DO YOU HAVE A WAY OF SAVING YOU FROM YOU?
During the trading day today I tweeted the following:
I'll explain this concept again because I think that it is the single most important component of investment success.
You cannot simply depend on being a good stock picker to make it in this business. You must also have a means of controlling risk that is of your choosing and attuned to your tastes. It may be as simple as having a 5% stop below your entry point. It may be as complicated as a mechanical system with 18 separate parameters that take into account everything from price momentum to the current wind gusts in Santiago, Chile. Doesn't matter. There needs to be a system of controlling risk in place.
My risk-management system triggered today. I absolutely hated the fact that it triggered and was praying that I would avoid it since the beginning of the week. It is no secret that I am bullish here. I think that we are about to see a bottom - perhaps by the middle of next week - that could drive this market substantially higher over the coming months. And that is exactly why I have this system in place: To save me from me.
I'm not saying that my personal feelings about the market are incorrect or inaccurate. In fact, I am right more often than I am wrong. This site is a testament to the fact, as is my past history on Wall Street. When I am wrong, however, it always begins with the confidence I have right at this moment about the bullish outcome of the market from this point on. You don't fall into steep drawdowns by being indecisive about which way the market is going to go. You fall into a deep drawdown because of the fact that you unequivocally and without any doubts believe in your analysis.
I am here to tell you that you need something to circumvent that belief. You need an interruption switch that gets you away from you at points where the danger is the greatest. This is coming from a guy who in his twenties blew up a hedge fund that had many millions of dollars under management and many more millions in capital commitments after finishing the prior 12 months ranked #1. I had a client base that other fund managers would kill for. I had the resources. I had the institutional support. I had the track record.
I didn't have one thing: There was NO interruption switch. There was nothing in place to save me from me during times when danger was bubbling beneath the surface.
So when I decided to make a second run at the markets after taking some years away from the market, I was like a mad scientist in the laboratory. I didn't need to mess with the stock picking part. I have that down. I've always had that down since the mid-90's when I was giving trading advice to guys twice my age on the trading desk of Bank America. If anything, it is just getting better.
What I had to do in Phase 2 of my investment career is to make sure what occurred in Phase 1 never occurs again. I developed a completely mechanical means of getting me out of the market in three steps. The first step, which triggered today, takes me into a 25% cash position and sets up a hedge of the portfolio. The second step, which is still a ways off from triggering, takes me into a 50% cash position. The final step takes me into a 100% cash position and goes 25% net short. This is all mechanical. I have absolutely nothing to do with this other than humbly bowing my head and honoring its wisdom. It takes ME out of the equation during times when danger is bubbling beneath the surface. That is the entire purpose.
Now, of course, there are times when it will take me into 25% or 50% cash at or near the bottom. That is to be expected. This isn't an all-seeing and all-knowing Oracle with a grey beard and blue hat with pointy tip that I keep locked in my basement. Anything that is in place to prevent a catastrophic drawdown from occurring will have incidences where it makes you look foolish as an investor. At the same time, having such a system in place also prevents you from being victimized by the second half of 2008. Or the second half of 2011. Or if you want to go further back, the first half of 2000. All of these traumatic periods that have blown up hedge funds, ruining the lives of the gardeners, limo drivers and call girls who depend on hedge fund managers for their income would all be prevented by having a systematic safeguard in place that takes the fund manager out of the equation.
And that, my dear readers, is why I pulled off the road today and dumped 25% of the portfolio in the dirt. It's not because I dislike YELP or any of the stocks I trimmed. I, in fact, like them all just as much, if not more than the first day I bought them. My decision is rooted in a discipline that was born out of the devastation and subsequent soul searching that ensued when the market blew me out of the water in 2004 and 2005. Lessons that I have capitalized on and will hopefully not only prevent me from making the same errors, but you as well.
