Mac Murray

Chapter II The Take Off: Dropping In Without Wiping Out

THE TAKE OFF

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Chapter I  Big Wave Coming

Chapter III  Exit the Wave Without Going Over the Falls

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Chinese Blue Marble Half Slice

“A lot of people take risks because they don’t know the odds—they don’t know what the true risk actually is.”

–Nassim Taleb

Chinese Blue Marble Half Slice.

The question is: Is it possible to safely engage these big waves of the stock market? Or must we face the death-defying risk exposure of a big wave surfer?

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High Risk/High Return Fallacy

Academics would have us believe that if we seek to generate high returns, we must expose ourselves to high risk.  In other words, invested money can render higher profits only if it is subject to the possibility of being lost. Hence the refrain:  “The higher the risk, the higher the return.”

This belief is false. (see Be Careful Who You Listen To)

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Chinese Blue Marble Half Slice

“Academics say; the riskier it is the more return. But we say the less risky it is, the more return.  So we’re really talking at complete odds with each other.”

–Seth Klarman

Chinese Blue Marble Half Slice.

Ayala Land

ALI

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Faulty Assumption: Buy Everything At Once

The great number of statistically significant studies indicates repeated exposure to higher risk virtually assures financial ruin.  This fact alone should give us pause.

Deeper probing behind higher risk/higher return thinking reveals the unspoken assumption that the investment in question is to be acquired by means of a single buy transaction.  However, purchasing your maximum allocation to a stock in one fell swoop is unnecessarily high risk.  No world class fund manager enters a stock this way.  On the contrary he or she would build a position over time incrementally—by means of numerous smaller buy transactions.

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How Much Do I Buy?

Furthermore, high risk/high return commentary almost never makes mention of the mission-critical importance of position sizing as a defensive strategy.

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Chinese Blue Marble Half Slice

“How much to buy or sell is the single most important aspect of trading.”

–Curtis Faith, Original Turtle

Chinese Blue Marble Half Slice

Outside of the Original Turtle Rules, I’ve never once heard position sizing asserted as the key component of a trading plan.  Speaking for myself, after nearly 1000 hours of research I’ve also come to conclude position sizing is indeed the means by which risk is controlled.

Controlled risk keeps the risk of loss low and ensures you’ll be around long enough to generate higher returns.  Hence Seth Klarman’s assertion, “the less risk, the more return.  They’re two sides of the exact same coin”.

I can imagine a plethora of reasons why the high risk/high return mantra is foisted upon the public.  None of them is good for the investor.

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Chinese Blue Marble Half Slice

“The public must always believe absolutely, with the strongest conviction, the idea that will make them contribute the most to the market.”

–Victor Niederhoffer

Chinese Blue Marble Half Slice.

Benpres Holdings Corporation

BPC

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Back to the million dollar question: How do we safely catch these big waves?  The answer:  patiently and with surgical precision.

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International Container Terminal

ICT

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Very Low Risk in Action

Imagine you’re the portfolio manager of the Very Low Risk Fund which touts a fixed downside risk of less than 1%.  Let’s say you’ve been patiently keeping an eye on XYZ, a growth stock whose fundamentals look promising.  Finally, your Big Wave Indicator signals XYZ is beginning a high probability long term trend. You then begin building a position via incremental purchases, not by one big purchase.

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Chinese Blue Marble Half Slice

“We think that risk is best controlled by taking a large number of small trades versus making a few large bets on a small number of trades.”

–Toby Crabel

Chinese Blue Marble Half Slice.

Fixed Fractional Money Management

The size of each purchase is governed by what is known as a fixed fractional formula.  Put simply, this formula, in the example of the Very Low Risk Fund, allows you to incrementally build up an appropriately sized investment in XYZ while at no point exposing your total trading capital to 1% or more risk.  The idea is, if you risk only 1% of your total trading capital in any given trade, theoretically you’d need one hundred trades in a row to go against you before you go bust.

And what’s the likelihood of that happening?

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Objective, Systematic and Disciplined

We must also take care to point out that fixed downside risk is wholly dependent upon draconian adherence to trading rules which give primacy to risk management.  There is no place for “gut-feel” here. (See the Merits of Rules-Governed Trading)

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Philex Mining Corporation

PX

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Chinese Blue Slice

“One of my risk management rules is that if we lose more than 1.5 percent of our total equity on a given trade we get out.”

–Monroe Trout, Rand Financial


“First of all, I try very hard not to risk more than 1 percent of my portfolio on any single trade.”

–Bruce Kovner, Market Wizard


“The very first rule we live by: Never risk more than 1 percent of total equity on any trade.”

–Larry Hite, Hite Capital Management


“The initial commitment in any market is small: 0.50% or less of account equity.”

–Paul Mulvaney, Mulvaney Capital Management

Chinese Blue Slice

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This begs the question:  If portfolio managers handling billions of dollars aren’t willing to lose much more than 1%, why should you?

And just in case you are wondering if very low risk = wimpy returns, think again: the Global Markets Fund of Paul Mulvaney, the last of four fund managers quoted above, ended 2008 up 108.87%. That’s right–a one hundred and eight percent year-end return.

In the context of a systematic, risk-averse approach to “big wave investing,” low risk is our pathway to higher returns.

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For more detail on risk management see:

When Failure Is Not an Option

The Primacy of Fixed Downside Risk

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Anglo Phil Holdings Corporation

APO

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Entries and Exits

Despite our extraordinary attention to detail for Entries, you may be surprised to learn many studies indicate that relative to your returns Exits are far more important.  Catching a 10-story wave is one thing.  Riding it for all its worth and exiting the wave with your limbs still attached deserves a chapter of its own.

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Chapter III     Exit the Wave Without Going Over the Falls

E. M. Murray.  Managed Equities.  Fixed Downside Risk.

E. M. Murray. Customized Stock Portfolios. Professional Management. Fixed Downside Risk.

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