-euro bailout.
Disaster may have been averted when Greece, under fierce EU pressure, agreed over the weekend to form a new government that would approve the deal and stave off bankruptcy.
But that did little to calm investors, who were already looking ahead to the next problem: Italy. Italian bond yields hit a euro-era high of 6.4% Friday, raising fears the country may soon need a Greece-style emergency bailout.
The Greek agreement "may spark a brief relief rally," said Alan Ruskin, head of global G10 currency strategy at Deutsche Bank. "But it won't last and we will soon go back to focusing on Italy."
"At the end of the day, it does seem like a grand plan is elusive at best," said David Ader, head of government bond strategy at CRT Capital Group in Stamford, Connecticut.

"We've seen one European bank and one US brokerage fail. We know there are strains for French banks. We're wondering how long it will be before Greek default worries spread to Italy and Spain," he said. "In a situation like that, money managers are going to decide to simply take their risk down."

Flight to safety

Investors are betting the market will see evidence of that as soon as this week, as flight-to-safety flows help boost US Treasury debt, lift the dollar against the euro and weigh on stock markets around the world.

The biggest fear is that a disorderly default in Greece or elsewhere would ripple across the global financial market the same way the Lehman Brothers collapse did in 2008. That, investors fear, would probably be enough to plunge the global economy into recession.

"This is going to be pretty negative news for risk markets," said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "We are going to see a continued flight-to-quality tomorrow."

Benchmark US 10-year note yields dropped more than 29 basis points in the past week and a half as worries about Europe overshadowed signs of economic improvement in America.

Ashraf Laidi, CEO of Intermarket Strategy in London, said he expected the euro to struggle again this week after losing nearly 3% against the dollar last week. By year end, he said it could fall below $1.30. It was around $1.38 Friday.

"This past week really raised some tricky questions," he said. "For the first time I can remember, the possibility that Greece really could leave the Eurozone was being talked about in cafes and bars as well as on trading desks."

The weekend deal in Greece may stabilize things a bit in that it suggests Greece will keep the emergency funds flowing while making the tough spending cuts needed to get its fiscal house in order.

"What we had been afraid of was a stalemate. Now it seems the hard cuts will be made. I think equity markets will cheer this," said Michael Yoshikami, president and chief investment officer at YCMNET Advisors in Walnut Creek, California.

The cheering may not last long, though.

"These 24-hour risk-on rallies, I don't know how much longer people are going to be willing to do that," said Ader. "Sell-offs are getting deeper because the rallies are only short-covering moves. People are not getting long and putting on bets that everything is suddenly OK."

From Greece to Italy

Deutsche Bank's Ruskin said the focus is likely to shift quickly from Greece to Italy in the weeks ahead, and that should mean more volatility and unwillingness to take on risk.

Italy's debt-to-output ratio stands at 120%, second only to Greece in the 17-country Eurozone, and its borrowing costs are rising.

Prime Minister Silvio Berlusconi recently refused a loan offer by the International Monetary Fund and his government may be on the verge of collapse.

"Berlusconi says Italians are not feeling the crisis but that's because the European Central Bank has been providing high levels of liquidity at low interest rates and buying Italian bonds," Ruskin said. "That begs the question, should the ECB stop that to show them this is really a crisis?"

"I have to believe a lot of investors like me are thinking this could be the start of Italy week," said James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. "Italy is going to rapidly rise on investor radar screens and may be the bigger story."

There is NO Risk Today!

It's a "Risk On" Day!

Risk Off? Not In the Grains Markets!

Silver to the Slaughter

The risk trade is coming off big-time!

What Is the Greatest Risk Right Now?

Risk and the Faulty Models That Increase It

By Niels Jensen
Absolute Return Partners

“When models turn on, brains turn off.”
–Til Schulman
I have been thinking a great deal about risk over the past couple of years. The depth of the financial crisis took many of us by surprise. I made mistakes. I am sure you made mistakes. In fact, the whole industry made mistakes, from which we should all learn. Whether we will is another story, but we should try.
Making those mistakes is all the more frustrating because I was aware of the dangers but, like most others, underestimated the magnitude. In fact I wrote about them – see for example the October 2007 Absolute Return Letter (Wagging the Fat Tail).
Now, let’s distinguish between trivial risk (say, the risk of the stock market going down 5% tomorrow) and real risk - the sort of risk that can wipe you out. The geeks call it tail risk, and James Montier provided an excellent definition of it in his recent paper, The Seven Immutable Laws of Investing, where he had the following to say:
“Risk is the permanent loss of capital, never a number. In essence, and regrettably, the obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk clearly isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure.”
Following James’ line of thinking, let me provide a timely example of the complex nature of tail risk:

The Japanese disaster

Contrary to common belief, the disaster at the Fukushima Daiichi nuclear power plant was not a direct result of the 9.0 earthquake which hit Northeastern Japan on 11 March. In fact, all 16 reactors in the earthquake zone, including the six at the Fukushima plant, shut down within two minutes of the quake, as they were designed to do. But Fukushima is a relatively old nuclear facility – also known as second generation - which requires continuous power supply to provide cooling (the newer third generation reactors are designed with a self-cooling system which doesn’t require uninterrupted power).
When the quake devastated the area around Fukushima, and the primary power supply was cut off, the diesel generators took over as planned, and the cooling continued. But then came the tsunami. Around the Fukushima plant was a protection wall designed to withstand a 5.2 metre tsunami, as the area is prone to tsunamis. However, this particular one was the mother of all tsunamis. When a 14 metre high wall of water, mud and debris hit the nuclear facility, the diesel generators were wiped out as well. But the story doesn’t end there, because Fukushima had a second line of defence – batteries which could keep the cooling running for another nine hours, supposedly enough to re-establish the power lines to the facility. However, the devastation around the area was so immense that the nine hours proved hopelessly inadequate. The rest is history, as they say.

Other tail risk events

I have included this sad tale in order to put the concept of risk into perspective. You cannot quantify a risk factor such as this one because, if you try to do so, the prevailing models will tell you that this should never happen. Take the October 1987 crash on NYSE. It was supposedly a 21.6 standard deviation (SD) event. 21.6 SD events happen once every 44*10⁹⁹ years according to the mathematicians amongst my friends¹(10⁹⁶ is called sexdecillion, but I am not even sure if there is a name for 10⁹⁹). The universe is ‘only’ about 13.7*10⁹ years old (that is 13.7 billion years). Put differently, 19 October 1987 should quite simply never have happened. But it did. (My source is Cuno Pümpin, a retired professor of Economics at St. Gallen University.)
So did the Asian currency crisis which resulted in massive losses in October 1997, which statistically should only have happened once every 3 billion years or so. By comparison, our planet is ‘only’ about 2 billion years old. And the LTCM which created mayhem in August 1998 was apparently a once every 10 sextillion years (10²¹) event. And I could go on and on. The models we use to quantify risk are hopelessly inadequate to deal with tail risk for the simple reason that stock market returns do not follow the pattern assumed by the models (a normal distribution).

Black swans galore

The smart guys at Welton Investment Corporation have studied the phenomenon of tail risk in depth and kindly allowed me to re-produce the table below which sums up the challenge facing investors. In short, severe losses (defined as 20% or more) happen about 5 times more frequently than estimated by the models we (well, most of us) use.
Table 1: Severe Losses Occur More Frequently than Expected

Source: Welton Investment Corporation (www.welton.com)

Why your birthday matters

It is not only tail risk, though, which brings an element of unpredictability into the equation and effectively undermines Modern Portfolio Theory (MPT), which is the foundation of the majority of applied risk management today (more about MPT later). One of the least understood, and potentially largest, risk factors is what I usually call birthday risk. Effectively, your birthday determines your ability to retire in relative prosperity. Is that fair? No, but it is the reality. Woody Brock, our economic adviser, phrases it the following way:
“I would happily live with vast short‐term market volatility in exchange for certainty about the level of my wealth and future income at that date when I plan to retire. Wouldn’t you? Wouldn’t most people?”
And Woody goes on:
“But if this is true, then why does most contemporary “risk analysis” completely bypass this perspective and focus on shorter term risk?”
To illustrate the point, let me share with you some charts produced by Woody and his team at Strategic Economic Decisions. Most people have the vast majority of their assets tied up in property, stocks or bonds, or a combination of the three. It is also a fact that most people do most of their savings over a 15-20 year period – from their mid to late 40s until their early to mid 60s, the reason being that most of us are net spenders through our education and until the point in time when our children move away from home. It is therefore extremely important how those 3 asset classes perform over that 15-20 year period. Now, look at the charts below (all numbers are annual returns, and the asset wealth column represents a weighted average of the other 3 columns):
Chart 1a: Growth in US Asset Wealth, 1952-1965

Chart 1b: Growth in US Asset Wealth, 1966-1980

Chart 1c: Growth in US Asset Wealth, 1981-2000

Source: Strategic Economic Decisions (www.sedinc.com)
When you look at those charts, wouldn’t you just love to have retired in 2000? A solid 7.9% per year for the preceding 19 years turned $1 million in 1981 into $4.2 million in 2000, whereas those poor souls who retired in 1980 managed to turn $1 million into no more than $1.1 million during the previous 14 year period. And those who are retiring today aren’t much better off following an extremely volatile decade. This is effectively a birthday lottery but, as we shall see later, there are things you can do to address the problem.

The problems with MPT

However, before we go there, I would like to spend a moment on MPT, as I believe it is important to understand the shortcomings of the prevailing approach to investment and risk management. (Much of the following is inspired by Woody Brock.) Let’s take a closer look at three of the most important assumptions behind MPT (there are many more assumptions behind Modern Portfolio Theory. Wikipedia is a good place to start should you wish to read more about it):
1. Risk-free investments exist and every rational investor invests at least some of his savings in such assets, which pay a risk-free rate of return.
2. Returns are independently and identically-distributed random variables (returns are trendless and follow a normal distribution, in plain English).
3. Investors can establish objective and accurate forecasts of future returns by observing historical return patterns. (Strictly speaking, this assumption was relaxed by Fischer Black in 1972 when he demonstrated that MPT doesn’t require the presence of a risk-free asset; an asset with a beta of zero to the market would suffice.)
Well, if these assumptions are meant to stand the test of time, then good old Markowitz (the father of MPT) is in trouble. Truth be told, none of the three stand up to closer scrutiny. The concept of risk-free investing no longer exists, post 2008. Banks are giant hedge funds which cannot be trusted and even government bonds look dicey in today’s world. Secondly, returns are clearly not random. If you have any doubts, just look at how the trend-following managed futures funds make their money. Thirdly, from 26 years of investment experience, I can testify to the fact that historical returns provide little or no guidance as to the direction of future returns.

A new approach is required.

So what does all of this mean? First of all it means that universities and business schools all over the world should clear up their acts. Two generations of so-called financial experts have been indoctrinated to believe that MPT is how you should approach the management of investments and risk whereas, in reality, nothing could be further from the truth. It also means that investors should kick some old habits and re-think how they do their portfolio construction. Specifically, it means that (and I paraphrase Woody Brock):
i. the notion of the “market portfolio” being an appropriate performance benchmark should be discarded;
ii. there is in reality no meaningful distinction between strategic and tactical asset allocation - the difference is illusory;
iii. investors should once and for all reject the notion that there is an optimal portfolio for each investor from which he or she should only deviate “tactically” in the shorter‐run;
iv. market‐timing deserves more credit than it is given;
v. MPT is a straitjacket preventing investors from rotating between different classes of risky assets (with vastly different risk/return profiles) as market conditions change.
Please note that this does not imply that asset allocation is irrelevant. Far from it. However, it does mean that a bespoke approach to asset allocation, where individual circumstances drive portfolio construction, is likely to be superior to a more generic approach based on a strategic core and a tactical overlay.
This is nevertheless serious stuff. Effectively, Woody Brock is advocating a regime change. Throw away the generally accepted approach of two generations of investment ‘experts’ and start again, is Woody’s recommendation. As a practitioner, I certainly recognise the limitations of MPT and I agree that, in the wrong hands, it can be a dangerous tool, but there is also a discipline embedded in MPT which carries a great deal of value. And, in fairness to Woody, he does in fact agree that you can take the best from MPT and mix it with a good dose of ‘common sense’ and actually end up with a pretty robust investment methodology.

A solution to the problem

Here is what I would do in terms of applying his thinking into a modern day investment approach:
1. Do what you do best. Some investors are made for short-term trading. Others are much more suited for long-term investing (like me). Don’t be shy to utilize whatever edge you may have. MPT suggests that markets are efficient. Nothing could be further from the truth. If you have spent your entire career in the medical device industry, the chances are that you understand this industry better than most. Use it when managing your own assets. Insider trading is illegal; utilizing a life time of experience is not.
2. Take advantage of mean reversion. Mean reversion is one of the most powerful mechanisms in the world of investments. At the highest of levels, wealth has a long term ‘equilibrium’ value of about 3.5 times GDP. As recently as 2007, wealth was well above the long term equilibrium value and signalled overvaluation in many asset classes. But be careful with the timing aspect of mean reversion. The fact that an asset class is over- or undervalued relative to its long term average tells you nothing in terms of when the trend will reverse. A good rule of thumb is to buy into asset classes when they are at least a couple of standard deviations below their mean value.
3. Be cognizant of herding. We are all guilty of keeping at least one eye on other investors, and we are certainly guilty of letting it influence our own investment decisions. This is how investment trends become investment bubbles and fortunes are wiped out. Herding is relatively easy to spot despite the fact that former Fed chairman Alan Greenspan argued otherwise – probably because it was a convenient argument at the time. But herding is also subject to the greater fool theory. You can make a lot of money investing in fundamentally unsound assets, as long as you can find a greater fool to whom you can sell it at a higher price. It works fine but only to a point.
4. Think outside-the-box. All those millions of baby boomers all over the western world who will retire in the next 10-15 years have been told by the MPT-trained financial advisers that they need to lighten up on equities and fill their portfolios with bonds, because they need the income to live on in old age. STOP! Who says that bonds can’t be riskier investments than equities? When circumstances change, you should change your investment approach accordingly and not rely on historical norms. Given the state of fiscal affairs in Europe and North America, it does not seem unreasonable to suggest that circumstances have indeed changed.
5. Bring non-correlated asset classes into the frame. One should consider having a core allocation to non-correlated assets. Traditionally, many non-correlated asset classes have not met the liquidity terms required by the majority of investors (see below on liquid versus illiquid investments), but there are exceptions, the most obvious one being managed futures. The asset class proved its worth in 2008 with managed futures funds typically up in the range of 20-30% that year.
6. Take advantage of investor constraints and biases. The classic, but by no means only, example is the outsized impact a downgrade to below investment grade (i.e. a credit rating below BBB) may have on corporate bonds, as some institutional investors are not permitted to own high yield bonds and are thus forced to sell regardless of price when the downgrade takes place.
My favourite example right now is illiquid as opposed to liquid investments. I strongly believe that less liquid investments will outperform more liquid ones over the next few years for the simple reason that the less liquid ones are struggling to catch the attention of investors who, still smarting from the deep wounds inflicted in 2008­09, stay clear of anything that is not instantly liquid. This has had the effect of pushing the illiquidity premium (i.e. the extra return you can expect to earn by investing in an illiquid as opposed to a liquid instrument) to levels we haven’t seen for years.

Sobering Message from Simon Maierhofer

from Simon Maierhofer at ETF Guide:

The stock market is lulling investors to sleep. Since early September stocks have gone nowhere but up. Four weeks of steady gains have rekindled optimism and created a state of euphoria not seen in years … since late 2007 to be exact.
The irony of this article is that few investors will feel compelled to read anything that resembles a warning or contains a bearish message. The few that read this piece will probably scoff at it. That’s how bear market rallies work and that’s why they are effective.
The soothing rhythm of the VIX has lulled investors into a state of complacency. If you had to describe investor’s alertness in sleep lingo, a state of REM sleep would probably be the closest comparison.
History tells us that the (bear) market only strikes when least expected.
Based on a variety of sentiment measures, a stock market decline is viewed to be less likely to happen now than in 2000 or 2007.
Investors and traders are content to hold on to massive long positions without hedge. One of the easiest ways to hedge your stock portfolio is via put options. The CBOE Equity Put/Call Ratio has tumbled to the second lowest reading in years. The only time investors hedged less was in April 2010.
Back then, the put/call ratio dropped to 0.45. The lack of hedging is dangerous for prices because the market is without a safety net. The only option for spooked investors without hedge is to sell. Selling causes prices to drop.
On April 16, 2010, the ETF Profit Strategy Newsletter warned of the consequences of a low put/call ratio: “Selling results in more selling. This negative feedback loop usually results in rapidly falling prices. The pieces are in place for a major decline. We are simply waiting for the proverbial first domino to fall over and set off a chain reaction.”
The first domino dropped just a few days later, setting off the May 6 “Flash Crash” and ultimately resulted in a swift 15% correction for the Dow (DJI: ^DJI), 17% correction for the S&P (SNP: ^GSPC), 19% for the Nasdaq (Nasdaq: ^IXIC), and 21% for the Russell 2000 (Chicago Options: ^RUT).
This Time is Different
The spirit of “this time is different” is one of the most fascinating phenomenons known to Wall Street. Investors’ sentiment precisely follows the ebb and flow of stock prices. When prices are up, the future is expected to be bright. When prices are down, the future is supposedly bleak (just think of the 2007 peak and 2009 bottom).
This approach of linear extrapolations feeds the herding mentality, which contrarians use as contrarian indicators. This approach is not foolproof but, nevertheless, is one of the most accurate, if not the most accurate timing tool known to underground Wall Street aficionados.
The chart below illustrates the four most prominent occurrences of extreme optimism, or the “this time is different” effect. The green line connects the price of the S&P with the timeline and various sentiment gauges.
Investors thought this time is different at the 2007 peak, in May 2008, in January 2010, and again in April 2010. The only thing different at all four times was the velocity of the descent, but each period of euphoria was greeted by despair.
Optimism and Bad News
If you have watched CNBC’s 60 Minutes over the past two weeks, you are aware of some serious “Black Swans.”
Scott Pelley’s introduction to Ben Bernanke’s interview couldn’t have been more sobering: “That is the worst recovery we've ever seen. Ben Bernanke is concerned. Chairmen of the Fed rarely do interviews, but this week Bernanke feels he has to speak out because he believes his critics may not understand how much trouble the economy is in.”
The financial media, however, ignored Ben Bernanke’s outright scary assessment of the economy and focused on the silver lining: A bad economy may lead to QE3 and its cousins QE4 and QE5. What’s better, an improving economy or more QE? Apparently QE is just as good as more jobs.
Yesterday’s 60 Minutes focused the next big thing; Municipal and state defaults. In the two years since the “Great Recession,” states have collectively spent nearly half a trillion dollars more than they collected. There’s a trillion dollar hole in their public pension fund and according to New Jersey’s Governor, the day of reckoning is near.
Meredith Whitney, one of the few analysts who foresaw the bubble building in banks (NYSEArca: KBE) and financials (NYSEArca: XLF) believes at least part of the three trillion municipal bond market will unravel within the next year.
For much of 2010 municipal bonds were brewing their own little bubble. As it is common with bubbles, they are rarely foreseen by the public eye. In the case of muni bonds, yield hungry investors ignored the red flags.
On August 26, the ETF Profit Strategy Newsletter warned that it is time to get out of muni bonds (NYSEArca: MUB), corporate bonds (NYSEArca: LQD) and Treasuries (NYSEArca: TLT). The chart below shows what has happened to muni bonds.
Yes, history doesn’t repeat itself but it often rhymes. In 2007, Merrill Lynch’s Global Economics Report foresaw a bright future: “The Merrill Lynch global economics team believes that the economy will continue to grow in 2007 – with no sign of a significant cyclical slowdown.”
According to J.P. Morgan, Barclays Capital and Goldman Sachs (Merrill Lynch failed to foresee its own demise in 2007 and is no more), the S&P will gain between 15 – 20% in 2011 and the “economy will continue to grow in 2011.” No, this time is different, really!
According to history, now is the time to at least be cautious and protect your investments. An ounce of protection is worth more than a pound of cure. Based on long-term valuation metrics the stock market is priced to deliver pain, not gain (see November 2011 ETF Profit Strategy Newsletter for a detailed analysis).
Based on sentiment, the market is overheated and due for a correction at the very least. Timing a top is tricky, but based and support and resistance levels and seasonal patterns it is possible to narrow down when the market is ready to roll over.
The ETF Profit Strategy Newsletter includes a semi-weekly update along with the most recent technical analysis and important support/resistance levels. A break below major support is likely to break the bulls’ spirit and the market’s streak … while most are still sleeping.
Oh, here are the missing lyrics for Rock-a-Bye Baby: “When the wind blows, the cradle will rock. When the bough breaks, the cradle will fall. And down will come baby, cradle and all.” It doesn’t sound like a good night’s sleep.

Big Banks Carrying Far More Risk Than They Want Us to Believe

from WSJ:
Three big banks—Bank of America Corp., Deutsche Bank AG and Citigroup Inc.—are among the most active at temporarily shedding debt just before reporting their finances to the public, a Wall Street Journal analysis shows.
The practice, known as end-of-quarter "window dressing" on Wall Street, suggests that the banks are carrying more risk most of the time than their investors or customers can easily see. This activity has accelerated since 2008, when the financial crisis brought actions like these under greater scrutiny, according to the analysis.

Note on Risk Strategy

from Mish Shedlock:

"In my world, the way to produce above average returns over time is to take some chips off the table when risk is high, and put them back on the table when there is a good risk-return opportunity."

Yen Is Barometer of Risk Aversion

The yen is often seen as a global barometer of risk aversion. The graph below demonstrates the strong inverse relationship between the movements of the yen (against the euro, in this case) and those of the Dow Jones World Index. As shown, a falling yen indicates risk tolerance (and a willingness to buy risky assets) and a rising yen shows risk aversion (and an indisposition towards risky assets). A downturn in the yen exchange rate could be a good indicator to keep an eye out for confirmation of better times ahead for stocks and commodities.

Drama Creates Trauma: Risk Management

from Dr. Brett-


I recently received an email from a trader who was going through difficult emotional swings as a result of swings in his portfolio. He assured me that he was a knowledgeable, experienced trader and that he limited his risk to 5% per trade.

I didn't need to read any further to know the problem.

So let's return to Henry Carstens' P&L Forecaster to see what's gone wrong.

In the top chart above, we're looking at forecasted returns for a $100,000 portfolio in which the standard deviation of returns per trade is 1% or $1000 and the trader has entered a period of flat performance (average zero return per trade). That might represent the scenario in which a trader risks 1% of portfolio per trade with moderate discipline. Over the course of 100 trades, that trader shows an equity peak of about $9000 (up 9%) and trough about -$3000 (down 3%), for a peak-to-trough drawdown of 12%.

In the world of professional money management, such a swing would merit the attention of risk managers. I don't know too many portfolio managers who would feel good about going from up 9% on the year to down 3% within the span of 100 trades. It wouldn't be a catastrophe, but it would be a concern.

Now, in the bottom chart, let's take a look at the performance of the trader who ramps up risk to a 5% standard deviation per trade, like our correspondent. That again might represent a scenario of risking 5% of the portfolio per trade with moderate discipline. Over the course of 100 trades, that trader displays an equity peak of about $15,000 (up 15%) and trough of almost -$30,000 (down 30%) for a gut-wrenching peak-to-trough drawdown of 45%.

In the world of professional money management, that would be wholly unacceptable.

We all hit periods of flat performance; during those times, note how risk levels affect *psychological stress*. In one scenario, we swing from 9% up to 3% down. Raising the risk per trade by a factor of five swings up from 15% up to 30% down. Note that the order of the gains and losses could just as easily have been reversed: in the first scenario, we could have first gone from 9% down to 3% up; in the second scenario, we could have gone from 30% up to 15% down.

It's the swings that are important--and the effect of those swings on the psyche.

When we trade size that is too large for our account size, we subject ourselves to drastic swings in P/L, and that subjects us to drastic swings in mood. In turn, we then make trading mistakes that bring a negative expectancy to each trade, and the size eventually blows us up.

My advice to the gentleman? Think of the charts above as measuring risk per day instead of risk per trade, so that the equity curves represent 100 days of trading. You can see that a 1% standard deviation of returns still generates peak-to-trough drawdowns of over 10%. I would cut risk below that level--risking less than 1% per day, and thus significantly less than 1% per trade--for at least a month of consistent, disciplined trading before considering a *modest* rise in size (which, in turn, would need to be accompanied by a full month of consistent, disciplined trading).

Only such a sustained period of trading without large swings will counteract the emotional fallout created by the large equity swings. In trading, if you create drama in your returns, you'll create trauma--and that's how trading careers end. The links below explain this in detail.

RELATED POSTS:

The Psychology of Risk and Return

Risk Management and Human Biology

Inside the Trader's Brain

Risk Aversion Trumps Potential Profits!

I frequently hear asset management people tell people to hold onto stocks that are falling with the justification that eventually, they just have to turn around, or that they have fallen so far, they must have hit bottom. They reason that prices must move higher, and investors should therefore remain in them so that they don't lose out on the opportunity when stocks eventually move higher. I disagree with this philosophy for various reasons:

1. Opportunity Loss -- Every dollar that is invested in a losing stock/trade is a dollar that can't be used in a winning stock or trade. If that money is locked up in a bad trade, there are a myriad of opportunities missed that might have made money instead! One opportunity that is lost on a falling stock is the opportunity to short it instead. Even if -- like me -- you don't short stocks, you could profit from buying an ETF that does short that market sector! You could be making money from the ill sentiment toward that stock, instead of losing it. Or you could at least stop the loss by hedging with an inverse ETF in the same sector. Perhaps the greatest opportunity missed with this philosophy is the opportunity to have purchased that same stock or ETF at a much lower price. Taking a small, early loss is the only way to avoid this opportunity loss.
   
2. Clear Head -- When you exit a bad trade, your analytical skills improve immediately because you have cleared your head and can see the markets with a more objective perspective. It is amazing how releasing our minds from the emotion of a bad trade can help us to more clearly recognize the good ones.
   
3. Irrational Markets -- There is a saying (don't know who to attribute it to) that the financial markets can remain irrational longer than you have money to wait out that irrationality. This is true! You'll go bankrupt waiting for that "inevitable" turnaround that you just knew would eventually come. Even if that turnaround does come one day, there is a good chance you'll never see it because you'll lose your money waiting for it. It also seems to come just when we have been pushed out of the market after we just couldn't stand any more loss.
   One of my favorite thoughts from Phantom of the Pits is that we must recognize the blessing of a small loss. He also says that the trader who loses least, wins most.
   
4. The "Falling Knife" -- This idea comes from the very potent image that if you try to catch (or in this case, hold onto) a falling knife, you will get very bloody and experience severe physical trauma. The same concept is also true of our finances. Trying to catch a falling stock also bloodies the financial waters of our lives just as surely as catching a physical knife blade does. These financial "gurus" who suggest "holding on" to losing investments always reason that because prices have fallen substantially, they must therefore begin to rise now. No, they don't! Prices that are down can go even lower. Much lower! Momentum is to the downside! Stocks can go to zero! Don't try to catch a falling knife! Take your losses early, and you'll not only sleep better at night, but you'll also be able to keep a clear head (#2 above) to select other investments and get back into the market to make money instead.
5. Fox in the Hen-House -- Many of these supposed investment advisers and experts are in a losing market position themselves. It is true that "misery loves company". Many of these people (or their clients) are losing money on the same stocks they are recommending to others, and therefore they are hoping that by suggesting that other people buy them also, their own (or their clients') loses will stop and the stocks they recommend will start to move higher again, thus rescuing them from their own misery and losses. Corporate executives are notorious for recommending their stocks even while they are selling those same stocks themselves. These people have a gross conflict of interest, so all their comments should be taken with a grain of salt -- better yet, a pound or two of salt. This is also true for many investment advisers.
   

I would rather exit a bad trade quickly (Phantom's Rule #1), and buy that stock back again later at a much better price when the bottom has truly formed and when my thinking is clear. Thus, my purchase price is better and my return on investment is also improved versus someone that buys and holds regardless of market turmoil.

Miss First 20% and Last 20% of Trend
One investment tip that I have heard attributed to the Rothschilds (although I don't know if this is true) is that they don't try to catch the first 20% or the last 20% of a stock's rise. If someone holds onto a bad trade, they stand to risk all or most of the rise, not just miss the first or last 20%. I have found that my trading methodology allows me to accomplish this -- getting in at the early stages of a new trend, and getting out just as the momentum is starting to wane. Sometimes I'm wrong, but more often than not, I'm successful, and my successful trades are far more profitable than my bad ones. Learning strong technical analysis skills helps tremendously to reduce the risk and raise profits.

Best Book on Risk Vs. Profits
My philosophy on focusing on reducing risk instead of on profits was influenced heavily by Phantom of the Pits in his book, "Phantom's Gift". It's the best book on trading that I've read, and what makes it even better is that it is available free. That's not just a bargain. From the perspective of return on investment (ROI), it's value is therefore literally infinite! My only real investment is the time to read it and the effort to change my behavior. I can't make a better investment than that!