Always buy only in a Down Day for the stock
This would get you better prices when others are dumping. BE PATIENT, do not ignore this rule and chase after a running stock, do not be egged on to swing the bat, the market is full of opportunities even if this one is gone. What matters is that each and every single ‘buy’ does not lose money. Invest in haste and repent in leisure.
As a stock moves up away from you, you might think that the next ‘down day’ would be at a much higher level from today. While that is possible, more often than not, ‘down days’ can easily wipe out days and weeks of gains, allowing you to buy at more bargain levels when greed turns to fear and dumping occurs. Keep your cool and not be swayed by Mr Market.
An up day causes both sellers and buyers to be overly-optimistic, meaning that sellers will put forth a higher price, and you will subconsciously be willing to pay a higher price because you THINK that the stock is going to continue going up. The converse happens on a down day, both sellers and buyers naturally think that the stop is going to tank further, so sellers would be selling at a low price to get out because they subconsciouly fear the loss, and for the buyers, it takes more courage to pull the trigger which also forces you to think more carefully about entering the position.
On a down day, buy at the Bid, not the Ask. Be patient, there is much higher probability of your Bid being taken rather than the stock rallying beyond your Bid for the whole trading session.
If you really really really have to buy on an up day (re-read this whole section and think very carefully!), you can buy at the Ask. If your conviction is indeed that strong, don’t lose the opportunity by scrimping a few pennies.
Determine that maximum position that you would commit for the stock. For each purchase, do not exceed 25% of that maximum position.
Buying power is king (i.e. cash). If opportunities present themselves to buy lower (which happens more often than not), you need buying power to take advantage of that. Without buying power, you are out of the game to improve your returns. The bulk of the gains from value investing occurs when you are able to buy a ton at ever lower prices.
When averaging down, try to buy matching the original dollar amount invested
Maintaining the dollar amount invested (as opposed to matching by number of shares) will result in buying more units at a lower price. This will help to increase profits.
Only average down when there is at least a 2% drop from the previous buy price
Stocks seldom stay at the same level. This is to prevent the situation where you end up accumulating a bunch of stock all around the same level. Without new information or new analysis, the amount of stock you want to buy at a price level would be the same. If you end up accumulating, you might as well have bought the whole lot at the original purchase price. The end result is nonetheless also undesirable to end up with a large position bought at the same price.
Adhere STRICTLY to your position sizing and buy-in plan
Your position sizing and gradual buy-in plan helps to keep you from buying a large position at the start due to your optimism (you will have that when you decide to buy).
When the stock drops and you have a large position, you will be paralyzed because if you use up your bullets to average down, and the stock drops further, you are out of the game, either temporarily or for good.
When the stock drops and you have a small/manageable position, you can average down much more confidently and aggressively. You have less to lose, can think more clearly, and you have lots of spare ammo.
Space out purchases of a stock. Do not buy the same stock two consecutive days in a row.
In a down market, stock prices take some time to crash as more investors know about the event and/or more people sell off in response to the sell off (e.g. technical chartists, people selling off when its too painful, etc.). Spreading out the purchase increases the chance of getting better prices. Don’t be greedy by thinking that you would miss out on the next day’s low price.
Never “average up” unless there is a change in the analysis or new information came that changed the analysis.
The gains of most value investing “trades” are made by averaging down. This is the most logical – if you think that the original purchase price was a bargain, a lower price is an even greater bargain.
There is a human tendency to buy more on an uptrend because as the stock moves higher, you will think that it will go even higher because of the recency effect, you feel good thinking that a “buy” was a great decision, you become greedy and want to increase your position to earn more profits, you start to look for signs that justify the current price is a good price (e.g. charts stretched out a certain timeframe to show that the current point is a “low”), you “see” what you are looking for, you become fearful that the stock will move up and leave you behind, you think that the current price is a good price which will be hard to come by in future. These psychological illusions will cause you to purchase shares at higher prices and at larger volumes, exactly the opposite of what you should be doing!
If you think about it, if you are buying stocks when the prices move up, and you are averaging down when the prices go down, you are literally buying stocks every single day – that is not reasonable. Buying stocks that have moved up because they have moved up is pure short-term speculation.
NEVER buy using leverage or margin!
Keeping away from leverage allows you to survive huge market downturns (which comes now and then) and allow you to fight another day. Margin calls have taken out countless firms in the subprime crisis, it has taken out LTCM when Russia defaulted, it has taken out companies in the dot-com bust, etc.
The market can remain irrational longer than you can remain solvent.
If you made a mistake in buying when you shouldn’t have (i.e. not following these Buying Rules), and you have ran out of cash because you have been averaging down a collapsing stock, you might be tempted to reverse that mistake by buying on margin at what you think is an intra-day low, and flipping quickly when the intra-day bounce comes. DON’T! There is no reason why there definitely would be an intra-day bounce, especially with a tanking stock. You will be in really big trouble because you might end up with two sucker choices: hold the margin debt till the next day (i.e. throw yourself into the arms of sadistic Mr Market) or you have to eat the loss before the day ends. Don’t compound your mistakes.
NEVER overpay when you are entering a sea of short sellers!
Short sellers are smart, they know when to let the buyers take the lead and when to act. They know that after buyers purchase what they want, buyers will then be at the mercy of the shorts.
Don’t be suckered into chasing after a rapidly rising stock price (i.e. the bait) and end up paying a high price, before short sellers start driving things down again. It is extremely important to executing your discipline to buy ONLY WHEN the price is below or at a bargain price level which you have determined beforehand (before the trading starts, while you were still rational).
It is more than likely that you can get what you want at a low price because the short sellers play in situations where they can win (e.g. small shares float, hedge fund short-sellers with large capital) so they will drive the share price down. This can be further compounded moving closer to options expiry (3rd Friday of every month) if they are long puts.
NEVER buy on margin in this situation. Shorts can cause ‘flash crash’ in the stock price and flush you out.
Do not rush into a purchase without having done sufficient research
You might think that the opportunity window is slim and closing, but more likely than not, the stock will not run away, you can still buy at the depressed prices.
Bad news doesn’t just rain, it pours.
Do your research quickly, and only buy after you have completed it and reasoned it through.
Buy in haste, repent in leisure.
Put in buy orders in a graduated manner
For example, if you are willing to pay $5 for the stock, you might put in limit buy orders for 100 shares at $5, 150 shares at $4.80, 200 shares at $4.60p.
This allows you to capture additional upsides due to the intraday price volatility. It also helps to alleviate some regret when you buy a whole lot at a price, and the day ends at a lower price.
THINK VERY CAREFULLY before committing your last dollars into a position
Read and re-read this quote from Charlie Munger: “There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn’t awash in cash – and I don’t want to go back.”
If you are committing your last bit of dry powder, it must really be a situation where you absolutely wouldn’t lose money on the position, where you have superb conviction that the downside is very limited, and the upside is large.
In most situations where prices are not rock bottom (think about mortgage REITS and financial instituations in March 2009), stock prices can still go down by a lot. The pain comes because when the position goes down, you lose tons of money and you can’t do anything about it. In contrast, if you have significant ammo left relative to the losing positions, you would not be affected much by prices tanking because you are able to average down and make greater returns.
The mistake of buying a large position at one shot, is much worse than the mistake of selling a lot at one shot. This is because stock price drops are generally more severe and steep, while stock price increases are generally more gradual (typical human behaviour of panic and greater fear of loss compared to same magnitude of gain).
Buffett on buying: “If you tell me the economy is going to be terrible for 12 months, pick a number, and then if I find something that is attractive today, I am going to buy it today. I am not going to wait and hope that it sells cheaper six months from now. Because who knows when stocks will hit a low or a high? Nobody knows that. All you know is whether you’re getting enough for your money or not.”
Another Buffett quote on buying: “When you get a chance to buy something of extraordinary value, whether it’s a farm or an apartment house or a piece of a business or an entire business, the time to do it is then, and not worry about whether you could do it a little cheaper a month later or two months later.”
Mistakes were made in the analysis which led to the buy, and it is no longer a worthwhile investment after correcting those mistakes.
Newer events showed that the fundamentals of the company have deteriorated and it no longer meets the buying criteria (e.g. think blue chip stamps).
The capital is better channelled to another better investment.
This is a tricky one, you don’t want to end up jumping from one supposedly leaking ship that is getting better, to a supposedly freshly leaking ship. The new ship had better be worth it!
If your investment thesis is playing out, with the original leaking ship showing signs of recovery, then the new supposedly leaking ship must at least be a 50% better bargain. [Adopted from John Templeton.]
If the situation had not changed with the original leaking ship since you bought it, and your level of conviction in your investment thesis is pretty much the same with the new potential ship, then by all means switch over if the new ship has better returns (take note to look into the probability distribution for the outcomes as well)
It is overvalued based on your hurdle rate.
Caveat: If you are holding on to a great company (i.e. high ROIC, high IRR) + the risk of permanent capital impairment is low + you have the ability hold the position without being forced to liquidate it, then in this situation where the 3 stars are aligned, keep on to it even though it has reached fair value. You should seriously consider selling when such an investment becomes grossly overvalued, e.g. 2 times.
For other cases, start cutting back when the stock reaches fair value, and sell out when it gets to 20% premium over fair value. The momentum usually lasts longer than expected, and this 20% rule keeps us from selling too early. [Adopted from Ronald Canakaris of Montag & Caldwell.]
Once you see an impending crash, sell out all your positions (read this post on the different types of crisis and how to monitor). Special “sell rules” apply in market crisis mode:
After you have bought in at the end of big drop days, sell off immediately after any upward spikes (or at most 1-2 days later). In a market crisis, the pain will last for some time (e.g. 2 years), don’t worry about missing the recovery, there would usually be a lot more pain before that happens.
If all your ammo has been committed due to averaging down, again sell off a portion of your position immediately with large spikes up. While you might think that “value investing” means buy-and-hold, and only selling at fair value or never, you will be doing yourself a big disservice by kicking yourself out of the game early on. Prices can crash much lower, so the opportunity cost of not being able to commit significant amounts of capital are extremely good prices can be extremely painful.
Flexibility during a market crash is extremely important. You reduce your long position on upward spikes not because you are predicting that prices will fall, but because you need dry powder to give yourself flexibility to buy great companies at very depressed prices if and when the opportunity presents itself. If you have some steady stream of cash inflows that are significant relative to your portfolio size, then you may not need to pare down your positions because those cash inflows will give you that flexibility.
It is too difficult to determine if a spike up will go higher, or a spike down will go lower (never underestimate the market’s capacity to panic). so don’t waste time predicting. You need to set yourself up in a manner where you would be happy regardless of the market going up or down. Having enough diversification (e.g. 5-7 positions) and dry powder allows you to benefit both ways.
Seth Klarman made a point that if you hold a fully priced security, then your risk of capital loss is higher. In an uncertain market, if you hold a security that has just spiked up after tanking, the risk of that security turning back down is also as high. Of course if your analysis is done well, the risk of permanent capital impairment even if you hold on the security at the lower price, should be much lower compared to a fully priced security. Nonetheless, the risk of the stock being depressed for an extended period of time (e.g. 2 years) is almost just as bad a permanent capital loss of the same loss magnitude.
When should you not sell after a upward spike? Only after there has been major blood on the streets. Read more here and Cramer’s tips on spotting bottoms here.
You can read some of the thoughts that go behind the above rules in my previous post here.
POSITION SIZING RULES
After surveying position sizing methodologies of various investors (see my post here), I would like to pen down my thoughts on position sizing.
I think the position sizing methodology adopted needs to be suited for the circumstances of the investor (e.g. resources available), and to a much lesser extent, the personality of the investor (e.g. how risk averse you are).
Based on the circumstances, there should be an optimal position sizing methodology. Whether or not that is palatable to the personality of the investor, it should be up to the investor to instill the necessary discipline to handle the methodology.
Current Position Sizing Methodology
In my situation, time is a scarce resource.
This means that I can either do mid-level research on 1-2 ideas a year, or I can do high-level research on say 5 ideas a year. It is a trade off between the quality of the research and the number of opportunities that can be pursued.
The number of opportunities I come across or uncover will also be fewer.
Due to these considerations, if I am looking to build a portfolio with 20-odd positions (e.g. a 3-5-10 allocation), it would result in too much cash being left idle. As such I would go for the following methodology:
~10 positions, 5-10-20 allocations
5% for a good buy
10% for a good buy and with other value investors on board
20% for a woohoo! bargain
A counter argument to the above is that since you do not have the time to do in-depth research, you should in fact hold much more positions to diversify (at the extreme being index funds). I guess this is the illogical thing that I’m doing so that I would still be doing research instead of shutting off with index funds.
How Each Position is Built
I agree how Anthony Bolton builds his positions, in essence doubling down each time catering for 4 times after the initial purchase. With a small portfolio however, if you are building towards a 5% max position, catering for 4 double downs is difficult because your initial position will be so small to make any impact. For such a situation, I would want to have the last salvo at least a double down and for the initial position to be decent (i.e. not too small to be negligible). The middle positions can be less than a double down because typically stocks can drop many levels down on bad news. This will mean the following:
5% = 0.75% + 0.5% + 1.25% + 2.5%
10% = 0.75% + 0.5% + 1.25% + 2.5% + 5%
20% = 1.25% + 1.25% + 2.5% + 5% + 10%
How Cash Position is Determined
Finally, I had a lingering question before: when you need to liquidate some positions to build up your cash position, should you sell positions that are doing well? or reduce positions that are not doing well?
With a position sizing strategy, the answer becomes clearer. In normal times, the cash position will be driven by how many bargains are being found. In times of higher risk, your margin of safety should be increased, and the cash position would still be driven by the bargains available. In the rare situation where you forsee a market-wide downturn (e.g. the 2008 credit crisis, not the dot-com crash), and you wish to build a certain cash position (e.g. 80%), then you should increase your margin of safety to a level that gives you that cash position.
As you increase your margin of safety, stocks that no longer meet your new buying criteria should be sold. However if the dark clouds from such a position is dissipating, or you foresee a near-term catalyst, then you might grant more leeway to continue to hold.
Future Position Sizing Methodology
The position sizing methodology should change if I am able to look for opportunities full time, and have more time/resources to look after a larger number of positions (e.g. 20-odd). How each position is built would change depending on the size of my total portfolio.