It’s hard to admit that you’re stupid.
You could turn $400,000 into $20,000… and still walk away without that self-awareness.
But when one young trader saw a $380,000 loss on a single call option, it taught him a valuable lesson. He wrote an article for Vice in which he called himself stupid 10 times.
This wasn’t even a story of complete stupidity…
Sure, this anonymous trader gambled in “meme stocks” like AMC Entertainment (AMC). As they did with many young people, these meme stocks sucked him into the excitement of the pandemic’s bull market.
But those are the trades where he made money. He emerged from a series of speculative bets having turned $5,000 into $50,000. He was ready to start playing it safe.
That’s a smart instinct. But his execution was terrible – and it turned his bet on a “safe” company into anything but a safe move.
This trader found one good investment thesis. Then, he put everything he had into it: the $50,000 he’d made from his previous trading, plus all the savings he’d built up by working a good job and spending conservatively.
The company he pegged all his wealth to was Alibaba (BABA), the e-commerce giant that’s like China’s version of Amazon. He did some research. This was a stable, wildly successful blue-chip company… Yet its share price ($245) was down more than 25% from its peak.
The company was still making tons of money, pushing down its price-to-earnings (P/E) ratio. Analysts he found online were confidently calling Alibaba a buy.
He decided to buy Alibaba $200 calls – essentially using options to make a leveraged bet on the company. If he was right and shares turned around, he’d make a fortune. If he was wrong… well, how far could shares of this great company fall?
He put all his available cash into the trade. Alibaba’s stock kept falling. He saved more money from his salary, and he put that cash in, too – another $100,000. He couldn’t even pay his $900 rent until his next paycheck came in.
And Alibaba still kept falling. He eventually sold when his $400,000 investment in BABA calls was down to $20,000… a 95% loss. And since he put on his trade, the company’s shares are down more than 50%.
This trader’s problem wasn’t his investment thesis. He was right in thinking that Alibaba is a solid company at a good price.
In hindsight, he realizes his true error…
I should have listened to [my mom]. She told me to diversify a little. Don’t go all in on one. But I felt like, because she told me not to do it so many times, I actually had to.
As his situation illustrates, everyone and their mother knows you need to diversify. This isn’t an insight. It’s a platitude or an empty hand-wave to prove that you talked about the risks in an investment. It’s an admonition akin to “eat your vegetables”… acknowledging the wiser action without changing anyone’s behavior.
That’s partly because diversification is boring and it’s more fun to go for the big score.
But it’s also because it’s difficult to implement…
Proper diversification involves understanding correlations that vary across time between assets with shifting categorizations. This is an area that human minds – even those of accomplished statisticians – can’t easily understand.
Do you diversify across stocks and bonds? Growth and value? Cyclical or acyclical? Reopening or work-from-home? Of course, you can diversify by sector, industry, size, and other features as well.
So instead of “eat your vegetables,” giving someone advice to diversify is more like telling them to “eat healthy.” Sure, I’d like to… But how?
Well, not putting all your liquid net worth into a single option trade is a good start. But the unsexy answer is that you need to keep slogging away and try to understand your investments.
To do that, here’s a simple first step: Try thinking about diversification within a framework we think provides better insight today…
Right now, I’d suggest that you want to do two things with your portfolio: participate and protect.
That means you want to participate in the booming economy and the bull market it’s fueling, but also protect your wealth from the downturns that may come by holding conservative, value-creating businesses.
In the last two quarters, real gross domestic product (“GDP”) grew by 12.2% and 4.9%. “Real” means adjusted for inflation – so on a nominal basis, that’s growth of 16.8% and 9.7%, respectively.
The economy is undeniably on fire. Consumers have turned on their spending spigots. Employers are hiring every available candidate they can find.
This economy says you need to stay invested and participate.
But, of course, everyone knows it. High stock prices already reflect the current economic strength.
While the market can keep going higher, when valuations get this high, the risk of a major reset rises. If growth disappoints or sentiment shifts, a 20% or 30% downswing can happen quickly.
With the market this high, you also want some positions that protect you from a correction or even a recession.
The new year is the perfect time to take a hard look at your portfolio. Walk through it, position by position, and ask yourself which of your holdings are designed to participate… and which are designed to protect.
And finally, make sure you aren’t in danger of losing it all if one of your “safe” bets goes south.
Here’s to our health, wealth, and a great retirement,
— Dr. David Eifrig
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Source: Daily Wealth