Investment strategy: Risk vs reward

It’s crucial to create—and stick with—an investment plan. Here’s how Keith Richards, portfolio manager at Barrie, Ontario-based ValueTrend Wealth Management approaches the investment strategy of risk/reward-based trading.

After reading an article of mine in The MoneyLetter’s sister publication, Investor’s Digest of Canada, one subscriber sent me an e-mail noting that I had sold American International Group, Inc. (NYSE─AIG) at $54 a share (as per my comments on the stock in that story). His point was that the stock has since gone over $60 a share and I had not held onto the stock for its continued gains. He wondered why I had failed to realize all of its upside.

His comment from there was “I don’t know about this market timing thing.” This inspired me to write an article for The MoneyLetter to help readers understand the concept of a market trading system and the importance of having one.

Despite the ever-present potential of missing out on future gains, I have learned (sometimes the hard way) that you must adhere to some type of sell discipline in your over-all investment strategy for the securities you hold.

What ‘market timing’ isn’t

To start this article off, I think it’s important to clarify that I don’t do market timing—at least the way many people perceive it. Market timing in most people’s minds is picking peaks and troughs. I don’t do that; most people can’t.

What I actually do

Instead, I attempt, through technical and fundamental analytical tools, to determine a measurement of risk versus reward.

You should understand that any stock or stock market has both the potential to rise, AND the potential to fall. You don’t know what will happen in the future, and neither do I. By the way, if you do have an unfailing, provable and guaranteed system for identifying whether a stock will rise or fall and over what period of time it will do so, please come and work for me. I’ll start you off at $1 million a year.

Identifying and measuring risk versus reward

Although one cannot measure exact tops and bottoms on a stock, or a market, one can most certainly identify potential risk versus reward. Realize that at any given time, a stock, or a market, has both upside AND downside potential. There will never be a situation where you can count on the absence of either risk or reward potential on a stock—both are always present. Risk and reward exist simultaneously and perpetually on all tradable securities.

Thus, instead of futilely trying to precisely time a peak or trough on a stock or a market, I attempt to quantitatively measure risk/reward on that market at a given moment.

I do this by adhering to a number of steps that I have outlined in my past strategic investment planning articles in The MoneyLetter: (“Creating Your Own Systemic Approach to Investing” Parts 1, 2 and 3, published in the first issue of The MoneyLetter in each of November 2014, December 2014 and January 2015). The system I have developed over the years is pretty good at doing this.

No strategic investment plan is fail-safe . . .

Please understand that there will always be times that your system works, and times when it fails you. You can pick past trades from any system, and there will be winners to brag about, or losers to be sour about.

. . . Just ask Warren Buffet

Warren Buffet bought silver a few years ago. It was a bad call, and he sold at a loss later. He has a system to fulfill his strategic investment objectives—and his system suggested at the time it made sense to take a position in silver. It resulted in a poor trade where he lost money. Warren shouldn’t have bought silver. Hindsight is great, isn’t it? But, you move on. I know he did.

Good systems have dry spells

A good trading system will sometimes look like it has “lost its touch” for what will feel like long periods of time. At ValueTrend, we’ve had the occasional lousy quarter in our past. So has Warren Buffett. It happens. In fact, we at ValueTrend had two back-to-back lousy quarters in 2012. That was tough to swallow for us. But it didn’t stop us from sticking to our system. It all works out if you stick with a proven system.

Risk, reward and AIG

So, let’s talk a little about my decision to sell American International Group (or “AIG”), as per the reader’s e-mail that started this column.

I’ll draw from my comments made surrounding the ever-present reality of both risk and reward potential existing on all stocks at all times. If the potential reward of a stock starts to decline versus that ever-present and unavoidable risk, you rotate into something else.

AIG, in this case, had both upside potential and downside risk potential when we sold it. From there, it’s the best race horse who wins: the stock that’s been sold (AIG in this case) may rally, but perhaps after selling, you buy something that rallies even more. Or not. You can’t know at the time, but the odds are fairly “calculable”.

More to the point, we made lots of money on AIG: more than most investors who got into the stock later in the game. We bought it at a substantially lower price back in 2013. We bought when the risk was very low; and took a profit on both the stock and the currency at a point where a certain level of technical resistance was present on the charts. No pain in that!

Wouldn’t it be nice?

I wish that somebody would ring a bell at the top or bottom of every stock’s movement. Perhaps a high-toned bell for the top, and a deep, resounding “bong” for the bottom. That would be great, and I look forward to the day when that starts happening. But until they start ringing those bells, I will keep using my system to measure risk versus return.

Our record speaks for itself

By the way, as I noted to the writer of the e-mail: We are among the few portfolio managers who will post results online. I often wonder why most managers don’t want to do this, but I’m sure you could take a guess as to why not.

Using our buy/sell discipline, we do beat the market, and have displayed a standard deviation of 6.4 over the past six-plus years. Our drawdown in the financial crises of 2008-2009 was about half of the stock market—vastly outperforming buy and hold market investing.

We’re achieving better returns with vastly lower risk by using a disciplined strategic investment system. That’s all we care about.

I hope this helps you towards understanding why you too should incorporate some type of systematic approach in your trading. Don’t take my word for it. Ask Warren Buffett!

 

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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