Investment Wobble Protection

red-onion-slice.jpg

The other day, the family and I were at a burger joint here in Austin called Mighty Fine.

It’s a great place to eat. The food is delicious, the restaurant is clean, and they are open and transparent about how the food is prepared.

There’s even a glass window in front of the kitchen, so you can actually watch them making the food.

Usually, I love that…

This day, however, there was a guy slicing up an onion for onion rings.

About To Cry

Actually…“slicing” is too polite.

Hacking.

This guy was HACKING at the onion like his knife was a machete.

And the knife had to be as blunt as a spoon. It just was NOT going to cut easily through that onion.

On every cut the guy would push to make the knife slice through, and the onion would wobble and pitch under his hand.

His fingers were RIGHT THERE holding the onion.

After a few seconds, I was cringing. I just couldn’t watch anymore.

I was sure this was going to be a batch of pink onion rings.

It was like watching a squirrel try to run across a busy street.

You’re whole body goes tense, and you just don’t want to watch what’s going to happen next.

Be Sharp

I do quite a bit of cooking at our house, so I have some experience with the situation this guy was in.

The solution to his problem is…a sharper knife.

It seems counter-intuitive, but it’s true.

A sharper knife seems more dangerous because it seems like he could cut himself more easily.

But a sharper knife would mean that he would use less force and use a more controlled slice.

He wouldn’t have to whack at the onion. He could just pick his place, slide the knife along with an easy smooth motion, and avoid the wobble.

The sharper knife is actually safer overall.

Familiar Feeling

I know this cringing feeling pretty well.

It’s the same feeling I get when someone tells me they are investing in mutual funds, index funds, bond funds, or straight stocks.

I just don’t want to watch.

These investments are the same as using a blunt knife to slice an onion.

You have to put your “full force” behind the investment to make it work.

You end up risking so much of your savings on the investment that when the market wobbles…

…and rolls off the counter…

…there’s going to be BLOOD everywhere.

Like I said, I just can’t watch.

Scary Options

So if the solution to a dull knife is a sharp knife…

…and if those investments are the dull knives

…then what’s the sharp knife investment?

Options.

Yes, I am explicitly saying that options are SAFER than mutual funds, index funds, bond funds, and stocks…IF USED CORRECTLY!

If you grab that sharp knife and start hacking away at the onion, and putting your full force behind each slice, yeah, that’s going to be dangerous!

You’re probably going to cut something off.

But that’s not how you use a sharp knife.

To use a sharp knife, you place the blade precisely where you want to slice, and then you use only enough force to keep the blade moving smoothly through the onion.

Precision Investing

It’s the same with options.

You don’t put all your savings into options. You use a barbell investment strategy.

Only a small portion of your savings, your “force”, goes into options.

The rest of your savings goes into actual safe investments, like FDIC-insured CDs, T-Bills, or just a straight bank account.

Then when the market wobbles, you can’t lose any more than the small portion that you’ve risked.

And you have the bulk of your money safe and ready to invest…

…while everyone else is dashing for the bandages to staunch the bleeding.

Same Game Better Tools

Often you can even use the same investment strategy.

If you’re buying stocks, you can just buy call options on those stocks instead.

The cost of the premium is like paying for insurance on your house. It costs a little, but if disaster strikes, you are protected.

And in the stock market “IF disaster strikes” is more like “WHEN disaster strikes”.

Same for index funds. Most have an ETF that is tracking the same investment index, and you can usually buy call options on those as well.

Of course, you could also try out Dividendium’s Options Trading Service.

That service is focused on looking for under priced options and waiting for a positive surprise to create a big payoff.

Don’t Cut Yourself

If you’re using a “blunt knife” for your investing, consider switching it out for the “sharp knife” of options investing.

If used correctly, options are safer overall than the alternatives.

And you won’t be in danger of lopping something off when the next market drop comes to shake the table.

Always Barbell?

After reading the previous post on implementing a barbell investment strategy, a friend asked:

“Would you always recommend the barbell or No Lose strategy to people, or would you sometimes recommend investing at minimum in an index fund that tracks the market?”

I would always recommend a barbell strategy.

I would recommend NEVER investing in an index fund, or mutual fund, or bond fund.

This goes back to my view of the stock market. I think it’s all a scam, or a pyramid scheme of sorts.

I’d rather see someone put money in a bank account than in a fund.

But again, that’s me. Most financial advisors would say I was crazy…but then they get paid whether you lose money or not…

Case in Point

Take a look at this chart pulled from BigCharts.

DJIA 2000 to 2013

Look at year 2000 (00). That’s when it “peaked” for the dot com boom.

On the day that it peaked (and the weeks leading up to the peak), there was no reason to think that this was “the peak”.

This means any other day could just as easily be the peak…like, for example, TODAY.

So any time you decide to invest in the market, you could be investing at the peak.

Peak Problem

Why is that a problem if, as they say, “the market always goes up”?

Take a look at that red line.

Investors that put money in the market at the 2000 peak don’t make money until the market is above that line…and STAYS above it.

If you track across that line, the market doesn’t STAY above the line until 2012…SO FAR.

If the current bull run ends and the market again drops below that red line, then those investors will again have lost money from where they started.

12 Years For Nothing

So, if you had bought in 2000…only 12 YEARS later would you have made any money.

But when you were doing your investment planning, you probably based all your calculations and plans on making 4% to 6% per year. And you based how much you would save each year on that assumption.

Now you have 12 years of NO GAINS.

12 years of expected 4% to 6% gains is an overall expected gain of 60% to 100%.

So your plan called for having 60% to 100% MORE money than you do after those 12 years.

Basically you’re WAY short of where you thought you would be.

And to get to where you wanted to be, you have at least another 12 years to go…assuming the market doesn’t drop again.

And if you look at that chart again, you can see that over those 12 years there were indeed more drops.

Always

So, yes, I would always recommend a barbell strategy.

If the market drops, the most you can lose is what you are risking. The 10% to 15%.

As Taleb pointed out, we know that we ARE taking on risk, it’s just really hard to estimate how MUCH risk we are taking on.

Putting everything at risk by investing in a fund is TOO much risk.

How To Implement A Barbell Investment Strategy

Barbell Strategy

…your strategy is to be as hyperconservative and hyperaggressive as you can be…

…you need to put a portion [of your money], say 85 to 90 percent, in extremely safe instruments, like Treasury bills…

The remaining 10 to 15 percent you put in extremely speculative bets, as leveraged as possible (like options)…

That way you do not depend on errors of risk management; no Black Swan can hurt you at all, beyond your “floor”, the nest egg that you have in maximally safe investments.”

This quote is from The Black Swan: Second Edition: The Impact of the Highly Improbable Fragility by Nassim Nicholas Taleb.

Taleb’s contention here is that you will know you are taking on risk, but you will probably incorrectly estimate HOW MUCH risk you are taking on.

For example, when you buy a stock, you know that you COULD lose money. You can logically reason out that you ARE taking on risk.

But the catch is that you probably won’t correctly estimate the AMOUNT of risk you are taking on.

Say you bought a stock thinking it could only lose 10%. Or that your stop loss would save you from losses of more than 10%.

But it’s possible that the stock could drop to 0. Or the stock could gap down on open and jump right over your stop loss. Suddenly the 10% loss you were prepared for is now a 50% loss. Neither of these possibilities is likely…but we are bad at estimating HOW likely, so we will likely underestimate how likely.

Taleb’s point is that because we are bad at estimating HOW MUCH risk, the best way to take on risk is to take an ALL or NOTHING approach to risk.

No Risk

For the “nothing” side of taking on risk, he is recommending that you put 85 to 90 percent of your money in the safest investments you can find.

And by “safe” he means guaranteed return, with no chance of loss. Even if that return is miniscule.

This does not include blue chip stocks, or “well-established” company bonds, or any of the other “safe” investments that investment advisors would suggest.

I think it would include CDs (Certificates of Deposit) that were FDIC insured, and of course the Treasury bills mentioned in the quote above.

The idea here is that no matter how poorly the market does, the bulk of your money (85% or 90%) is always safe.

For my own investing, I consider this safe money to be my answer to “how much money do you have?”

Any money I have in other investments, I consider to be already gone.

By taking this frame of mind, I never suffer the emotional pain of losses in my investments. And I always feel secure because I know my “floor”…the lowest my net worth can go.

All Risk

For the “all” side of taking on risk, he is recommending that you put 15 to 10 percent of your money in “extremely speculative bets, as leveraged as possible (like options)”.

I particularly like that he calls them “bets”. These aren’t investments. They are gambles.

And he mentions “options”.

As of today, there are 1711 stocks on Dividendium’s list that have options available for trading…and that’s only dividend stocks.

And each of those stocks has multiple strike prices and multiple expiration dates. If a stock has 10 strike prices trading for 5 expiration dates, that’s 50 different options per stock. For just the dividend stocks, that’s more than 85,000 possible option bets.

So now we have to figure out which ones to buy.

Which Options?

I’ve been using this “barbell strategy” for a while now.

And over the past few years, I have been refining how I chose the options…whittling it down from the ocean of 85,000 options to just a few purchases each month.

I now have a system that plays against the biases of other traders…against their tendency to misestimate how much risk they are taking.

The system looks for where it appears that the options traders are underestimating how much risk they are taking.

Then the system tells me to place very small bets. Less than $1 per share, and often less than $0.50 per share.

If the bets pay off, then I could make hundreds to thousands of percent returns on the trade.

I recently detailed 5 of those options trades that paid off. The returns for the trades ranged from 289% to 2664%.

Happiness Risk

What I really love most about this method of investing is that when I “barbell” my investment risk, I am completely avoiding any happiness risk.

I hate to lose money unexpectedly. It just puts me in a bad mood.

With this strategy, any money that I put into options is already assumed lost. That’s what I expect. I don’t count the value of the options I own. I don’t even look at that value.

After I buy an option, it will either expire worthless, or in 3 to 12 months it will be worth a substantial amount.

If an option expires worthless, I never know. The system doesn’t tell me about those. And I assumed that money was gone anyway, so I won’t miss it.

But if an option has appreciated a substantial amount, I get an email telling me to sell it immediately.

So the only emails I get from the system are “buy” emails and “profit” emails. Both are fun to get…the “profit” emails are substantially more fun of course.

And in the mean time, I intentionally spend zero time watching the market. I don’t even know what stocks I’m buying or own. But I know that I can’t lose more than my “floor”, my safe money.

In fact, someone asked me yesterday how many different options I currently own…I didn’t and still don’t know. I think it’s some where between 25 and 75 different options.

I could of course look it up in my trading account…but then I’d be risking my happiness by seeing numbers that I don’t want to know.

When I place my trades, I intentionally avert my eyes from the trading balance and any of the profit/loss numbers on the individual positions.

I only want to know about gains because that eliminates the risk to my happiness.

The System

If this system sounds good to you. If you like the idea of getting only buy emails and profit emails, and not spending any time watching the market. You can signup to use the system too.

There are only 200 spots available.

After the spots are filled the system will stop allowing new signups.

This makes sure that the options the system recommends are available for all the subscribers to buy. (Some of these are very thinly traded.)

If you’re interested, want more information, or want to sign up, check out the DEMO of how the Options Trading Service works.

Summary

Our poor abilities at estimating risk make it likely that we will underestimate how much risk we are taking on, and end up losing a lot more money than we thought we could.

To avoid this mistake, we should instead carve out a portion of our money (10% to 15%) to risk on highly leveraged bets. And keep the rest (85% to 90%) as safe as possible.

One way to find those highly leveraged bets is to use Dividendium’s newly available Options Trading Service.

In fact, this Barbell Investment Strategy is the whole reason I created this service.