General Investing Articles

Cheat Sheet / Updated 12-08-2022

The nascent world of modern decentralized finance (DeFi) has grown rapidly since the advent of Bitcoin in 2009. Read on for helpful tips on how to navigate this exciting new realm.

Article / Updated 12-02-2022

It may not be obvious to many people how disruptive and game-changing factor investing is to the long legacy of hot shot money managers that are to Wall Street what celebrities are to Hollywood. You see, by isolating and identifying key characteristics that define outperforming investments, factor investing puts you on the same elevation as the professional money manager, giving access to a selection process once attributed to managers’ exclusive stock-picking prowess. This holds out the promise of market-beating returns without having to pay high fund manager fees. The entire field of factor research has been a giant pain in the backside for overpriced money managers, even ones who have had market beating runs. In previous decades, a successful fund manager was simply assumed to be performing due to his stock-picking expertise, and many assumed almost god-like status. Bookish academics have inadvertently undermined these market legends by demonstrating that, with very few exceptions, winning stocks shared key factors in common and these factors could be used in advance to pick a winning portfolio. In fact: Currently, factor models can explain up to 95 percent of the differences between active managers, an attribute formerly ascribed mostly to manager skill. Factor investing offers the potential to achieve market beating returns without high manager fees, saving you money! Factor investing put the exclusive tools of professional money managers at your fingertips, but to work, you need to use them efficiently and with discipline. Factor-based (or smart beta) strategies are gaining popularity and market share, competing with index funds (passive returns), and traditional manager (active) returns, as shown in the figure below. Navigating the Factor Jungle More than 300 factors have been discovered in recent years, but not all pass the feasibility test. Here’s how you define a good factor: Did it outperform (make money!) in the past? Will it make money (net of costs) in the future? Why does it work? (The answer to why helps you answer whether it will make you money, and also whether the effect might be already duplicated by another factor that already contains the elements of another factor.) As factor investing gains popularity, it becomes even more important to do your own research and answer these three questions. You would think the academic spotlight now aimed at this field would make things clearer and better defined, and in many ways it is. What surprises new investors is what John Cochrane of the University of Chicago warned is becoming a zoo of factors. Factors are becoming so numerous and exotic that investors are confused by the sheer proliferation of discoveries (one hedge fund claims to use over 80 different factors in its stock pickings!) Keep your strategy simple and focus on the proven factors, and the stocks, mutual funds, and exchange-traded funds (ETFs) that incorporate them. Avoiding the Factor Zoo So why are there so many factors to choose from? There are many reasons, but most of them break down to one of the following: A newly discovered factor works because of attributes that are already integral parts of an existing factor. Or, the factor is really a phantom result of poor statistical analysis and/or outdated or incomplete historical stock price databases. Answering the three questions above helps you determine whether a factor includes the right attributes. Avoiding supercomputer factors Supercomputers crunching numbers can be both a blessing and a curse. The details are beyond the scope of this book, but if you're interested it's worth reading more of what professor Cochrane has written about this. In short, the dangers of data mining and selection bias can cause very smart people to come up with powerful factors that aren't very profitable: Data mining: The process of analyzing dense volumes of data to find patterns, discover trends, and gain insight into how that data can be used. Selection bias/survivorship bias: Caused by choosing non-random data for statistical analysis; for instance, back testing a factor's historical performance against the pool of all existing small capitalization stocks inadvertently eliminates just as many stocks that are no longer trading as they've gone bankrupt or merged. For example, the chart below shows what percentage of stocks that were trading in the past are now delisted versus what percentage are still actively trading. Clearly, any factor would have to have outperformed in the real world that included these defunct stocks and not just when run against a database of currently existing stocks. Seems obvious in retrospect, but many factor discoveries have proven to be based on incomplete or biased databases. Computers are only as good as the data you feed them. A huge number of factors that seem to work on historical data models do not pan out in the real world for various reasons. These factors are the product of powerful computers searching through enough data to find a situation where a new factor looks good by sheer accident and randomness. Of course, you want to avoid these factors because they don’t have the predictive power for the future and won’t bring you success in the future. The risk of using a factor from the factor zoo isn’t just underperformance, but also the trading and management fees it costs you to carry it out. In addition, there's the opportunity cost to you had you done something more effective with your money! Finding investable factors Literally hundreds of factors have been discovered and analyzed in recent years (see the sidebar for some examples). Many of these factors work on paper, but to be useful for you in your investment strategy, factors need to clear a much higher bar. Some factors only work in certain decades, or with a specific sector of the stock market. If a factor can’t duplicate its outperformance in other decades and over long periods of time, it's not really investable. An investable factor also needs to yield enough expected outperformance that it outearns the amounts you pay in costs, fees, and taxes: All portfolios, no matter how efficiently run, have trading and operating expenses, and all investments have a buy/ask spread, meaning that you lose a little money simply transacting a buy or sell when it's needed to follow the rules of any particular factor. Unless you’re holding your portfolio in a tax-sheltered account such as an IRA or a 401(k) (many now offer the ability to trade individual funds and stocks), there are potential tax costs for executing any strategy. You especially need to account for taxes if you’re using a high turnover factor strategy where gains are likely to be taxed at the less favorable short-term capital gains tax rate than the more favorable long-term capital gains rate. When we distill these ingredients to their essentials, some basic rules emerge. These three things make a factor attractive: Doggedness: The factor must show up through different time periods and not just one random decade or period. No one-trick ponies here. You want factors that persist for any investing period, given enough time. Prevalence: The factor must demonstrate an advantage with various different countries and market sectors. Investability (actionable): The factor must be able to be deployed cost effectively (costs include trading fees, taxes, and potentially time/research efficiency for more esoteric factors). Factor outperformance is cyclical, yet hard to time. One factor is always leading the pack and your odds of guessing which one is negligible. Morningstar, a leading investment analytics company, has studied factor investing extensively and concluded that factor investing offers the promise of: Improved absolute returns (more gains!) Improved risk-adjusted returns (gains with less risk and a smoother ride than other approaches!) Extended periods of outperformance followed by droughts (long periods of underperformance relative to whatever cap-weighted index you’re trying to beat) When using factors, you must stick with your strategy to earn the rewards! There will be times when you feel like bailing! It’s best to wait for the historical outperformance of solid factors to materialize. Any attempt to time a factor approach requires skill and probably adds additional headwinds of trading costs and tax inefficiency (unless you're doing it in an IRA or tax-favored account). Even the best factors experience periods when they underperform the market, and these are hard to predict. You need patience to let a factor work for you. You need to stay in it to win it! The key is, of course, to diversify factors in your portfolio.

Article / Updated 12-02-2022

Factor investing can help you build a portfolio designed for your unique risk tolerance, investment time horizon, and financial goals using characteristics that history shows lead to consistent outperformance. An investment time period is the timeframe you expect to hold an investment, usually short (less than five years), intermediate (five to ten years), or long term (more than 10 years). Factor investing provides a building block that gives you the best odds of reaching retirement and income goals successfully. It helps improve portfolio results and reduces volatility. Factor investing, done right, enhances diversification in a way that lowers risk without sacrificing returns, by placing your investment eggs in many baskets to help ensure positive results! Following a systematic approach In a nutshell, factor investing is about defining and following a set of proven guard rails that keep your portfolio on track. Using a factor strategy not only gives you better returns, but delivers them more consistently while also protecting you from the dangerous pitfalls and mistakes that get other investors in trouble. Leveraging the power of a persistent strategy Investors worldwide have always sought the secrets that would help them invest right alongside legendary investors like John Templeton, Warren Buffett, Jesse Livermore, Benjamin Graham, and John “Jack” Bogle. Investing systems and rules have come and gone over the years, because it turns out many of them worked only in specific markets and just for a few years. These strategies picked up on short-lived trends and rules in stocks that were true only for a limited time due to certain conditions unlikely to repeat. When you’re investing based on factors, you’re interested in a persistent strategy — one that can deliver results in the future. By figuring out the themes, characteristics, and properties common to winning investment, or factors, you can discover a set of rules to create higher-performing portfolios. But how do you even try to comb through the mountains of market data over the last 100-plus years to find what works? Well, it turns out that you’re in luck! In the last few years, financial academics have been hard at work doing just that — distilling these factors into useful sets of rules that you can put to work in your portfolios today. Though nothing works 100 percent of the time, especially over shorter periods, factors are most effective when combined with other factors in a master strategy. This has the effect of loading the dice in your favor. Saving time with factor investing Time is money, the old saying goes, and investors since the ancient Chinese rice traders have always looked for ways to save time by streamlining and systematizing their trading and investing decision processes. We all have busy lives, jobs to get to, kids to take to after school sports, and a million other things. A factor investing strategy can help improve your life by helping you make best use of your time and energy. James used factor investing to save time during the COVID-19 market bottom in March of 2020. He needed an approach that identified resilient stocks and funds most likely to benefit from a market rebound, while also giving clients confidence in the historical reliability of these stocks to survive and thrive the unprecedented economic and market downturn everyone was experiencing as the world rapidly went into social distancing, quarantines, and government-mandated shutdowns. He came up with a multifactor portfolio for new clients using the same principles in this book that was both sophisticated and easy to understand. This strategy gave them the confidence to enter the depressed stock market and stay on board for what turned out to be a profitable 18 months for investing, with many portfolios doubling in value. Using modern advances As investors, you always want to look for ways to take advantage of advances and breakthroughs in the investment field. Two trends that have come together to move investing forward have been computers and history; specifically, better methods of market data analysis and greatly expanded historical datasets to feed those computers. Modern computers and new ways of crunching market data are at the forefront of the growing interest and advances in factor investing. Just as important is the expanding dataset as researchers and archivists have combed through old ticker tapes, micro-fiche and ledgers to complete the historical dataset of stock prices and company data; in some cases, right back to the Buttonwood Agreement that pre-dated Wall Street. What is the Buttonwood Agreement? It’s a single-page document that started the New York Stock Exchange 230 years ago on May 17, 1792, when 24 merchants and brokers met under a buttonwood tree and put their signatures to a set of rules and safeguards for trading. The meeting was necessary to re-establish public confidence in markets after the infamous Financial Panic of 1792 that had caused mayhem earlier that spring. Investing options were limited back then. The only stock available was in the Bank of New York, The First Bank of the United States, some insurance companies, and Revolutionary War Bonds issued by Alexander Hamilton to help pay off the War of Independence from British rule. Today, you can also take advantage of databases, services, and perhaps even pre-packaged investment products such as funds and ETFs that attempt to apply factor methodology in a practical way to select investments based on current stock and bond metrics. Luckily, technology has made factor investing far easier and more cost effective than ever, as we detail in later chapters. This enhanced dataset provides a richer and more complete testing ground to ferret out meaningful factors and to test existing assumptions more fully. This is an advance that you can benefit from! Following proven guidelines that work Even a broken clock is right twice a day, and, like a coin toss, any system can come up with a winner or two from time to time. As an extreme example, a rules-based system (factor) that consisted of “sell all U.S. stocks and buy bonds” may have worked very well as a factor from September 1929 until July 1932, but this was only due to the stock market crash that kicked off the Great Depression. Using this factor after 1932 would have been a recipe for disaster and decades of underperformance! The point here is that you’re looking for guidelines that provide a more universal advantage, and are not dependent on a specific set of historical circumstances. The best factors you’re interested in work in many different markets, countries, and decades. They aren't just one-trick ponies that have shown results once or twice in history, perhaps by chance or due to unique circumstances. You want rules that operate more broadly and dependably. Following a disciplined core strategy The most successful investors have a disciplined strategy driving their success. Incorporating factors into your investing adds not just a methodology for investment selection but also discipline to portfolio activity as it helps you determine what to buy, sell, or hold, and gives you the confidence needed to participate in the long term. Protecting against emotional investing The emerging field of behavioral finance says that regardless of how you design your portfolio, the major reason for your success or failure is your emotion-driven actions. In other words, if you want to be successful at investing, you have to protect against emotional investing, which results in buying high and selling low, repeatedly. The long-running DALBAR study, which has been updated annually since the inception of the 401(k) over four decades ago, proves that this problem is widespread and damaging to wealth building. Investors lack discipline (of course it's not you, just other investors). What is DALBAR? Located in Boston, DALBAR is one of the nation's leading independent research firms committed to raising the standards of excellence in the financial services industry. It compiles and analyzes mountains of data on mutual funds, life insurance, and banking products and practices. It has also been behind the nation's leading study on investor behavior for the past 28 years. One of its most followed publications is the annual Quantitative Analysis of Investor Behavior (QUIB) Report, which measures how investors have performed with their actual investment portfolios versus how the funds they hold have performed during the same periods. You might think that investor performance and fund performance are the same thing, but DALBAR consistently demonstrates a devastating investor performance gap due to investors shifting money among their investments (for example, from stock into more conservative bonds or cashing out at exactly the wrong times). Compounded over the years, this performance gap is devastating, costing many investors literally hundreds of thousands — or even more — in retirement dollars they could have enjoyed. For example, its 2021 study shows that this performance gap jumped to a shocking 1032 basis points for 2021. 100 basis points equals one percent, so this represents a lag of 10 percent for investors versus the performance of the average fund they were investing in. Obviously, despite the recovery from the 2020 COVID-19 market lows, many investors bailed (perhaps believing the recovery was too good to be true) and then got back in at higher prices in the fall, only to experience a downtrend and realize they had once again bought high without benefiting from the previous gains. In short, DALBAR's extensive research shows that investors are their own worst enemies. The results, as shown in the chart below, are sobering and hard to dismiss as the researchers used real-time data from millions of investor-directed 401(k) accounts. DALBAR has concluded that as much as two-thirds of the market return investors should have enjoyed were squandered to emotional investing — selling into fear after downturns, and buying into euphoria after upturns. The problem, of course, is that investors end up bailing near the bottom, when they've had enough pain, and buying again near the top of the market cycle, when they can't stand to miss out anymore. These mistakes get compounded over the years, and become even more damaging. The results are similar in every annual update of the DALBAR study. In short, it turns out that most investors are doing exactly the opposite of what they need to do to build wealth. They are buying high and selling low. A factor-based approach helps you avoid becoming an emotional investor. A portfolio strategy based on factors (ideally a diversified combination of multiple factors) can provide discipline, and powerful protection against emotional investing by offering a portfolio with which an investor can feel confident riding through inevitable downturns on the way to new highs. Only historically persistent factors can provide this sort of assurance, enabling investors to achieve their financial goals and helping to make sure their emotions don't cause them to outlive their assets.

Article / Updated 12-02-2022

Factor investing is an investment portfolio general strategy that favors a systematic approach using factors or “shared characteristics” of individual stocks (and other assets, such as bonds) that have a historical record of superior risk and return performance. These factors can range from individual characteristics, such as the company’s sales (revenue indicated on the company’s income statement) or debt (total liabilities indicated on their balance sheet), to their performance in macro environments, such as inflation or economic growth. A factor is a trait or characteristic that can explain the performance of a given group of stocks during various market conditions. There are two main categories of factors: style factors and macroeconomic factors. Style factors Style factors take into account characteristics of the individual asset, such as its market size, value and industry/sector, volatility, and growth versus value stocks. Style factors help to explain or identify characteristics that drive that asset’s price performance in the marketplace. These factors are also referred to as microeconomic because they are an individual security or asset that drives its performance as a singular member or participant of the overall market and economy. Style factors include value, size, quality, dividend, growth, volatility, and momentum. We'll go over a few of these here: Value factors Looking at value means typically looking at the company’s fundamentals. The fundamentals are the most important financial data of the company, like the company’s sales and net profits, balance sheet (assets and liabilities), and important ratios, like the price-earnings (P/E) ratio. Looking at public companies (as through their common stock) through the lens of value factors is one of the most important factors because value investing has survived and thrived ever since they were initially codified by the work of Benjamin Graham during the Great Depression years. One of the most important reasons to embrace value as a primary factor (especially for beginning investors) is the emphasis on stocks that are undervalued, which makes them safer than other stocks. Undervalued means that all the key fundamental financial aspects of the company (like book value or the price-earnings ratio) generally indicate that the price of the stock is not overpriced, meaning that you will not pay an excessive stock price versus the value of the underlying company and its intrinsic worth. The reason becomes obvious in market data; overpriced stocks are more apt to decline more sharply in a correction or bear market versus reasonably priced stocks. The bottom line is the fundamentals of a stock mean a safer bet and a better chance at long-term price appreciation. Size factor The size of the asset, in this case, public company, is a reference to its market size based on market cap or capitalization (total number of shares outstanding times the price per share). The most common cap sizes used are small cap and large cap. If you’re seeking growth, lean toward the small-cap factor. Large-cap assets may be safer but typically don’t exhibit the same growth or price appreciation relative to the small-cap stocks. The historical data generally bears this out. Growth factor The growth factor highlights the measure of change in sales and earnings by the company in relation to its group (like in individual industries or sectors). Is the stock growing better than its peers? If so, this factor should be considered. As the historical market data suggests, companies with growing sales and revenue show stronger relative stock price appreciation, since investors notice the growth and buy up the stock. Volatility factor Market research over an extended period of time suggests that low-volatility stocks tend to earn a better return over the long term compared to high-volatility stocks. Given that, this factor will be beneficial. A useful indicator to look at is beta, which is listed at many popular financial websites for a given stock. The beta indicates how much more (or less) a given stock is volatile versus the general market (based on recent market trading data). For beta, the stock market itself is assigned a value of 1. A stock with a beta that is less than 1 is less volatile than the general stock market, while a stock with a beta greater than 1 is more volatile than the general stock market. A stock with a beta of 1.2, for example, is considered 20 percent more volatile than the general stock market. A stock with a beta of, say, .9 is 10 percent less volatile than the general stock market. A good example of a stock that has low volatility would be a large-cap public utilities company. A good example of a high-volatility stock would be a small-cap technology firm. If you’re a retiree, you would most likely benefit from this factor to ensure getting low-volatility stocks. Macroeconomic factors You could compare stocks and the stock market/economy to fish in a pond. You can analyze the fish and choose great fish (using, for example, style/microeconomic factors). But you should also analyze the pond (macroeconomic factors). You could choose the greatest fish in the pond, but what if the pond is polluted? Then even the great fish will underperform (putting it mildly). Shrewd investors will find a different pond. For investors, the U.S. economy and stock market represent the “biggest pond” on the global financial scene. So if you’re going to participate, you should understand the good, the bad, and ugly of this marketplace. Economic growth factor Gross domestic product (GDP) is one of the most watched economic indicators by investors and non-investors alike. It’s a broad measure of the economic output (value of products and services) in a given timeframe (typically a calendar quarter or year) by a nation’s economy. When GDP is growing, companies (and their stocks) are doing well. In fact, when the economy is growing and doing well, the stock market tends to outperform other markets (such as the bond market). Factors tied to economy growth such as GDP offer profitable guidance for investors. Given that, the major investing sites regularly report this and related economic data so that this factor helps investors optimize the returns in their portfolio. Inflation factor Inflation is a key factor. Most folks look at price inflation (the rising price of consumer goods and services). However, price inflation is not a problem. It’s a symptom. Many people don’t understand the cause of inflation (including many government officials and economic policy makers unfortunately). The cause is monetary inflation (the overproduction of a nation’s currency supply) that precedes the price inflation. When too much money is created and when that supply of money is chasing a finite basket of goods and services, then the price of these goods and services will rise. The goods and services didn’t become more valuable the currency lost value (due to overproduction). A complicating factor is the supply shortage issues during late 2021 to 2022 that augurs in cost-push inflation. When shortages occur (supply issues) and consumers contain to purchase the products in question (demand), the price inflation is further exacerbated. In early 2021, when the federal government and the Federal Reserve were increasing the money supply (by spending trillions of dollars), this was the cue for alert investors to consider the inflation factor. This factor would have guided portfolio managers toward securities that would have outperformed in an unfolding inflationary environment. Interest rates factor In early 2022, the Federal Reserve (America’s central bank) is (and likely will be) raising interest rates. Interest rates are essentially the price of borrowed money, and a factor on interest rates is key to making more optimal choices in your portfolio. In general (and all things being equal), low interest rates are good for the economy while high (or rising) interest rates tend to be negative. Because so much economic activity (both business and consumer activity) is tied to credit (business loans, credit cards, home mortgages, and so on), rising interest rates tend to dampen or diminish economic activity while low or decreasing rates tend to do the opposite. Given that, factors tied to interest rates can help you avoid stocks (and bonds) that would be harmed by rising interest rates so that your portfolio can continue to perform satisfactorily.

Cheat Sheet / Updated 11-10-2022

Factor investing helps maximize your odds of being a successful investor in many ways, including helping you control and avoid self-defeating investor behaviors. Understanding the behavioral finance aspect of factor investing, as well as how great investors have dealt with it in the past, can make you an even better investor.

Cheat Sheet / Updated 10-21-2022

Are you surprised that it's so hard to consistently earn money on the stock exchange? The explanation is as simple as it is sobering: It's because we are all human beings, with all the associated genetic dispositions that come with that fact. The neural structure of the human brain is the result of our evolutionary development. Your thought and behavior patterns, such as the deep-seated fight-or-flight response, continue to influence your decisions today on the financial markets. Your nature is not particularly well-suited to trading, but you can learn to do it. The human brain is capable of change and development. You can learn the mental prerequisites for brain-compatible trading. With the right mindset, you can recognize and avoid errors before they occur. The innovative discoveries of modern neurofinance research will lead the way to success factors for brain-compatible and, therefore, successful trading.

Article / Updated 09-15-2022

Investing appears to be complicated and complex. But if you can take some relatively simple concepts to heart and adhere to them, you can greatly increase your success. Here are ten time-tested principles of investing success. Following these principles can pay you big dividends (and capital gains) for many years to come. Regularly save and invest 5 percent to 10 percent of your income: Do this as soon as you begin earning money on a regular basis. Preferably, invest through a retirement savings account to reduce your taxes and ensure your future financial independence. Understand and use your employee benefits: Often, the most valuable benefit you have through your employer is a retirement savings plan, such as a 401(k) plan that enables you to make contributions and save on your current income taxation. Thoroughly research before you invest: Be sure you understand what you're investing in. Don't purchase any financial product that you don't understand. Ask questions until you understand the risks and returns of the product. Shun investments with high commissions and expenses: The cost of the investments that you buy is an important variable you can control. All fees must be disclosed in a prospectus, which you should always review before making any investment. Invest the majority of your long-term money in ownership investments: With your long-term money, focus on investments that have appreciation potential, such as stocks, real estate, and your own business. When you invest in bonds or bank accounts, you earn a return that probably won't keep you ahead of inflation and taxes. Avoid making emotionally based financial decisions: Successful investors keep their composure when the going gets tough. You need the ability and wisdom to look beyond the current environment, understanding that it will change in the months and years ahead. Be especially careful about making important financial decisions after a major life change, such as marriage, the birth of a child, a divorce, job loss, or a death in your family. Make investing decisions based on your plans and needs: Your investment decisions should come out of your planning and your overall needs, goals, and desires. This requires looking at your overall financial situation first and then coming up with a comprehensive plan. Tap information sources with high quality standards: You need to pare down the sources you use to keep up with investing news and the financial markets. Give priority to those that aren't afraid to take a stand and recommend what's in your best interests. Trust yourself first: Look in the mirror. You'll see the best financial person that you can hire and trust. What may be missing is enough education and confidence to make more decisions. If you need help making a major decision, hire conflict-free advisors who charge a fee for their time. Work in partnership with advisors. Never turn over control. Invest in yourself and others: Don't get so wrapped up in making, saving, and investing money that you lose sight of what matters most to you. Invest in your education, your health, and your relationships with family members and friends.

Article / Updated 08-02-2022

Over the years, day traders have developed many different ways to manage their money. Some of these are rooted in superstition, but most are based on different statistical probability theories. The underlying idea is that you should never place all of your money in a single trade, but rather put in an amount that is appropriate given the level of volatility. Otherwise, you risk losing everything too soon. Calculating position size under many of these formulas is tricky stuff. That’s why brokerage firms and trading software packages often include money management calculators. Optimal F is only one method. There are other methods out there, and none is suitable to all markets all the time. Folks trading both options and stocks may want to use one system for option trades and another for stock trades. If that’s your situation, you have one big money management decision to make before you begin: how much money to allocate to each market. Optimal F The Optimal F system of money management was devised by Ralph Vince, and he’s written several books about this and other money management issues. The idea is that you determine the ideal fraction of your money to allocate per trade based on past performance. If your Optimal F is 18 percent, then each trade should be 18 percent of your account — no more, no less. The system is similar to the fixed fraction and fixed ratio methods, but with a few differences. The following figure shows the equation for finding the number of shares of stock, N, to trade according to the Optimal F method. F is a factor based on the basis of historical data, and the risk is the biggest percentage loss that you experienced in the past. Using these numbers and the current price, you can find the contracts or shares you need to buy. If your account has $25,000, your biggest loss was 40 percent, your F is determined to be 30 percent, and you’re looking at a stock trading at $25 per share, then you should buy 750 shares: The Optimal F number itself is a mean based on historical trade results. The risk number is also based on past returns, and that’s one problem with this method: it only kicks in after you have some trade data. A second problem is that you need to set up a spreadsheet to calculate it (so read Ralph Vince’s book if you want to try it out). Some traders only use Optimal F in certain market conditions, in part because the history changes each time a trade is made, and that history doesn’t always lead to usable numbers.

Article / Updated 08-02-2022

The Kelly Criterion is a method of management that helps you calculate how much money you might risk on a trade, given the level of volatility in the market. It emerged from statistical work done by John Kelly at Bell Laboratories in the 1950s. The goal was to figure out the best ways to manage signal-noise issues in long-distance telephone communications. Very quickly, the mathematicians who worked on it saw that there were applications to gambling, and in no time, the formula took off. Using the Kelly Criterion for trading is only one method. There are other methods out there, and none is suitable to all markets all the time. Folks trading both options and stocks may want to use one system for option trades and another for stock trades. To calculate the ideal percentage of your portfolio to put at risk, you need to know what percentage of your trades are expected to win as well as the return from a winning trade and the ratio performance of winning trades to losing trades. The shorthand that many traders use for the Kelly Criterion is edge divided by odds, and in practice, the formula looks like this: Kelly % = W – [(1 – W) / R] W is the percentage of winning trades, and R is the ratio of the average gain of the winning trades relative to the average loss of the losing trades. For example, assume you have a system that loses 40% of the time with a loss of 1% and that wins 60 % of the time with a gain of 1.5%. Plugging that into the Kelly formula, the right percentage to trade is .60 – [(1 – .60)/(.015/.01)], or 33.3 percent. As long as you limit your trades to no more than 33% of your capital, you should never run out of money. The problem, of course, is that if you have a long string of losses, you could find yourself with too little money to execute a trade. Many traders use a “half-Kelly” strategy, limiting each trade to half the amount indicated by the Kelly Criterion, as a way to keep the trading account from shrinking too quickly. They are especially likely to do this if the Kelly Criterion generates a number greater than about 20 percent, as in this example.

Article / Updated 07-19-2022

Among the mass market website tools and booklets focused on retirement planning, you should try T. Rowe Price’s Retirement Income Calculator. It walks you through the calculations needed to figure how much you should be saving to reach your retirement goal. The assumptions that you plug into this calculator are really important, so here’s a review of the key ones: Asset allocation: Enter your current allocation and then select an allocation for after you’re retired. For the retirement allocation, you can choose a fixed combination of 40 percent stock, 40 percent bond, and 20 percent money market fund. The calculator doesn’t include real estate as a possible asset. If you own real estate as an investment, you should treat those assets as a stock-like investment because they have similar long-term risk and return characteristics. (Calculate your equity in investment real estate, which is the difference between a property’s current market value and mortgage debt on that property.) Age of retirement: Plug in your preferred age of retirement, within reason, of course. There’s no point plugging in a dream number like “I’d like to retire by age 45, but I know the only way I can do that is to win the lottery!” Depending on how the analysis works out, you can always go back and plug in a different age. Sometimes folks are pleasantly surprised that their combined accumulated resources provide them with a decent enough standard of living that they can consider retiring sooner than they thought. Include Social Security?: T. Rowe’s calculator asks if you want to include expected Social Security benefits. We’d rather that they didn’t pose this question at all, because you definitely should include your Social Security benefits in the calculations. Don’t buy into the nonsense that the Social Security program will vaporize and you’ll get little to nothing from it. For the vast majority of people, Social Security benefits are an important component of their retirement income, so do include it. Based upon your current income, T. Rowe’s program will automatically plug in your estimated benefits. So long as your income hasn’t changed or won’t change dramatically, using the calculator’s estimated number should be fine. Alternatively, you can visit the Social Security website to get your latest estimate. Rowe’s analysis allows to you make adjustments such as your desired age of retirement, rate of savings, and to what age you’d like your savings to last. So, for example, if the analysis shows that you have much more than enough to retire by age 65, try plugging in, say, age 62, and voilà, the calculator quickly shows you how the numbers change.