So much of investing is the avoidance of doing dumb stuff. If you’re not sure what “dumb stuff” entails in investing then let me provide you a very incomplete list:
- Selling a broad index fund after if dropped 20+ percent and going to cash.
- Putting more than 5 percent of your portfolio into a single stock.
- Frequently trading in and out of a stock based on its gyrations without a well-defined trading strategy.
- Buying individual stocks without reading 10Ks, 10Qs, or knowing how to perform at least a simple valuation based on fundamentals.
- Being sold an investment product instead of proactively researching the investment on your own.
- Paying a front-end sales load for a mutual fund.
- Buying most IPOs on the first day of public trading.
- Trading volatility or other structured products with too much leverage.
The one thing the above have in common is that they all reflect the need of an investor to “do something” to try to get better returns. The reality is that all of these actions are hazardous to an investor’s wealth.
There’s one simple trick to avoid all the bad behavior that hurts an investor: dry powder.
Dry powder can come in two forms:
- Periodic savings from your paycheck.
- Keeping a portion of your portfolio in cash until you find the “right” opportunity.
Every investor has heard about the benefits of dollar cost averaging. They’re not exaggerated and I won’t rehash them here. It’s one of the few free lunches in investing and the best use of the periodic savings from your paycheck.
But you probably didn’t come here to be told to dollar cost average your paycheck into a low-cost, tax-efficient portfolio. You came here to know what to do with the portion of your portfolio you’re now keeping in cash as dry powder so you can do potentially dumb stuff while keeping the bulk of your assets in a responsible, diversified portfolio.
Some solid options if you have the need to do something besides have patience while invested in diversified portfolios over long periods of time:
- Trade around a core position: every time one of your core diversified holdings drops by some threshold, whether it’s 10, 20, or 30 percent, use your cash to buy some more and then hold on until it appreciates back to the previous price level. Sell, then repeat.
- Trade around a core position but sell long-dated put options. Same as the above, but instead of buying the underlying asset you sell an at-the-money put option with a maturity date of 6 months from sale. Hold onto it until 90 percent of the time value (theta) disappears or it gets assigned to you. If it gets assigned to you then hold onto the underlying until it appreciates back to the original strike price. This strategy has the added benefits of some downside protection, timing the sale of insurance when it’s dear, and a dash of sophistication and sexiness because it involves options (even though it’s a dead-simple strategy).
- Speculate on companies you think will do really well, allocating no more than half a percent of your overall portfolio to any single position. There are lots of ways to do this – I don’t recommend it for most people but if you keep your position size very small for each stock you probably won’t do too much damage (plus it’s fun to say you bought shares of Tesla 8 years ago!).
- Use an active trading strategy, making sure you placed your stop loss where you’re only risking 0.25% of your portfolio on any single trade at least until you’ve mastered the art of trading. For most people this will be a waste of time and money, but at worse it’s a slow bleed with plenty of action.
The last two options typically lead investors astray; however, if you use the recommended position sizing you won’t do too much damage to your terminal wealth.