WINNING INVESTMENTS with EXCHANGE-TRADED FUNDS

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THE HARDEST PART

Foreward (2013). The philosophy that follows has evolved into the 'rolling returns' concept of managing and measuring funds and portfolios. The text below reflects our earlier thinking on risk management.

The hard part in investing with any method or system, or any philosophy, or none at all, is the drawdown--how much does a trade, or a portfolio, drop in value before it recovers and exceeds its previous high?

The hardest part is when it happens immediately just after you have invested cash in a new stock or a new system. Especially a new system--particularly one which does not advocate a 'stop-loss' order to limit the extent of a loss.

Fear floods in. Maybe this system does not work. You know about the drawdown business, but maybe this one will be much bigger than the backtests show. Maybe you will lose much more money than you ever want to accept.

The impulse is to quit--sell--get out--resolve not to try another system again, or try another later, maybe right away. Fear is a powerful emotion. It can run you out of a trade with ease--unless you have prepared in advance to address it before it comes.

This system has no 'stops', as you know. It has experienced a -17% drawdown, then gone on to make 223%. The question is, can you tolerate a transient 'loss' that big for a gain of that size in a period of less than four years?

Here is a partial solution. You know from an earlier page that the system has encountered five periods with drawdowns from -8% to -17%. They occur on average about every nine months. They last about three to eighteen weeks. The solution is to wait for the next drawdown. Then commit cash to the system. This way, you will not be entering at a peak. And your odds become better that a turn up in the market is nearer and nearer the longer you wait. How near is that?

The danger, of course, in addition to the possibility of a larger-than-historic drawdown, is that in the waiting you run out of patience. You reach its limit in your personality and quit.

Of the two emotions, fear is the more intense and therefore, the greater cause of immediate, self-defeating, adverse action by an investor. Impatience being milder, but compelling, is the more frustrating because more often than not, immediately after abandoning the fund or the system, it turns on a dime and shoots to new highs.

Think each trade all the way through before entry. How long will you hold the trade? What specific factor(s) alone will cause or allow you to exit? (Your answer to these questions is, or should be, when the market trend changes or the trade drops out of the top rankings--or leaves the bottom rankings if you have sold short.) You should not veer to other reasons after the trade starts. They will not be reasons. They will be emotions.

Finally, limit your each position dollar size to a small fraction of the total dollars you decide to commit to the system. If the position is gaining for you, add to it near the end of drawdowns. Follow strength, not weakness. In the system, weakness will cut its own losses.



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