In the area of personal finance, an important concept that many investors ignore at their own peril is sequence risk. In essence, sequence risk describes the risk that you start withdrawing from your retirement savings at the worst possible time when the investment portfolio is suffering significant losses. In this case, the recovery in your retirement savings will be hampered by the fact that you are withdrawing assets from it, thus reducing the amount of money working for you to recover previous losses. But this sequence risk exists in any investment portfolio and not only when you start withdrawing assets from it.
My rule of thumb is to have a stop loss about one standard deviation below my entry level (e.g. 20% below entry price for single stocks and about 15% below entry for index trackers). When I am stopped out, I tend to get back in when the share price has risen by more than half a standard deviation from recent lows (so I am willing to give up a recovery of 10% for single stocks and about 7.5% for index trackers). This way, I take out the risk of a major drawdown and still get back in before the recovery is fully done.
In a sense yes, Stop loss strategies work tremendously well. But the tricky bit is to decide when to get back in once you have been stopped out. This is why I advocate for a combination of stop-loss and re-entry strategies: https://www.pm-research.com/content/iijtrade/8/4/44.abstract
Stop loss is a basic of risk management, BUT for retail investors it's a massive issue because on ETFs brokers can execute your order even when it's far away from the actual level claiming that the bid-offer spread has widened.
I experienced it first-hand when HL executed a SL on a Nasdaq ETF 10% lower than the market price on a day when markets were quiet and up!
Could it happen if the SL order was 20% away? Unfortunately there's nothing that proves the contrary, so this is good practice in theory, but the reality is different
Oh my. I think that may have something to do with using HL ;-) I haven't heard of these things in brokers that specialise more on trading like ii or interactive brokers, etc.
Brilliant piece Joachim. Thank you. I try to closely follow Gary Antonacci's Dual Momentum strategy and what you are describing in this piece very closely resembles the research and subsequent strategy produced by Gary in his book Dual Momentum Investing. I try to be aware of my psychological flaws and like an evidence based approach and the Dual Momentum strategy is the best I've found so far and incorporates a lot of your thinking in this post. Thank you.
Nope. I have learned in more than 20 years of managing money that fudging it is going to cost you far more than sticking to the rules. Trust me, I paid my "school fees"...
That is interesting. One thing to be aware of though is capital gains tax when switching assets. In some countries (e.g., our common native Germany, if I remember correctly), capital gains are tax-free if an asset had been held for more than a year, in others (like here in Spain where I live), you always pay.
JK - I'm sorry you've lost me here. I understand sequence risk (or at least I think I do!) yet your example assumes that the asset we abandon will have negative momentum from our departure point (as in the Nasdaq post 2000). The selection of any random asset is a bit too far for me, giving that we know the ex-post returns of the assets from that time period on. What should an investor do without perfect foresight into asset class performance after drawdowns? What am I missing here? Thanks, Pete.
This does however go against the whole universe of personal finance knowledge I've interacted with on my money adventures so far. Switching money in and out of asset classes and funds seems to me like a recipe for selling low and chasing positive looking performance around the markets. My approach is based around holding a handful of big ETFs with some factor tilts. I'm not at all confident I could come up with rules and implementation to dance in and out like this.
Very interesting indeed, now predict what will happen in the future without hindsight?
I don't have to. This is why I have stop loss and re-entry strategies in place :-)
That was my 1st thoughts, how do you get back in?
My rule of thumb is to have a stop loss about one standard deviation below my entry level (e.g. 20% below entry price for single stocks and about 15% below entry for index trackers). When I am stopped out, I tend to get back in when the share price has risen by more than half a standard deviation from recent lows (so I am willing to give up a recovery of 10% for single stocks and about 7.5% for index trackers). This way, I take out the risk of a major drawdown and still get back in before the recovery is fully done.
This has certainly giving me something to dwell on...........
Just another thought, do you not think, it might not work next time?
And by the time it hasn't you have run out of years to recover.
That is the nightmare that makes me wake up in the middle of the night sometimes.
Great content, as always.
I will carry on ignoring this though as timing the market is kryptonite to me
Is it simply the saying "cut your losses"?
In a sense yes, Stop loss strategies work tremendously well. But the tricky bit is to decide when to get back in once you have been stopped out. This is why I advocate for a combination of stop-loss and re-entry strategies: https://www.pm-research.com/content/iijtrade/8/4/44.abstract
Totally agree. The central point is in the chart I already posted under "Investing for immortals":
https://www.visualcapitalist.com/chart-timing-the-market/
Switching to "any random asset" seems a bit strong?!
Of course it is. Nobody would simply switch into a randomly selected asset. Though we know from these experiments with monkey throwing darts that they tend to perform quite alright: https://klementoninvesting.substack.com/p/those-reindeer-are-good
Oh and I forgot to link to this post as well: https://klementoninvesting.substack.com/p/checking-in-on-the-reindeer
Stop loss is a basic of risk management, BUT for retail investors it's a massive issue because on ETFs brokers can execute your order even when it's far away from the actual level claiming that the bid-offer spread has widened.
I experienced it first-hand when HL executed a SL on a Nasdaq ETF 10% lower than the market price on a day when markets were quiet and up!
Could it happen if the SL order was 20% away? Unfortunately there's nothing that proves the contrary, so this is good practice in theory, but the reality is different
Oh my. I think that may have something to do with using HL ;-) I haven't heard of these things in brokers that specialise more on trading like ii or interactive brokers, etc.
I'm pleased to hear it because since that happened I decided to close my HL account and move it to the ones you mentioned!
Although the issue could be deeper: ETFs liquidity and market making (mine was on the anasdaq but UK listed)
'Furthermore, you benefitted from the stunning performance of US tech stocks in the 2010s'
And don't forget to write a thank you-note to the FED.
Another informative note, Mr K. This sounds somewhat similar to Meb Faber’s rule - sell and buy cash (or other) when Stock Price is below 200DMA.
I shall ‘Google search’ for sequencing risk, but if anyone has reference to a really good analysis can you please post the http link here.
Meb Faber's 200D MA work is one source. And as mentioned above in another comment, Gary Antonacci's Dual Momentum approach works well, too: https://www.amazon.co.uk/Dual-Momentum-Investing-Innovative-Strategy/dp/0071849440
Brilliant piece Joachim. Thank you. I try to closely follow Gary Antonacci's Dual Momentum strategy and what you are describing in this piece very closely resembles the research and subsequent strategy produced by Gary in his book Dual Momentum Investing. I try to be aware of my psychological flaws and like an evidence based approach and the Dual Momentum strategy is the best I've found so far and incorporates a lot of your thinking in this post. Thank you.
I love that approach. It is part of my toolset when I pick stocks.
You must have a heart of stone 😀. Is it easy for you to keep doing this, or do you feel like fudging it sometimes 🤔
Nope. I have learned in more than 20 years of managing money that fudging it is going to cost you far more than sticking to the rules. Trust me, I paid my "school fees"...
That is interesting. One thing to be aware of though is capital gains tax when switching assets. In some countries (e.g., our common native Germany, if I remember correctly), capital gains are tax-free if an asset had been held for more than a year, in others (like here in Spain where I live), you always pay.
True that. And in again other countries like Switzerland, where I used to live, there is no such thing as capital gains taxes...
JK - I'm sorry you've lost me here. I understand sequence risk (or at least I think I do!) yet your example assumes that the asset we abandon will have negative momentum from our departure point (as in the Nasdaq post 2000). The selection of any random asset is a bit too far for me, giving that we know the ex-post returns of the assets from that time period on. What should an investor do without perfect foresight into asset class performance after drawdowns? What am I missing here? Thanks, Pete.
Very interesting stuff Joachim!
This does however go against the whole universe of personal finance knowledge I've interacted with on my money adventures so far. Switching money in and out of asset classes and funds seems to me like a recipe for selling low and chasing positive looking performance around the markets. My approach is based around holding a handful of big ETFs with some factor tilts. I'm not at all confident I could come up with rules and implementation to dance in and out like this.