The Most Important Number for Any Investment

BY KEITH KAPLAN CEO, TRADESMITH

I used to be a great stock picker… and a terrible investor.

That’s not a contradiction or an oxymoron. In fact, it’s something I’m sure you’ve experienced whether you realize it or not.

Ask yourself this: How many times have you bought a stock, rode it higher, then sold it… only to look at the price a year later and find out you missed out on so much more?

I’ll bet you have. It’s not a good feeling. It used to happen to me often… until I developed a unique tool to ensure it never would again.

More on that in just a bit. First, though, listen to this…

In October 2016, I bought Advanced Micro Devices (AMD) . Here’s what it did over the next four years:

This chart makes me look like a genius. AMD gained more than 1,000% in the four years after I bought into the stock.

But I’m not a genius. Because I sold the stock a couple of weeks later and never saw those gains.

Why would I do that? Quite simply… I trusted my gut. The same gut that I trust to tell me right and wrong and who to be friends with. You know… the emotional part of each of us that influences our decisions.

AMD fell a little bit after my buy, I got nervous… and I sold. I left 1,000% gains on the table because I didn’t know how insignificant a 3.5% loss was for a stock like AMD.

Great stock picking… but terrible investing.

So that’s the problem. But how do we fix it?

Quite simply, we need to cut our emotions out of the picture. And that means building a regimented process for understanding exactly when to buy any stock, how much to buy, and when to sell it.

I have a background in mathematics and computer science. So when I realized I could apply this knowledge to investing, it was my eureka moment.

I systematized buying, holding, and selling with the formula below:

That formula makes up our Volatility Quotient – our algorithmic number that tells you how much volatility we should expect and consider “normal” for each individual stock.

But before I show you how to use VQ, it’s important to understand what inspired it.

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Fixing Investors’ Logical Fallacies

You may have heard about Richard Thaler and Daniel Kahneman. These guys are heroes when it comes to their studies around investor psychology that led to winning the Nobel Prize.

Their first finding was that investors tend to commit certain logical fallacies depending on how they’re performing. When investors lose, they’re actually inclined to take on more risk instead of doing what they should: mitigating it.

I bet you’ve had this happen plenty of times. When a stock you own is falling, you say to yourself:

• “I’m going to buy more on the dip.”
• “This stock will come back, and my break-even price will be lower.”
• “It’s not a REAL loss until I sell.”

When you think this way, all you’re doing is adding more risk to your position. How do I know?

Momentum is the single most important factor in investing. MSCI has studied this factor and labeled it one of the most important in figuring out if a stock will rise or fall.

When a stock has a confirmed uptrend, it’s more likely to rise in the short term. When a stock has a confirmed downtrend, it’s more likely to fall in the short term.

And by buying more of a stock as it’s falling, or by waiting for that stock to turn around, you are taking on risk and even increasing it. Worst case, you’re setting yourself up to lose more money. Best case, you’re missing out on other opportunities that could be winners.

It’s a logical fallacy that every investor succumbs to – even experienced ones.

So how do you combat it?

Hard as it is, you should do the opposite of what your gut tells you in this situation. You should cut your losses when a stock is in a confirmed downtrend. Stop the bleeding and move on.

But what Thaler and Kahneman found about winning is even more important to understand.

When investors see a stock they hold is rising, they get excited. So what do we do?

We sell the stock to “lock in our gains.” The temptation to see our good decision turn into profit is too great.

But that’s the exact opposite of what we should do.

In this scenario, we’re lowering our risk when our winning trade is putting us in a statistically better position to take on more.

That leads me to TradeSmith’s discovery of the single most important number in investing AND why it works.

How the Volatility Quotient Keeps You in Winners

The formula I showed you above is for “VQ,” which stands for Volatility Quotient.

That’s the proprietary measure of an individual stock’s volatility that we developed at TradeSmith.

It measures historical and recent volatility – or risk – in stocks, funds, or cryptocurrencies. And that measurement is focused on the moves these assets make.

It tells you:

• When to buy.
• How much to buy.
• When to sell.
• And how much movement you should expect from each asset.

To show you an example, here are the VQs of some popular stocks:

The VQ numbers show you that different stocks have different volatility patterns. The higher the number, the more volatile the stock.

You can use these numbers to determine a price when you should sell before losses get more out of hand… or lock in gains before they evaporate.

Now, let me leave you with a single nugget that may change your investing life forever.

Those two Nobel Prize-winning economists were essentially saying something simple we’ve all heard before: The trend is your friend.

If the confirmed trend is up, stay in your stock. Ride the winner!

If the confirmed trend is down, cut your losses.

The best way to get the most out of a winner and cut the loser (and watch out for winners becoming losers) is to deploy a trailing stop. A trailing stop acts as a point at which you sell a stock (or any other fund, crypto, etc.) that rises along with the stock price, but doesn’t fall any lower from the initial value.

And here’s where VQ comes in as the most important number for any investment…

How the VQ Limits Losses

When most people set a trailing stop, they pick a “generic” number like 25%.

If you buy a stock at $100 and it goes down over time by 25% and never makes a new high since you purchased it, you sell at $75.

And if that stock rises to $200 and never falls 25% from a high, you’re still in that position, and your stop-loss point rises to $150.

With this strategy, you automatically ride your winners and cut your losers.

But you must understand that no two investments are the same. That’s why you should use the VQ number, instead of a generic number, for each stock you buy to determine exactly what the right stop loss would be.

Looking at the table I posted above with popular VQs, that means your trailing stop loss for Microsoft (MSFT) would be about 22%. But for Super Micro Computer (SMCI), your trailing stop loss would be closer to 63%.

Super Micro Computer moves around nearly three times as much as Microsoft. Now you know that if you were to buy Super Micro, you would have to suffer through a lot of thrashing, but it may be worth it.

And we can really see the difference between an ordinary trailing stop loss and a VQ trailing stop loss.

On my AMD trade, had I followed the standard 25% trailing stop, I would have made nearly 50% instead of losing 3.5%.

BUT, had I used a VQ-based trailing stop, well, I could have followed the signals and made more than 20 times that.

At the time, AMD had a VQ of about 40%, much like it does now. Following that, I would set a trailing stop at that level and not touch AMD unless it closed 40% lower than my buy price. And you can see the results:

Using a VQ trailing stop, in the case of AMD, would have been the difference between a 48% gain and a 1,297% gain.

As you can see, the VQ is an important number to factor into any investment.

It sets expectations, cuts out emotions, and gives you a rock-solid framework for making better decisions.

TradeSmith strives to do this with every piece of software we release and newsletter we publish. It’s our guiding light to serving you… and your guiding light whether the markets are ripping higher, tanking lower, or treading water.

All the best,

Keith Kaplan
CEO, TradeSmith