The market is going up every day. Everyone’s ideas are working.
Which means it’s a good time to make sure we are prepared for a sell-off.
It’s a good time to talk about what to do when things go wrong.
Review your book when times are good: I had this jiu jitsu instructor who was a real character. New students would always ask him “Hey Kirtie, what do you do if someone gets you in the rear naked choke?” And he would kind of roll his eyes and get ready to go through all the escapes, because that was the job, but he would often say, “Bro, if you are in the rear naked choke, you f’d up a long time ago.” Meaning, practice all the basics I am telling you so you don’t end up in this terrible position in the first place.
So the best piece of advice is to review your book while things are green and make sure your ship can withstand a storm. I’m not saying to sell your investments and go to cash. But step back and look at what you own. Are these good businesses? Are they paying you dividends? Do you have a strong view on the upside over the next 5 years. Have you done your own work? Do you have conviction? Are you OK with the sizing? Or, is this a low conviction idea you read about on Twitter and are going to sell on the lows at the first big sell-off. If a lot of your ideas are ‘trades’ it’s best to rethink or prune them now on the highs, not on the lows. Don’t get into the rear naked choke in the first place.
Make $1 million instead of losing $1 million. This is also in the preventative maintenance category. Word has it this lesson comes from Stevie himself based on his observations about the trading style of new PM’s. The story goes that a new PM does lots of work on a high conviction idea. He loves it. He’s sure it’s going to go +100% and he’s made it a huge size in his book. He has already calculated how much he will make when it gets to his price target, and his performance fee on that, and what he will do with the money. And he’s made it big because he doesn’t want to have the regret that he left money on the table with such a good idea.
So he’s sized up, but then some unexpected bad news comes along, which is always the case. It might be a macro problem. It might be a wobble in the business. But suddenly he is -30% on this huge position and losing lots of money. The risk manager comes along and tells him he has to cut it. The risk manager says he doesn’t care how great the idea is, the PM is losing too much money, and the rules are the rules. And the PM is freaking out anyways and not sleeping because this was not what he predicted either. So he sells the position for a big loss.
Then the story goes that 2 years later that stock goes up to the original price target and the PM is in a bar somewhere telling everyone about how right he was. ‘See it went to my price target. I knew it all along. I was right!’. But his friends point out that he never made any money on the trade. He sized it too big and ended up losing money. Because the road from A to B is not a straight line. There is almost always a sell off and you need to be able to make in through the storms to the other side. So moral of the story is that sometimes it’s better to size the idea slightly smaller so you can handle the volatility and actually make it to your price target and make $1 million instead of losing $1 million. Here endeth the lesson.
Sell a third. Sometimes you have investments that are not working. It seemed like a good idea at the time, but it keeps going lower and you find yourself worrying about it all the time. Often in the middle of the night. Usually, the move is gradual so you feel a like a frog in hot water. The investment thesis hasn’t totally gone wrong, but there are a few new developments which are concerning. It’s hard to know if you should just be patient, or if you should act now. You don’t want to be the last person to figure out the whole idea is wrong, but then you don’t want to be the idiot who sold on the lows. And it’s hard to know which is which because often good ideas can have turbulence in the beginning when the idea is at a turning point and the long-term upside isn’t obvious yet to the rest of the market.
But if your gut is telling you something is wrong, and you are having anxiety attacks about the position in the middle of the night, it’s a sign you should do something. My solution to this is ‘Sell 1/3’. Sell a 1/3. Not the whole thing, not half, 1/3. That way you are still mostly in the idea, but if it keeps going down it hurts you less. Now check how you feel. Give it a week or two. How do you think about the stock? Often this small sale frees up your mind to think differently. You might realise you actually don’t like this investment and have many other better ideas in your portfolio you should be focused on and this one idea has been sucking up all your attention. If you find your conviction is building that you don’t like it. Sell another 1/3.
Or maybe the stock starts to work again. The news improves a bit and it trades better. Then you’re glad you didn’t blast the whole thing right at the inflection point. At least you still have 2/3. I find these gradual trades are easier cognitively when I’m really uncertain about something.
When being a muppet try to do as little as possible. Like I said in point #1 the best defence is prevention. But sometimes, and this is mostly a hedge fund problem, you are in a situation where you are losing too much money quickly, everything is going wrong, you were on margin, and you are getting risk managed. It’s an emergency situation. Again, this is really a bad position to get into in the first place, and why it is dangerous to use margin, but it does happen so we might as well discuss it.
The tip is that in the heat of the moment when you are blasting everything, trying to reduce exposure as fast as you can, realise you are mostly likely being a muppet. Most likely you should not be selling everything on the lows. Most likely the research work you did was good. In the middle of the chaos try to keep some stub positions in the high conviction ideas that you really like and still believe in. When you know you are doing the wrong thing but have to anyways, try to do it 10% less. Keep a few of those good positions. Even if it is a small amount. It will make it easier to get back in when they go up again.
When you build your book back up don’t make the same mistakes. It’s terrible when you’ve lost a lot of money. It’s so depressing. You beat yourself up. But it is part of the business. It happens. Some of it is unavoidable, but likely you made some mistakes which made it worse. As you build back up try to be more long term. Focus on the basics. My personal experience is that ‘trades’ don’t work. Generally, if it’s a ‘trade’ I don’t bother because trades never go smoothly, and if you don’t really have conviction you are going to get shaken out. Buy good businesses which maybe won’t be so volatile in the first place, and which will be easier to hold during the storms.
Learn how to make $1. Again, this is more of a hedge fund tip. Usually you were playing big with a lot of exposure, then it all went wrong, and you lost a tremendous amount of money that you now have to make back. Mathematically, the only way to make that much money back is with big positions. But that is the gambler’s mentality and you have to fight it. If you think about it your mind has been losing money. That’s the pattern it it is in. Your mind has been very good at losing lots of money quickly.
Now you need to turn the flywheel slowly back the other way. It’s counter intuitive but start small. Set your goal to just make $1. Don’t worry about the mathematics of the big hole you have to dig out of. Instead focus on just making $1. It seems stupid but it works. Make $1. Have an idea work. Now you will feel slightly better about yourself and the ideas will start to click again. You will start to see things a bit better. The self hatred will subside. Now try to make $1,000. Great. Now more ideas will click. You will size things slightly bigger. The flywheel will turn more quickly in the positive direction. With time you will be back in action. When the juices are really flowing you will make back that loss more quickly than you expected. Trust that. But the key is to start slowly. Make $1 first.
Be your own contrarian indicator. Again, this is an after the storm has passed tip. Be frank with yourself. Did I just sell on the lows? Are these actually great ideas that will now work? If I wasn’t in these positions and someone else was watching my trades would they think this was a great time to buy because the bulls had all capitulated? This is a complete mind fck but it’s good to do. We are all human. Again this is a judgement call. Sometimes it’s just too much mental baggage to get back into the exact same trades, especially if they wobble again. If you lose money on them twice you might shoot yourself. Other times you have a sick feeling in your stomach that you sold on the lows and it’s all going back up again. One hack which helps cognitively is to buy back a different name in the same theme. You can tell yourself something like “Yes, I sold on the lows, but I bought back in and actually upgraded the quality of the companies I owned.” Whatever you need to tell yourself.
So let’s take a few minutes this weekend to review our portfolios and do any adjustments we need to do. That way if we get a bit of volatility it’s manageable and we don't end up in the rear naked choke.
Erik
This is a gem