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TMFMmbop (35.06)

Confessions of a Day Trader

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June 15, 2009 – Comments (2) | RELATED TICKERS: MT , PM

We've caught a little bit of flak as well as earned some praise over at Global Gains recently because we recently sold two stocks -- both emerging markets small caps -- that we thought had gotten ahead of themselves in terms of valuation. At the same time, however, we noted that we'd be willing to buy these stocks back at the right price because they remained strong companies with bright futures.

Some people liked the move and were happy to make good money in this volatile market, while others accused us of having a trading mentality and thought we were sacrificing long-term returns. As I answered those questions, I realized my thoughts might be useful as part of the "Is Buy and Hold Dead?" debate going on on Fool.com. So, I figured I'd post something here.

That something
First, it's important to realize that not all securities are equal. Treasuries, for example, are risk free, while a volatile stock like Arcelor Mittal (MT) -- 1-year beta greater than 2 -- carries quite a bit more risk. So, if it got to the point where your expected return from Arcelor Mittal was 3% and you could get the same return from a risk-free treasury, you'd be not daft to sell your stock and replace it was a risk-free asset.

Similarly, when it comes to emerging markets small caps, I personally would accept anything less than a 10% expected future annual return. That's because --  between dividends and capital gains -- you should be able to approach that number with a stalwart like Philip Morris International (PM), which while certainly not risk-free, has one of the world's top 5 brands, a strong balance sheet, and oodles of cash-generating capabilities.

So why not make the trade?

Reasons not to make the trade
First, making a trade costs money. There's the transaction cost, and if you're selling a winner, the taxes. But don't let the tax tail wag the intelligent investor dog. While you should aim to minimize taxes, taxes should not be making asset allocation decisions for you. Similarly, trading costs have come down so far so fast at this point, that's not an inhibitor either.

The other reason might be that you're worried you're giving up significant -- though small probability -- upside. That's fine and a real concern since one big winner can have enormous power in terms of helping your portfolio achieve outsized gains. But if you're going to be that type of investor, you need to be willing to stomach significant volatility. And while that's fun on the upside, it can be crippling on the downside.

This doesn't mean you can't do it. Just be prepared. If you're good at valuation, though, or have someone you trust who is good at valuation, infrequent managed selling from overvalued assets to undervalued assets is one of the most powerful tools you have to improve returns and reduce volatility. But it involves being able to make a forecast and have confidence in a valuation.

Yes, those are specialized skills and they may not be correct 100% of the time, but in a volatile trading environment of any type, volatility can work to your advantage if you let it.

2 Comments – Post Your Own

#1) On June 16, 2009 at 1:24 AM, FleaBagger (28.88) wrote:

You wrote-

"Similarly, when it comes to emerging markets small caps, I personally would accept anything less than a 10% expected future annual return." [Emphasis added]

Did you mean "wouldn't accept"? That's the only way that paragraph makes sense to me.

Also, I saw in the TMF roundtable today (technically yesterday now) that you said you would be happy with a 10% annual return. Surely that's not including years when inflation is over 10%, is it? And you referenced some of the reasons that some of us expect very high inflation in the next few years when you discussed the 30-yr Treasury just a few minutes later. If, at some point, you could get a 30-yr Treasury yielding 10%, would you just go all-in and trust inflation to moderate at some point?

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#2) On June 16, 2009 at 7:32 AM, TMFMmbop (35.06) wrote:

1) Yes "wouldn't."

2) That would be 10% real return. I don't think I'd go all-in on a 10% 30-year treasury,  but I would look pretty hard at making a TIP with a 5% or 6% real yield a big part of my portfolio. That's basically a risk-free index fund, yes? 

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