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When the “Sell if it Drops 10%” Rule is Stupid

Should I sell when the stock drops?

If you spend much time studying stocks and investing you’ll eventually run into this risk management rule some people swear by “if a stock you’re holding drops by 10% no matter what else is the case, sell!”

We’ve covered the subject of risk at length but to summarize some key points:

  • Risk consists of two parts the probability of loss and the severity in the event of loss
  • Most traders don’t employ strategies that reduce the probability of loss and think only about reducing the severity of loss – this of course is stupid because if you’ve got a losing % even if you lose 2% at a time you’ll eventually bleed yourself dry, which is why we don’t buy lottery tickets
  • Most traders employ a severity of loss protection that includes two key points: never risk more than say 2% of your portfolio on a given trade, employ stop losses to ensure you can’t lose more than a certain amount
  • Most retail investors use diversification and asset allocation to minimize their risk

Generally, you’ll notice we advocate two positions when it comes to investing:

  1. Average Investors – For those who don’t want to spend time mastering investing stick with dollar cost averaging a strong diversification and asset allocation mix, hold long term and forget about it
  1. Sophisticated Investors – For those who want to learn to master investing the more diversified you are the less likely you are to beat the market so focus on highly concentrated well researched investments following the investment rules we teach

You’ll notice neither of these philosophies involve employing the 10% loss and sell rule.  Why not?

The basis of the rule is preventing loss but the underlying assumption of it is you don’t know when you invest that what you’re investing in is fundamentally solid and we patently disagree with this approach.  We don’t believe you should invest if you don’t know with a high degree of certainty what you’re investing in is fundamentally solid and we advocate a lot of learning and diligence to ensure this.

Selling if it drops 10% makes sense for people who are trading based purely on technical or even based on speculative investment analysis for example people who invest in uncertain growth stocks.  The reason is because it takes a disproportionate gain to make up for a loss for example a 50% drop requires a 100% rise to recover while a 90% drop requires a 1000% rise to recover.  The theory is a 1000% gain is highly unlikely.

Value investing suggests quite the opposite premise that if the asset’s value is solid then the lower it is the better investment it is because the upside is greater and chance it is undervalued is greater.  In other words the chance of a gain isn’t based on how much the asset needs to increase in price in percentage terms but rather what the underlying intrinsic value is.  If the intrinsic value is 1000% higher than the current price then given time it will eventually go there and you’ll earn a significant return.

In other words if you’re confident of a durable underlying value in the asset you’ve purchased the lower an asset drops in price the more interested you should be in buying and if the value is intrinsic then you’d be crazy to sell based on a 10% decline because it’s got an ever greater chance of increasing.

There is a caveat to all of this.  We certainly make mistakes from time to time so instead of selling when a stock you’re holding drops 10% you should re-examine the company to ensure your underlying assumptions are accurate and the intrinsic value is indeed what you estimated it to be.  If you discover you were in error either the value isn’t what you thought or the underlying asset isn’t durable and is decreasing in value with not guarantee of coming back then you should sell but selling should be based on fundamentals of the underlying company not a decrease in price.

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Currency Risk Inherent in Commodities Investing (for foreigners)

Since I’ve been advocating buying oil over the last few days I figured it was a good time to explain a point of larger scale finance that can affect a lot of people internationally if they start buying oil.

As you start to grow your wealth you’re going to increasingly become exposed to the global financial environment spending money in different countries and currencies, selling to different counties and currencies, dealing with different political and tax systems, different regulations, and so on.  What you’ll often find is what seems like a good business model in one market can be fatal in another.  The world is full of examples of big successful companies that entered a new market only to leave later after experiencing failure.

For our purposes the risk we’re going to focus on is currency risk.  If for example you’re an Australian business purchasing services from US providers the last couple months have been rough for you as the Australian dollar hit a 5 year low.  The same principle applies to investing, in this case investing in oil.  The US dollar is relatively strong at the moment and the price of oil is relatively low.  If the US dollar were to fall you’d see the price of oil rise relatively to international currencies while remaining the same price in real global terms.  In other words, the price of oil could go up by 10% and you could end up with zero profit in your local currency if those gains were either as a result of a drop in the US dollar or offset by gains in your local currency.

This is especially important for those investing from countries where their local currency is highly commodity, and in particular oil dependent such as Canada.  Canada’s dollar is trading quite low compared to the US dollar at the moment and oil is trading low as well.  The danger for Canadians is if the price of oil increases the value of the Canadian dollar is also likely to increase at least somewhat and this will, at least to some extent, undermine returns.

Of course in theory the opposite could happen if you were in an economy where your currency would fluctuate inversely to the price of oil and you could compound your returns.  (No currency will be entirely in line with the movement of any particular commodity but certain currencies at least tend to be more commodity dependent based on the make-up of their economy).

The basic lesson is to watch global factors especially as you begin to operate more and more globally.  It can help you to plan for risks such as fluctuations in foreign currencies and costs.  It also represents a tremendous opportunity as volatility opens the door for advantages in importing and exporting.  For example, prices are typically set between given markets based on relatively long term trends.  Books are a good example of this, visit Canada and you’ll see a price in USD and another in CAD.  These are physically printed on the books and aren’t likely to change quickly.  On the other hand the currencies could change quite quickly.  What you can keep in mind then is if say the Canadian dollar has fallen a fair bit in a short period of time, take advantage of it by buying goods from Canada where it’s an option in the period immediately after the fall prior to prices being corrected for the changes in currency value.  If on the other hand the Canadian dollar has risen a fair bit in a short period of time take advantage of using Canadian dollars to purchase abroad rather than locally because the prices will be lower on a relative basis for the same items.  In the early 2000s I took advantage of this disparity purchasing computer parts when purchasing across the border offered significant cost advantages.  Of course it only makes sense at a certain scale and convenience but it’s a valuable lesson to learn.

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The Fallacy of Timing Markets – Lessons in Investing Psychology & Strategy

In determining how I wanted to invest in oil today I stumbled upon an article asking if now was a good time to buy oil.  It discussed the classic buy low sell high dynamic and how oil does indeed look low.  Perhaps it was journalistic ass covering or investment advisor ignorance but the article went on the make some comments frequent among investors that cost far more returns than they create.

The two objections raised were “we don’t know how low it will go” and “we don’t know how long it will stay down”.

On the surface these pieces “wisdom” seem logical.  It’s actually a fact, we don’t know how low oil will go (though we can make reasonable guesses about how low it won’t go based on production costs, etc. for example it will almost certainly not fall much below $40/barrel if it even gets there) or how long it will stay down (we can make educated guesses here though we can only project based on a partial rebound not a full recovery if one ever comes).  So what’s the danger?  They expose a fundamental error in investing lore.

The psychological tendency is if something is worth $80 and it drops to $50 where you buy it, but it continues down to $45 before it recovers you will tend to think “look I missed out on that $5 extra I could have earned”.  And “if only I’d waited a little longer I could have caught it at $45 instead of $50”.  The reality is it doesn’t much matter because you made a solid return in a fairly short period of time.  More importantly, what this thinking will do to you more often than not is paralyze you from taking the action that would have earned you the return.  In other words at $45 you’ll tend to think “what if I buy now and it falls to $40?”  Then if it goes back up to $50 you might be busy waiting for it to go back to $45 while it rises back to $80.

Only fools try to time the market, it is simply too difficult.  Yes, there are technical traders who can do a pretty good job in short little bursts but that’s not what we’re talking about here.  What we’re talking about here is speculation based on longer term decisions.

If you want to consistently gain solid returns the way to do it is to discipline yourself around rules and principles.  In this case the rule is “when something falls to the point where it’s a great deal with a significant margin of safety buy it”.  We’re assuming of course that you’ve followed the other principles such as understanding what you’re buying, understanding why it’s a good buy and so on.  At this point if you’ve done it well it doesn’t much matter what happens next in the short term.  If it falls more great, buy more if you’re able.  If the fundamentals change so it’s no longer a good buy then get out.  Otherwise hold until your margin of safety has expired and act accordingly.

In the case of oil I know oil is a good price and yes it might fall in the coming weeks slightly (but not significantly).  If it does and I have new additional available cash I’ll buy more.  If it doesn’t then at least I took advantage of a good price and will watch to cash in accordingly.

What about the timing factor though?  Again, this is a question of margin of safety.  I’m projecting that oil will probably recover fairly reasonably within 6 months or so (this is also in line with some of the Saudi projections) but I don’t expect it to.  My initial margin of safety is to say “it will go up at least temporarily within the next 12 months”.  I know this has some cushion and yet the returns will still be very strong if this proves to be the case.  As a fall back I’m willing to wait 18-24 months at which point it won’t have been a stellar return but still quite reasonable (15% simple return based on a 24 month hold time).  Because of the factors involved I know this is unlikely, it will probably be much sooner and I’m very much ok with it if that does happen.

What if it doesn’t recover or doesn’t recover in the foreseeable future?  It is of course possible that I’ve made a mistake, that prices will fall further and stay low for the next few years.  I consider this unlikely but possible.  If this is the case where’s my margin of safety?  In this case the margin of safety comes from having a solid idea of the basement price it could reasonably reach (somewhere around $40/barrel), which is determined by global market demand, incentives, current state of the economy and most importantly the combination of these and production costs.  Based on these factors its extremely likely that it would fall below those levels especially for a sustained period and fairly unlikely that it will fall substantially below the current levels for any extended period of time.  In other words the worst case scenario is my investment is relatively safe with virtually no chance of more than a 10% loss, which is better than I can say for most stocks.

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Why Oil Now?

I recently advocated buying oil as it hit $50/barrel and explained why.  There’s a broader context worth understanding though around why I’m so intensely bullish on oil right now.

As mentioned previously in the long run productive assets (mainly real estate and businesses) will outperform commodities and so commodities aren’t a good investment so much as a trade.  To make money on commodities you need to capitalize on the volatility rather than holding them and you need to understand how to do so.  Even when commodities are low though I hesitate to employ those strategies because the wait time, which is always uncertain, can dramatically undermine returns relative to simply holding productive assets giving off cashflow.

What’s different today?

You’ve got to do something with your money and you’re looking for opportunities.  Aside from my own businesses I’m looking for returns primarily in three places:

  • Private loans
  • Real estate
  • Stocks

We could toss bonds in there on a rare occasion but generally I tend away from bonds for my own strategy.  In the last couple years this blend has served me well.  The problem is to do well in any of these (my personal target is in excess of 20%/yr.) requires locating deals that don’t come around often.  In private loans I’ve managed to generate 7%/quarter in each of the last two years but these were limited short term opportunities based on long relationships I had with businesses in need of short term financing they couldn’t obtain elsewhere.  Real estate is based on understanding the markets, shopping around extensively, and managing the properties well.  Stocks are based on short term inefficiencies in the prices of stable long term companies.  The challenge recently is I’m having a hard time locating any of those opportunities.  Last year in stocks I did fairly well on BP and Toyota but of the stocks I follow and understand there simply aren’t any solid opportunities with great margin of safety, the whole market is in my view fairly overpriced.

When it comes to real estate the markets I follow and know well are in one of two conditions:

  1. Overpriced – for example the markets flooded with Chinese money don’t have realistic pricing I can understand
  2. Uncertain – for example markets dependent on oil at the moment could soften considerably as job markets stagnate

This means there’s an absence of great opportunities as the other fall backs such as bonds and private loans aren’t looking particularly great either.

Under these conditions I’m looking at oil as by far the biggest, surest market opportunity I’m aware of and understand.  I’m betting on around a 30% return in 12 months or less with a reasonable margin of safety and willingness to hold on longer if necessary.  At the moment I simply don’t see any other comparable opportunities where I might etch out a solid 20+%.

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Time to Buy Oil? A Lesson in Trading

Anyone who knows me and my investment strategies well will know I’m not fond of commodities, in fact I’m notoriously against buying gold.  The rationale is simple, a productive asset (one where the base value is maintained but it also grows or puts out cashflow) such as a company or piece of land will by nature perform better over the long term all else being equal than a commodity will since the commodity by nature doesn’t grow.  In other words while you might invest in assets such as land and companies the strategy with commodities is to trade them and I tend not to take a trading strategy.

This being said there are exceptions and oil today is one such exception.  I’m buying oil and strongly recommending those I know to do the same.  That doesn’t mean you should run out and do it, everyone’s situation varies but it means I expect oil to produce strong returns in the near future.

What’s the big deal with oil?

Most commodity markets are fairly efficient based on the natural dynamics of supply and demand, much more so than companies or even real estate because they are much less complex, there is less to know.  Whereas in a company there could be poor management, or competition, or a million other factors aside from market conditions that affect the value of the company in the case of a commodity it’s really only the market conditions (supply and demand, whether artificial or not) that matter.

So what’s the key when it comes to commodities?  Same principle as normal, buy low, sell high.  The question is how do you know when it’s low or high?  In the case of stocks and real estate I recommend judging based on the income generated or income they are likely to generate in the future.  When it comes to commodities there is no income potential so you’re essentially betting that the supply will decrease relative to the demand.  The problem I have with gold is supply and demand are completely artificial based purely on market speculation than on real consumptive forces.  Commodities such as oil are different, they are based mostly on real consumptive forces no one really plans on buying barrels of oil to store in a vault as a store of value hedging against the decrease in commodities, etc.

These principles established we have another principle, which is critically important in both investing and trading.  Something might appear to be low but more often than not the market is right, so to beat the market on a consistent basis you need to know something the market doesn’t.  In other words you might look at a company whose stock falls and say “oh it used to trade at $100/share now it’s down to $50/share, that’s a good deal because it’s half price!”  But really the reason the market has decreased its value is because the projected outlook and profitability of the company has decreased so what looks like a stock on for half price is really a fairly priced stock based on the current market conditions so unless you have a reason to believe this is short lived that is better than what the market sees you’ll probably not do well buying that stock.

Same concept is true for a commodity like oil.  Let’s say some revolutionary new alternative energy source was released tomorrow (a bit like what happened to Uranium when cold fusion was first announced), you’d likely see the price of oil drop dramatically because the implication is the demand for oil will decrease as it will be replaced by this superior energy source.  (In practice implementation time of the new energy source, etc. might mean it would have little effect so this example is strictly for illustration purposes).  In other words when the price of oil fell it wouldn’t be a good buy because the market has changed and the price is not likely to ever recover as it’s been fundamentally changed by this new technology.

To consistently make good money then you need to see an opportunity where the value of the commodity or investment has fallen to below what it should be worth under normal market conditions and understand how and why it will correct in fairly short order.  This is where the uncertainty of the 2009 stock market crash comes in.  Companies like GE might have been on sale for 50% off but they weren’t necessarily clear purchase opportunities for most people because no one knew how deep the recession would go or how long it would last, the current prices might have been new fair prices for the foreseeable future.  It turns out with hindsight that this was a great purchase opportunity but it was a lot harder to see in the moment.

How does this apply to oil?  Since the summer oil has fallen from around $100/barrel to less than $50/barrel, a dramatic decline.  On the surface this is potentially a “buy low” opportunity, but let’s look deeper.  We evaluate as follows:

First, we need to understand why it has fallen dramatically so we can understand that this isn’t a fundamental change in the value of oil.  We can evaluate this through the answers to a series of questions.

  1. “Was $100/barrel a relatively fair market price?” In other words dropping from very high to much lower isn’t necessarily a sign of the asset being a good deal today, it might have simply been overpriced before.  This was a fallacy many made when they pointed to houses in 2009 worth half what they’d been selling for previously, the houses weren’t worth what they’d sold for at the peak, they were selling for inflated prices due to the market conditions and the real value was considerably lower.
  2. “What has changed in the market and what’s a new fair value based on the current conditions?” Using the real estate example maybe previously a property was in a good neighborhood but since then it’s become violent and gang infested with a lot of drug use, etc. so it’s no longer as desirable.  If this is the case it might still be a good deal but based on a new valuation so the question is what’s a fair valuation now based on present and projected market conditions?
  3. “Why has the value dropped lower than it should have based on the current or changing market conditions?” Markets over reaction and they under react the important thing to understand if you’re going to predict changes is why so you can apply logic to whether they’ll correct or not.

Before moving on we’ll answer these questions for oil.  Was $100/barrel a fair market price?  At the time, loosely yes maybe slightly lower, but oil stayed relatively stagnant for quite a long period of time.  It’s an environment where the fundamental drivers haven’t and aren’t changing very much.  Production levels typically don’t adjust by more than a few % per year and nor does demand.  Furthermore the market is fairly efficient with global distribution and exchange meaning opportunities for pockets of inefficiency in buying or selling are rare and typically quite isolated leaving little room for long term exploitation (production is a whole other matter but that’s not what we’re referring to here).  We can also look at production costs, which throughout much of the world have become fairly high in the $60-$70/barrel levels (it varies based on what reports you read and it depends on where but the likes of US shale development, Canadian tar sands development, Russian development, etc. hovers in this range with a margin of safety).  These production costs give a sort of guidance around what levels are fair in the market as well since it determines what levels justify added production.  Production costs are substantially lower in places such as the Middle East, but the market overall gets averaged.  In other words yes given the current and expected demand as well as production somewhere in the $90/barrel range it was trading at was quite fair for those market conditions.

What’s changed then and what’s a fair new value?  Here beyond just the immediate factor, which is OPEC specifically the Saudi policy regarding oil production/reserves and their pricing targets let’s look at the big picture.  In the last few years changing US oil policy and improved technology have resulted in massive increases in US oil production, which has decreased the US demand for crude.  Additionally, the global market has in general been fairly slow, China’s economy is slowing in its growth, etc.  Finally, additional technological efficiencies and developments both on the energy production side in the form of alternate energy sources and on the consumption side efficiencies in how we use energy such as more fuel efficient cars, etc. have helped to limit demand relative to supply.  In this environment the case for sustained moderate prices can easily be made.

The specifics of this situation in terms of what triggered the dramatic change in oil prices is OPEC decided to introduce a price target substantially lower than the then normal price level and to achieve this by flooding the global market with additional reserves driving down the prices.  Based on this new factor one might expect that somewhere around a $70/barrel price is more reasonable in today’s market conditions.

Why has it corrected so far below these levels then?  There are two key factors, the first logical the second emotional.  On the one hand there’s a temporary increase in the amount of oil available on the market relative to the demand (demand hasn’t changed much) as OPEC and specifically Saudi releases reserves onto the market but existing more expensive sources remain.  On the other hand as prices are falling fairly rapidly and dramatically the drama is triggering an emotional market response whereby there is more selling and less buying than normal as players wait for the market to settle and see where prices fall.

Now that we’ve answered the first questions the final question becomes:

“Why is this a short term inefficiency that will be corrected fairly quickly?”

To answer this we can look at numerous data points:

  1. As prices fall intrinsically this will lead to increases in demand because the costs of consumption will decrease. You can probably already observe this at the pumps of gas stations as it becomes more affordable to drive people are more willing to drive and to drive more.  This effect will take place across the globe and the system increasing the demand, which has the effect of increasing prices.
  2. As prices fall the high cost producers will decrease production thereby reducing the supply in the market (companies that have a $70/barrel production cost aren’t going to continue to produce if the price of oil is $50/barrel). Reducing the supply in the market will have the added effect of increasing prices.
  3. Supply is artificially high due to opening reserves and as these short term reserves are depleted prices will return to more normal levels.
  4. It’s not in the best interest of anyone including the Saudis or OPEC to have prices at levels as low as we are seeing right now. At say $70/barrel it can make sense because they can make up for decreases in price with increases in market share as the higher cost producers are forced out of the market at least temporarily.  But at say $50/barrel the economics aren’t favorable to any of those nations, which gives them an incentive to limit supply in order to drive the prices up to a more reasonable level.
  5. We can determine norms by comparing various phases in the market over the last 10 years. The last time prices were down at these levels was in a very recessionary economy post 2008.  Even as the economy sat in a fairly uncertain state prices were around $60/barrel.  Today the economy and global demand are much greater than back then, factors which don’t justify prices as low as $50/barrel and below.
  6. Anytime an asset gets cheap investors step in and start regulating the demand forces and trigger the start of a turn around.

At $60/barrel oil wasn’t a great buy because there wasn’t a strong margin of safety.  At $50/barrel or lower it is a great buy because the margin of safety is significant.  I’m expecting to see a 30% increase to at least $65/barrel sometime in the next 12 months if not sooner and making purchase decisions accordingly.  When oil reaches that level I’ll plan on selling because beyond that point, though it might rise much higher there is an element of uncertainty and no real margin of safety unless of course something changes dramatically in the market between now and then.  If it were a productive asset I might be willing to hold at that point based on the productivity of the asset but as a commodity it’s a trade, get in and get out, cashing in on the volatility.