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Using a Trailing Stop Loss to Reduce Risk

A reader writes in, asking:

“What are your thoughts on implementing a Stop Loss/Trailing Stop Loss for your positions? More specifically, does a trailing stop loss make sense given the added protection against downside risk? I thought it might be an interesting question given the current stock market valuation.”

How Does a Stop Loss Work?

For those who are unfamiliar, a stop loss order is an order that says, “if the price of this holding falls below $x, sell my shares.” A trailing stop loss is an order that says, “if the price of this holding falls by a certain dollar amount (or percentage) from its highest point since I placed this order, sell my shares.”

Example: Bob holds shares of an ETF that is currently worth $90, and he sets a trailing stop loss to sell if the price falls by 10%. That would currently mean that if the share price falls to $81, his shares will be sold. However, if the share price moves upward, the trigger price for his order will move upward as well. For example, if the share price climbs to $100, the new trigger price would be $90 (i.e., a 10% fall from the new high).

Does a Stop Loss Reduce Risk?

To answer the reader’s question, yes, a trailing stop loss is an effective way to provide some “added protection against downside risk.” It isn’t perfect protection, because the price at which the sell order is actually filled could ultimately be lower than the trigger price if the price is falling very quickly. Still, it does reduce risk relative to simply holding something without a stop order.

But, to state the obvious, the fact that something reduces risk doesn’t necessarily make it a good idea. Selling all of your existing holdings and moving everything into a short-term TIPS fund would also reduce risk, but it wouldn’t make sense for most people.

Is a Stop Loss a Good Idea?

Many people first learn about stop orders (trailing or otherwise) and think it’s a simple way to “miss” downward movement. For example: “I’ll set a trailing stop order to sell when the price falls by 10% and then I’ll buy again after it has fallen by 15%. That way I’ll get to miss out on part of the fall while still being able to experience the eventual rebound.”

The problem with this line of thinking is that it neglects to consider what happens if the stock falls 10%, but then rebounds before having fallen by 15%. In such a case, the person has sold their holding but does not buy back in at any point. At some point, they will have to decide whether they want to go ahead and buy back in anyway at a higher price than the price at which they sold.

Moving these two price points closer together (rather than 10% and 15%) does reduce the likelihood of such a scenario, but it also reduces the “payoff” when the strategy works out. That is, it reduces the amount of price decline that the investor gets to avoid.

In addition, on each roundtrip (i.e., selling the holding then eventually buying it again) there are transaction costs that must be overcome in order for the strategy to provide a net gain.

To state the issue another way: A stop loss order essentially says that you don’t want to sell at today’s price. But you would be willing to sell at a price lower than today’s price. For example, I don’t want to sell it today for $100, even though I could. But I would be willing to sell it in the future if the price falls to $90.

This is a line of thinking that does not, in itself, make sense. It only makes sense if you think that prices are predictable. That is, it only makes sense if you think that the lower price tomorrow means that it’s about to go down further rather than going back up. Unfortunately, short-term stock movements are not usually predictable. (This is why strategies that use price movements to predict future price movements are not generally successful.)

In summary, yes, trailing stop orders do reduce risk. But my personal view is that I don’t think most people should bother with them. Most people, if they desire to reduce the risk in their portfolio, are going to be better served by doing it in a simpler manner: by adjusting their asset allocation.

Why Forex (Foreign Currency Trading) Is Useless and Dangerous for Most Investors

A reader writes in, asking:

“I recently saw an article that said that forex trading was invented to be a risk reduction tool. The nature of the rest of the article gave me the impression that it was just fear-mongering. Make me scared about the fate of U.S. Dollars so I turn my money over to them. But if you could discuss the matter in an article on your blog I’d be interested to read it.”

In some cases — which are rare for individual investors — currency-related investment products can be helpful as a way to reduce risk.

Example: Theresa is a self-employed engineer. She lives in the US (and therefore spends pretty much exclusively in dollars), but the majority of her revenue this year will come from completing a project for a client in the UK — a project for which she’ll be paid £70,000. She anticipates completing the project in October. If she wants to, she could use currency futures to “lock in” the current exchange rate so that she knows how much the £70,000 will actually be worth to her (i.e., in dollars), thereby allowing her to budget her finances accordingly.

Most people, however, are paid in the same currency in which they spend. So there’s no need to offset any such risk.

In fact, for most individual investors, foreign currency trading is not only pointless but also harmful.

Firstly, investing in currency is a zero-sum game, before costs. That is, with forex, the investment you’re holding is a currency (or a derivative product whose performance is based on the price of a currency), and currencies do not actually earn any money. (This is quite different from stocks and bonds, which do on average earn money.) With a forex trade, if one party earns money, it is solely because the party on the other side of the trade lost money. And, after accounting for transaction costs, the total amount earned by the two parties is not zero, but negative.

Second, forex allows for degrees of leverage (i.e., investing with borrowed money) that are truly insane for an individual investor. Forex brokers typically allow for 50:1 leverage, meaning that for each $1,000 you invest, you can buy $50,000 of something by borrowing the other $49,000. Investing this much borrowed money wildly magnifies your results, whether good or bad. Of course, the fact that you can borrow huge amounts of money doesn’t mean you have to. But forex does give you the tools to absolutely destroy your finances in a hurry.

Finally, most individual investors don’t engage in currency trading. As a result, you’re engaging in a zero-sum game (negative, after costs) with people who are, in most cases, professionals. They likely have more experience, better skills, and more information than you have.

Are Commodity-Linked CDs a Good Idea?

A reader writes in, asking:

“I’d love to hear your thoughts on Everbank’s ‘5 Year MarketSafe Commodities CD.’ It guarantees return of principle and offers upside on the performance of several commodities.”

A quick perusal of the CD’s fact sheet (available here) shows three important points:

  • The CD is FDIC-protected against loss (i.e., you won’t get back less than you put in),
  • You may not withdraw any part of the CD prior to maturity, except “in the event of death or adjudication of incompetence,” and
  • The CD’s performance is “based on the performance of six commodities [gold, silver, copper, nickel, soybeans, and sugar.]”

The first two points are pretty straight-forward. The trickiness is all in that last point. If a person read only that statement, he/she might think that the CD provides something like the average return of those commodities, but with no downside (i.e., no ability to lose money), when in reality that’s not the case at all.

Instead, your total return for the 5-year period is equal to the arithmetic average of the annual returns for the commodities in question. (That is, with 6 commodities each having 5 different annual returns, they average those 30 different annual returns, and that average is the total return that you would get.)

For example, imagine a scenario in which each of the commodity prices in question goes up 10% per year for each of the five years. Without taking the time to read the details and work through the math, a person might expect that their CD would match the performance of the commodities. That is, they would expect a 10% compounded annual return, for a total return of 61% over the 5-year period. Not bad for a CD!

But that’s not what you would get. Not even close. Instead, your total return over the period would be 10% (because 10% is the average of the 30 annual returns of 10%).

In addition, the calculation of the annual return for each commodity is capped at 50% each year. And given the volatility of commodity prices, it’s not at all unthinkable that such a limit could come into play.

By way of comparison, it’s currently possible to get a 5-year CD with a 2.3% yield, which would grow your money by a little over 12% over the course of the period. So using this commodity-linked CD instead of a more typical CD would only make sense if:

  1. You expect the six commodities in question to increase in price by, on average, more than 12% per year for the next 5 years, and
  2. You don’t care about not being able to withdraw your money prior to maturity.

More generally, whenever a product offers downside protection and an upside that is linked to the performance of something very volatile, you only get a small portion of that upside. That’s the case with fixed indexed annuities linked to stock or commodity prices, and it’s the case with CDs such as this one.

Be Wary of Online Reviews

Over the last few weeks, I’ve received several emails that suggest that many people are still unaware of one of the major conflicts of interests that you face when reading material on a blog. Specifically, when you read a blogger’s review of a product or service, it’s important to understand that, in many cases, the review is meant to function as a sales pitch.

Imagine that you’re considering buying a Subaru Outback. You Google “Subaru Outback review” and you come across the website for a Subaru dealership, where they review the latest Outback model.

The review is likely a good source of information, written by a person who is knowledgeable about the topic. But there would be no doubt in your mind that the goal of the review is to sell you an Outback. And, because of that obvious goal, you would take anything you read with a grain of salt. You wouldn’t expect the review to lie, but you would expect the overall tone of the review and the information included (and excluded) to be influenced by the dealership’s goal of selling you a car.

That’s often what it’s like when you read a review on a blog (despite the fact that the conflict of interests is less obvious). The review is meant to function as a sales pitch, because the blogger participates in an “affiliate program” for the product/service being reviewed — meaning that the blogger receives a commission if you click from their site to the site of the product being reviewed and you make a purchase or create an account.

As with the Subaru dealership’s Outback review, a blogger’s review is unlikely to include any false information. But it’s super common to omit relevant information that might lead you to do something other than buy (or sign up for) the “reviewed” product. For example, when writing about the robo-advisor Betterment, somebody might write that it’s hands-off, easy to understand, based on solid research, and low-cost. All of those things are true. But the reviewer will often neglect to mention that all of those things are also true of a Target Retirement fund from Vanguard — and the costs of the Vanguard fund are even lower.

[Just to be clear, my point here isn’t that Betterment is necessarily a worse choice than a less expensive target date fund. It can make sense in some circumstances. The point is simply that it’s important to understand that the reviewer is likely paid a commission by Betterment but not by Vanguard — and you should be aware of the various ways in which that influences the writing.]

Commonly reviewed/promoted companies with affiliate programs include Betterment, Wealthfront, Lending Club, LendingTree, Personal Capital, CreditSesame, Fundrise, and many more. (The list changes frequently as companies begin new affiliate programs or end existing ones.)

At least in theory, bloggers are supposed to disclose the fact that a link is an affiliate link, but in the real world this is rarely done in a way that is obvious/clear for the reader. In general, if you read a review that seems especially positive, you will want to treat the review with some skepticism, as there is a good chance that the reviewer is operating as a paid salesperson.

Investing in Healthcare Stocks to Offset Healthcare Risk

A reader writes in, asking:

“What would you think about buying a healthcare mutual fund to reduce the risk of healthcare costs rising as I age? Or in a similar vein, what about buying stock in long term care facilities to reduce the financial risk of needing long-term care?”

In short, I would say that that idea makes no sense.

There is no particular reason to think that the performance of a healthcare mutual fund will be highly correlated to your personal healthcare costs. Nor is there any reason to think that the performance of a collection of long-term care stocks will be highly correlated to your personal need for long-term care.

In other words, neither one can function anything like an actual insurance product that directly reduces your out-of-pocket costs for care.

A line of thinking that I’ve seen from many investors is that healthcare stocks are in for several years of excellent performance because our aging population will cause healthcare companies to experience strong profits over the next couple of decades. And such stocks are therefore a safe holding for retiring baby boomers.

But as we’ve discussed here in the past, the performance of a given stock is determined by how that company’s earnings compare to the market’s expectations for that company’s earnings. So a company (or industry) can have good earnings growth over a given period, yet experience poor stock performance if the earnings growth isn’t as good as the market expected it to be.

For example, Morningstar reports that Vanguard Health Care Fund has a P/E ratio that’s about 25% higher than that of Vanguard Total Stock Market Index Fund. In other words, based on their current earnings, the Health Care fund is significantly more expensive — presumably because the market already expects the stocks owned by the healthcare fund to have higher earnings growth than the average stock in the U.S. stock market. So it’s entirely possible that healthcare stocks experience high earnings growth yet still perform poorly because the earnings growth isn’t as high as expected.

In summary, healthcare stocks — like stocks in general — are risky. And holding them as a way to reduce risk (including the risk that your personal healthcare costs will rise) is nonsensical.

Is a Self-Directed IRA a Good Idea?

A reader writes in, asking:

“I recently made an acquaintance who works in the financial industry. He suggested to me that I look into opening a ‘self directed IRA’ where I would have more choices of how to invest, including some things that sound pretty attractive. Is this a good idea, or should I be skeptical?”

A self-directed IRA is an IRA with a custodian that allows you to invest in things other than the standard choices available in a typical IRA at a brokerage firm (e.g., stocks, bonds, mutual funds, CDs, etc.). In other words, a self-directed IRA is a way to use your IRA to invest in so-called “alternative” investments (e.g., real estate or a small business).

And it’s not unthinkable that you might want to invest in something other than what’s available via a typical IRA account, so there’s nothing inherently bad about the self-directed IRA concept.

That said, opening a self-directed IRA sometimes works out very badly for either (or both) of two reasons.

There Are No Investment Unicorns

In many cases, a self-directed IRA is opened at the suggestion of somebody who is recommending a particular investment product/strategy, suggesting that such product/strategy will offer outsized returns. Unfortunately, in such cases the only sure bet is that the person recommending this strategy will make a good chunk of change if you buy what they’re selling.

It’s absolutely true that there are all sorts of things that have the possibility of higher returns — even much higher returns — than a boring “total stock market” index fund. But if anybody tells you that such higher returns are available without a higher level of risk, that person is either a) ill-informed or b) trying to take advantage of you.

Prohibited Transactions Are Bad News

The second reason that self-directed IRAs can be a bad idea is that they dramatically increase your chance of engaging in a prohibited transaction.

Internal Revenue Code section 4975 outlines several types of transactions that are prohibited for IRA accounts. Most IRA owners don’t have to worry very much about such prohibitions, because the typical IRA at a brokerage firm or fund company is relatively foolproof in this regard. That is, the IRA custodian keeps you pretty well safe by limiting the things you can do with the account. In many cases, a self-directed IRA will have no such protections. And with self-directed IRAs, people do run afoul of the prohibited transaction rules on a regular basis.

So what happens when you engage in a prohibited transaction? Here’s how the IRS describes the result:

Generally, if you or your beneficiary engages in a prohibited transaction in connection with your traditional IRA account at any time during the year, the account stops being an IRA as of the first day of that year. If your account stops being an IRA because you or your beneficiary engaged in a prohibited transaction, the account is treated as distributing all its assets to you at their fair market values on the first day of the year. If the total of those values is more than your basis in the IRA, you will have a taxable gain that is includible in your income.

In case it isn’t clear, that’s a very bad outcome. You would have a large amount of money appearing as taxable income in a single year (assuming the account is of a significant size, that is), and you would completely lose out on the continued benefit of the IRA going forward (i.e., the ability to grow your money at a faster rate due to not having to pay tax along the way).

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