In Search of the Perfect Investment

Sell when it falls. It will bounce back.

Don’t sell. It will fall into the toilet.

Swing for the fences? Harbor your meager capital? (My preference.)

The first studies on trailing stop losses were done in a different world. “Buy and hold” worked. Brokerage was pricey. Trading for you and I was prohibitive. The markets didn’t go up and down faster than a whore’s drawers, like they do today. There weren’t those high-speed computers accounting for 70% of the day’s buys and sells in stocks.

Hence Harry’s inviolate 15% Stop Loss Rule. And Investors Business Daily’s 8%.

I actually did studies in 1999 and 2000. They showed that automatic, inviolate stop loss losses really protected your capital. But look at the times then.  Everything was cratering. Here’s Cisco.

Any stop — 3% or 20% — would have gotten you out and preserved your capital — versus the alternative of holding the stock while you sat on a huge capital loss and the stock did nothing for the next ten years.

Inviolate stops have the huge benefit that they remove the emotion.

Remember, you bought the stock because your research convinced you it was great. You’re now in love with the thing. You can’t sell.

I talked to a bunch of investors in the last few days about a money manager they loved. They liked his returns. They liked his obsession with protecting their capital. But what they really loved  was his ability to handle the emotion — something they couldn’t do in their own trading. They readily admitted their own failings.

Let me state categorically: No matter how much you believe in your brilliant stocks, you have to have inviolate stops. I’m now suggesting a 3% stop loss. There are four reasons:

1. The world is a lot more volatile.

2. There are too many gotchas and cockroaches around — not just the company, but also major things companies have no control over — currency moves, regulatory craziness, government nuttiness, etc.

3. It’s much cheaper to get back in. A few years ago, you could pay $500 to buy 1,000 shares of XYZ Corp. These days it’s $7.95. That’s less than a sandwich at my local fancy delicatessen — not the one I shop at.

4. Selling and waiting to buy back can be handsomely profitable — if you have the patience.

The good news is that you can assuage your emotion by putting different trailing percentage stop losses on different stocks.

There is one major hazard in all this discipline of stop losses. What happens if we’re actually in a declining market and — within a month or two — you have no stocks, but just lots of cash?

What will you do with all the money? How will you “put it to work?”

Being in cash is putting it to work. That’s something you’ll have reconcile in your brain. Not easy.

I emailed the above thoughts this morning to my friend, a great money money manager.  He replied:

I would just add and stress that cash is a position. Even if the returns on it are nil, it is still a very important part of one’s portfolio.

The markets give you significant opportunities two or three times a year (we are in one right now). The rest of the time should be spent playing defense and that is where you use cash as a position.

I lost Ford because I got stopped out. I should be out of Mankind. But I have a wider stop load on that one. I pray that the FDA may give their assent to Mankind.

Tax planning for December. Traditional stuff of paying expenses early and delaying income may not work IF taxes are going to skyrocket next year.

However there is talk that with  the Republicans winning the house, there may be a compromise. The deal is that the Bush Tax cuts, which expire at the end of this year,  will be extended for 2011 and perhaps even 2012. One news report:

“Republican gains will put pressure on Congress to extend all of the Bush tax cuts,” said Ed Mills and Benjamin Salisbury, FBR Policy analysts, in a note after the Mid-Term results. “Senators Mark Kirk (R-IL) and Joe Manchin (D-WV) won special elections and will be seated almost immediately. Both have signaled some support for extending the Bush tax cuts, in addition to several seated Democratic Senators.”

FBR believes the compromise will ultimately be a kind of “decoupling” with the tax cuts for families earning less than $250,000 made permanent and the cuts for those earning above that level receiving either a one- or two- year extension. Either way, tax cuts for all will remain for another year.

This would have been unthinkable to Democrats two months ago. An informal poll of “Democratic Congressional Insiders” by Strategas Research put the chances of a one-year Bush tax cut extension at just 26 percent.

Allowing the cuts enacted by President Bush in 2001 and 2003 to expire would cause the rate on capital gains to sunset back to as much as 20 percent from the current 15 percent. Dividends would be taxed again at the income rate of the taxpayer, or as high as nearly 40 percent.

The options market is signaling that investors fully believe the tax cuts will be extended for all at least another year, according to Jon Najarian, co-founder of TradeMonster.com. There is not heavy put buying in stocks like Apple that have surged this year and would trigger a mighty big capital gains tax bill if the cuts were allowed to expire, the trader said.

The best piece on what might happen IF the tax cuts aren’t extended is from Goldman Sachs. Download it.

In short, this is a moving target. I’ll continue to report on it.

Your very own carry-trade. The classic carry trade is you borrow money from the bank, then lend it back to the same or different bank at a higher interest rate. The Fed has been encouraging banks to do this as a way of boosting their capital.

Personally, I hate borrowing. But let’s say you borrow $1 million on a mortgage. These days, you’ll pay 5% or $50,000 in interest. That money is deductible. It really costs you only $20,000 to $25,000. My bank  will pay 2% for a three-year CD. In three years, they’ll be paying me 5% for a 3-year CD. But I’ll still be paying them a deductible 5%. And by then tax rates will be higher. Much higher.

You can earn 6% to 8% with a CD in Australia — except that the Aussie is not cheap at present, though it’s less expensive than it was a few weeks ago…

You see BHP this morning?

Another reason to just age

A 54-year-old woman had a heart attack and was taken to the hospital. While on the operating table she had a near death experience. Seeing God, she asked “Is my time up?”

God said, “No, you have another 15 years, 2 months and 8 days to live.”

Upon recovery, the woman decided to stay in the hospital and have a face-lift, liposuction, breast implants and a tummy tuck. She even had someone come in and change her hair color and brighten her teeth! Since she had so much more time to live, she figured she might as well make the most of it.

After her last operation, she was released from the hospital. While crossing the street on her way home, she was killed by a bus.

Arriving in front of God, she demanded, “I thought you said I had another 15 years? Why didn’t you pull me from out of the bus’s path?”

God replied: “I’s sorry. I didn’t recognize you.”

A man thinks he is a dog.

He goes to see a psychiatrist.

“It’s terrible,” says the man. “I walk around on all fours, I keep barking in the middle of the night, and I can’t go past a lamppost anymore.”

“Okay,” says the psychiatrist. “I can help. Get on the couch.”

The man replies, “I’m not allowed on the couch.”

Harry Newton who strung his racquet at 72 lbs with Luxilon and dropped his grip size (by ripping off all the layers of grips) and played out of his mind yesterday, again. Tennis is tweaking. What works for Joe doesn’t work for Harry. You try different rackets, different shoes, different strings, different tensions, different strokes. It’s endless, but fun. The key is not to believe what anyone tells you until you’ve checked it out for yourself.

Gold is coming back. But BHP is an animal. Yipee.