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March 29, 2021

29.03.2021-"4 Simple Rules To Protect Your Portfolio From Yourself"

1.There are many ways to ruin a well-thought-out investment plan.< / br> 2.Your portfolio should have the best chance of success, for long-term investment.
3.Most of all, your portfolio needs protection from your own mistakes.
4.In this article, I will present four simple rules that will help you to give fantastic precautions.
You will learn three rules about how to buy, and one rule about how to sell.

Volatility is a concept that is often confused with risk.

Volatility refers to how dramatically the value of an investment can change over time. On the other hand, risk refers to the probability that an investment will lag behind the market or lead to losses.

In short, stocks with very large price fluctuations over time may be less risky investments than those that barely change in price. The true risk over a long period of time depends on the company's business more than on the absolute volatility of its share price.

As shown in the Fidelity Viewpoints example, for you, choosing the right asset allocation comes down to three key questions:

1.What is your financial situation?
2.What is your time frame for investing?
3. What is your emotional tolerance for market volatility?

While the first two questions are certainly important for determining the right asset allocation, in this article we will assume that you know how to prepare for the next stock market crash by paying off short-term debt and setting up an emergency fund. We will also assume that you are investing money for at least the next five years and beyond. If you haven't already taken care of these two aspects, you may need to focus on other things first.

Now let's focus on the third question, which concerns variability and temperament.

"How much volatility can I tolerate?"

This is a key question that we all need to answer, but it may be the wrong way to address the question of temperament.

Don't get me wrong. This is a fantastic question, and one you'll want to ask yourself as early as possible on your investment journey. As Adam Smith (alias of the late George J. W. Goodman) put it in a game of money:< / br>
"If you don't know who you are, (the stock market) is an expensive place to find out."

But I believe that most investors should go even further. In my opinion, the right question they should ask themselves is:

"How can I better tolerate impermanence?"

The financial services industry is built on Expert Advisors that create a portfolio with volatility that matches your goals and temperament.

Instead of defining a portfolio strategy that could help you control your temperament, you are given a portfolio that your temperament can handle. In my opinion, your portfolio does not need to be protected from volatility.

It needs to be protected from itself.

Volatility is a given when you invest in stocks. The higher the short-term volatility you can put up with, the more impressive the long-term results can be. With this in mind, anyone with a long-term horizon should aim for the best returns the market can give, and accept volatility in return.

As Morgan Housel, partner at the Collaborative Fund, explains:

"The whole reason stocks tend to do well over time is because they make you put up with things like this. This is the entrance fee. A feature, not a bug. "

But even if you understand the rules of the game and believe that you can handle the volatility, you can learn about the limits of your emotional tolerance at the most inopportune moment.

The real threat to your portfolio is not volatility, but your ability to handle it. As a result, your portfolio does not need to be protected from volatility. It needs to be protected from itself.

Here's what brings me to today's four rules for protecting your portfolio from yourself. Today, I'm focused on giving myself the best chance of success when it comes to managing volatility.

If you can apply these four rules to yourself, I believe that your success is inevitable.

Let's take a closer look.

Rule # 1: Invest a fixed amount monthly

One of the biggest mistakes of novice investors is that they try to guess the moment of entering or exiting the market (market timing). They believe that they can anticipate not only economic trends, but also the corresponding impact on stock prices. Anyone who is sufficiently familiar with financial literature understands that this is a dangerous hobby that can very quickly consume your long-term income.

There are so many reasons why market timing is a bad idea:

1. You need to be lucky both at the exit and at the entrance.
2.You are competing with institutional investors who use supercomputers and sophisticated data processing algorithms.
3. Your chances of success are very small, as the big ups and downs usually happen in tandem.

Those who try to guess market movements to avoid a losing year can easily jeopardize their long-term results by simply exiting the market at the wrong time. Even a few missed good days from an entire decade can wipe out most of your income. If you leave the market and it continues to grow, at what point do you admit that you were wrong and go back?

You will find many commenters bragging online that they have sold their shares "at the top" or that they have recently bought "at the bottom". But how many times did they get it wrong before they ended up being right? What is their average annual return over the entire investment period?

In the very long run, stocks will rise and follow GDP growth. If you are out of the market long enough, you are almost guaranteed to lose.

There are countless articles from analysts who claim to know the future movement of the market. But they did not expect a 35% decline in early 2020, nor a subsequent 70% recovery. However, they want you to believe that they have an understanding of what will happen next.

Now that we've sorted out what market timing is, I want to talk about my first rule that applies to my strategy: investing a fixed amount every month.

You can already apply this approach if you contribute a portion of your salary to retirement accounts on a monthly basis. This is usually done through broad-market ETFs investing in the S&P 500 (SPDR S&P 500 ETF, ticker SPY), emerging markets (Vanguard FTSE Emerging Markets Index Fund ETF, ticker VWO), or specific sectors such as REITs (Vanguard Real Estate Index Fund ETF, ticker VNQ) or Nasdaq 100 (Invesco QQQ Trust, ticker QQQ).

I would advise doing this for the bulk of the amount that you invest, no matter in index funds or individual stocks.

Here are the steps I use to follow this rule:

1. Every year I estimate the amount that will be allocated for the investment. These funds can come from projected monthly savings, expected bonuses or windfalls, and so on.
2. Divide this amount by 12.
3. I make sure that I invest monthly regardless of anything.

What I describe here is a kind of averaging of the cost of positions. The main difference here is that I don't mean the idea of adding funds to the same investment on a regular basis. I just mean that you should be committed to the investment process on a regular basis, with a fixed amount serving as both a minimum and a maximum, to make sure that you are participating in the market's returns.

Here are the immediate benefits of this approach:

1. This is an automated process that eliminates the risk of changing your mind.
2. This encourages you to invest even in those months when emotions are running high and when you may be tempted to back down for fear of a correction.
3. This prevents you from investing everything at once for a short period of time, as this can reduce future returns due to bad timing. You may be faced with a great investment opportunity, but you are always capable of making mistakes. Limiting the amount you can invest immediately limits the impact of your belief.
4. Knowing that you will have a fixed amount to invest on a monthly basis can enable you to stay on course, even during periods of high volatility and a correction of 10%, 20%, or even 30% from previous market highs, as happened in March 2020. More likely, you will expect an increase in the number of shares in the portfolio at times of market decline.

In general, a fixed amount invested monthly forces you to enter the market, while at the same time making it easier for you to get there. And that removes all value judgments from the equation. You will find yourself in the position of having to shop, despite your current beliefs, and remain cool-headed.

Rule # 2: Determine the maximum allocation for shares

Now that we've determined that you can protect your portfolio by allocating your investments over time, let's look at another important way to protect your portfolio from yourself during the buying process.

Firm conviction can be the enemy of truth. Even the best investors in the world made the mistake of making a few overly concentrated bets that didn't work out in the end. Some of them are well described in the book "Big Mistakes: The Best Investors and Their Worst Investments" by Michael Batnik.

The vast majority of financial literature tells you about the need for diversification. However, there is a strong belief that focusing your portfolio on just a few of the most promising stocks can significantly improve returns. After all, this is how Warren Buffett achieved a 21% annual return over his career. In his 20s, he invested all his money in Geico.

This simple diagram struck me with the same force that I believe Einstein must have felt when he discovered E=MC2: I have seen that with fifteen to twenty good, uncorrelated profit streams, I could significantly reduce my risks without reducing the expected profit. It was so simple, but it would be such a breakthrough if the theory worked as well in practice as it did on paper. I called it the "Holy Grail of Investing" because it showed the way to accumulate wealth. This was another key moment in our education. (Ray Dalio)

I am often asked, " How many shares should I own?» And I truly believe that the correct answer is different for everyone. This should depend primarily on how important the stock portfolio is compared to the total assets of the investor. And it should always depend on what is in the portfolio. If you follow Ray Dalio's logic, it should depend heavily on how correlated the stocks in the portfolio are.

Some investors enjoy a higher level of concentration more than others, and this is understandable.

One of the easiest ways to avoid getting too caught up in your own beliefs is to limit the maximum investment in one company in terms of cost – basis. What really matters is not so much the number of shares you own, but the largest amount you allow yourself to add to a given position.

Let's say that over time, you added $100k to your portfolio. This is your cost-basis, i.e. the total cost of the initial portfolio. Let's say that over time, the portfolio has tripled and now amounts to $300 thousand. Your cost-basis is still $100k. Focusing on how big the position is as a percentage of your cost-basis is key, because it shows where you've invested your dollars.

There are many different opinions about what should be the maximum underlying risk for one company in the portfolio. In the end, it all comes down to your risk profile, time horizon, and goals. It is important that this is determined in advance before you find yourself in the midst of the action.

If you don't want a single company to put the total return on your portfolio at risk, it's reasonable to set a limit of 5% (the equivalent of at least 20 balanced companies in the portfolio) to 10% (at least 10 balanced companies).

I found that my personal preference is slightly closer to the risky end of the spectrum with at least 12 balanced companies in the portfolio, i.e. with a maximum risk of 8% for one company, based on cost-basis (100/12).

If you focus on the distribution of risk in terms of costs, rather than on the current cost, you will benefit from two points of view:

1. This will prevent you from adding too much to losing positions.
2.This will encourage you to add to your profitable positions (winners), even if they have earned a lot.

It is important to note that with the addition of this simple rule, you will now make sure that your emotions will not be able to determine your asset allocation for individual investments. A very large position will be the result of your portfolio, not your personal beliefs.

Rule # 3: Don't add to losing positions

I recently came across this impressive article ( John Hampton is an outstanding reading, to which I intend to return. He's trying to answer a very difficult question.

"When do you average down?"

In his article, John Hampton shares the following photo of Paul Tudor Jones (a billionaire and well-known hedge fund manager) with a paper taped to his wall, which says that "losers average losers" (losers average losers).

I've been searching for an answer to this question for a long time and found that the best way to avoid a big loss in your portfolio is not to average it.

So many investors have destroyed their portfolio by averaging losers over and over again, turning what should have been a 2% position going down to zero into a 10% or 15% position going down to zero.

But what are "losers" really?

I'm not talking about stocks that have fallen 10% or 15% in the days or weeks after opening a new position. This is just an opportunity to open your position very slowly. Small changes in the short term rarely indicate that something is wrong with the company's business or investment ideas.

I'm not talking about drawdowns that are clearly correlated with broad market sell-offs or sector rotation. They are meaningless to the core business. The WisdomTree Cloud Computing Fund (WCLD) is now down about 20% from its previous high. As a result, I would not consider SaaS companies such as CrowdStrike (CRWD), Twilio (TWLO), DocuSign (DOCU), MongoDB (MDB), Datadog (DDOG), or Salesforce (CRM), which have fallen more than 20% from their previous high, as a reason to classify them as "losers". Everything must be perceived in its own context.

Similarly, if you own a Tesla (TSLA) with a cost-basis of $100, and your position has recently turned from 10x to "only" 7x after the recent sell-off, I would not consider this stock to be its loser, which you should refrain from.

The definition of failure will vary greatly from one investor to another. I tend to agree with David Gardner and his idea that losers are stocks that are at a loss in your portfolio. You already know them. Don't let them get in the way of portfolio success. It's perfectly normal to have unprofitable positions, they make up about 40% of all stocks (more on this later). You don't need to add to them just because they fell.

When I talk about adding a position to losing trades, I mean the temptation when we all have to "double" a position that has fallen well below its cost-basis so that we can reach the break-even point faster. That's what I want to avoid at all costs.

Diversification is a fantastic tool to avoid over-exposing your portfolio to the threat of an individual position. We have already considered this Rule No.2. But even if you avoid adding too much to individual stocks, you can still continually add to your losing trades. As a result, they may even collectively make up a large portion of your portfolio.

If you leave your losing trades well below the maximum allowed limit, this can be crucial over time in building your portfolio and its resulting returns.

If you allow yourself to average up to the maximum limit on all your losing positions, you will end up with a well-balanced portfolio... losses. Not a very good suggestion.

It is only natural that we want to increase unprofitable positions because of the illusion that they will quickly recover to our original value. However, abandoning this practice altogether can virtually guarantee that your losing trades will remain infinitesimally small positions. All of them should lie at the bottom of your portfolio, with only a small amount added to them periodically and a limited impact on overall returns.

I believe that "not averaging" (rule #3) is one of the most powerful precautions in portfolio management, along with regularly adding positions (rule # 1) and determining the maximum allocation of investments (rule # 2).

Rule # 4: Don't sell your profitable trades

Thanks to rule #3, your losing positions should represent a relatively small portion of your portfolio, because you won't add too much to them.

Now, the last important rule to protect your portfolio from yourself is the rule related to the selling process. And this rule is incredibly easy to follow.

Rule # 4 simply requires that you leave your profitable positions alone for years to come.

How many investors held shares of FAANMG (Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), Microsoft (MSFT), Alphabet (GOOG)) just a few blocks or just a couple of years? When all you had to do was keep them in your portfolio and let them grow to achieve outstanding returns?

Charlie Munger once said:

The first rule of accumulation of profitability (compounding): never interrupt it unnecessarily.

During the years it takes compounding to do its magic, an important tool in an investor's arsenal is the courage needed to handle large drawdowns.

We are all programmed to sell our profitable positions to secure our profits, potentially giving up much larger investment returns over time. Creating a rule to prevent this natural trend is a powerful way to truly unlock the potential of your portfolio.

You see, investing isn't that hard. If you can find a quality business that can increase your earnings over time, the correct period of holding the position is likely to be "forever". In fact, this is Warren Buffett's favorite period. This long-term approach takes emotions out of the equation altogether.

Some investors ask themselves every day whether they should sell. They watch anxiously as a 10x position turns into a 9x position and wonder if this is the beginning of the end.

Your best positions will take you through an emotional roller coaster many times over. This is our business. To take an example from our App Economy portfolio, which is my real investment – companies like Shopify (SHOP) and The Trade Desk (TTD) have grown 11 and 13 times their original value, respectively. But to achieve this, I can't even count how many times they've fallen by 20% or more.

As you can see in the charts below, regular movements of 20% or even 30% look relatively small in retrospect. But they can be heartbreaking when you go through them.

Investors can always find a reason to sell shares:

1. The CEO is leaving.
2.Insiders sell shares.
3. The company's forecasts are disappointing.
4. There will be difficult conditions in the next quarter.

In most cases, these reasons have little to do with the long-term potential of investment and more to do with the fragility of beliefs.

If you're ready to part with your stake the second the CEO leaves, your portfolio is ready for a strong sell-off over time.

If one bad quarter is enough to change your mind about the business, I don't want to upset you, but you will never keep the business for more than a few years.

I really like the quote from the latest Unity Software (U) earnings report. Management is well aware of the opportunities that open up for them, but they felt it necessary to remind shareholders of the following:

Of course, business, like life, is not linear, so it is likely that some quarters and years will be higher or lower than we expect.

Recognizing that most things in life are not linear is an important step toward accepting the unknown as an investor. If you currently have a future 100x position in your portfolio, the path to it is likely to be full of pitfalls.

One of the most powerful charts I've come across in recent years is a study conducted by Blackstar Funds with Meb Faber. The charts show the historical distribution of the 8,000 stocks traded on the NYSE, AMEX, and Nasdaq over the decades (1983-2006).

The conclusions are fascinating:

1. Two out of every five stocks are loss-making investments (39%).
2. Almost every fifth share is a terrible investment (a loss of 75% or more).

Comparing the returns of individual stocks with the Russell 3000 index (broad market index), we can draw other conclusions.

1. Most stocks lag behind the diversified index (64% lagged behind the Russell 3000).
2. Only 6% of stocks significantly outperformed the index (500% or more).

Now let's assume that your portfolio is distributed evenly invested according to the distribution from these charts. Profitable positions – the very companies that boost market indexes and can generate an alpha index for your portfolio will be prone to the same behavior. They continue to reach new record highs and slowly exceed their maximum allocation in the portfolio.

Since only 1 in 16 stocks significantly outperforms the index, it becomes clear that these are the most valuable assets in your portfolio.

The very nature of rebalancing will force you to sell some assets that are on track for your portfolio to achieve high returns, only to reallocate funds to new positions that have only a 6.1% chance of entering a significant market.

My personal conclusions from this research are what underpins my investment philosophy:

1. Alpha shows a very small number of companies.
2. Don't sell your profitable positions. Instead, add more to them over time.
3. Accept the fact that there will be unprofitable positions. According to statistics, they are about 40%.
< / br> By not selling your winners, you're letting your most precious alpha source run nonstop, even when your gut tells you otherwise.

That's it! No, seriously, that's it!

As explained at the beginning of this article, I believe that the right way to think about volatility is not to build a system to avoid it, but to build a mental model and a system to embrace it.

To that end, here are a few rules that I don't use:

1. Stop losses
2. Put Options
3. Dividend strategies
4. Principal protected notes

These are all ways to ease your drawdowns. This can help you sleep better at night, but it's also virtually guaranteed to lower your overall return. As a result, they are not for me. Stop losses, in particular, would force me out of my position in all of my biggest successes.

To illustrate, the chart below shows how low AMD (AMD) shares have fallen from their previous high since I bought them in 2017. If I had used any stop loss, I wouldn't have any AMD shares today. However, on the timeframe shown below, the stock is up 7-fold.

With the four rules discussed today, I've covered both ends of the spectrum:

1. My investments are phased over time.
2. I try not to bet too much on my strongest beliefs.
3. I do not allow myself to add on unprofitable positions.
4. I hold on to my profitable positions for years, allowing them to dominate my portfolio.

Investing is not easy, but it should be easy. With such precautions of entering and exiting funds from the portfolio, I believe that you are well protected.

These four rules worked perfectly for me, and since 2015, my portfolio has yielded 409%, outperforming the S&P 500 by more than 4 TIMES.

As shown below, I have had to deal with extremely high volatility, with the portfolio falling more than 20% from its previous high several times. The drawdown in March 2020 and the one currently caused by the recent sector rotation are clearly visible on the chart. It is also interesting to note that investments primarily in the digital economy – and this is my area of specialization-gave strong returns long before COVID.

I truly believe that the four rules above have had a greater impact on my returns than the choice of individual stocks.

Finding great investments is relatively easy. It's holding them and maintaining a diligent portfolio strategy all the way through, which is really challenging.

I'm sure many readers have other ways to keep their sanity. To each his own. No one should tell you how to handle your briefcase. Investing is personal. I hope that the rules I've discussed here can inspire you to think about how they might apply to your own investment journey.

Do you use any of these four simple rules?
What other approaches do you use to protect your portfolio?
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