Before I start my piece for the evening, I want to explain why my AIG piece is slow in coming. Short answer: It’s big, and I am still writing it. There is a lot there, and I am trying to get it right, realizing that I am just a generalist dealing with complex issues and not enough data. I hope to have the piece finished on Wednesday for Finacorp clients, and out be the end of the week here.
What I am going to talk about here is annoying to some who always feel that investing is about taking bold actions. I had one boss that would go nuts when I would talk about this strategy. Other friends, akin to deep value investors, would get perturbed as well.
I used this strategy extensively when trading corporate bonds 2001-2003. I was a fairly active trader, unlike what I do with equities today. Yet, even with equities, my rebalancing trades which have aided me in this volatile market, mimic some of the benefits of this strategy. Here are some examples:
1) Say you bought a stock and it rapidly rallies, yet not to the point where you think it is at fair value. Perhaps recent events have made you re-estimate fair value upward. What to do? Sell half of the position, and wait. If the price falls, buy back the position. If it rallies further, sell the rest.
2) Say you want to buy a stock, but it is plunging like a stone. You’ve done our homework — the balance sheet is strong enough to self-finance the company for three years, estimated earnings for the next indicate the company is cheap, what to do? Buy half of a full position, and wait. If the companies rallies sharply, sell the position. If it continues to fall, wait until it stabilizes, confirm your fundamental research and buy up to a full position.
3) Say you like a stock, but it has rallied past your buy point. What to do? Buy half. If the stock comes back to the buy point, buy a full position. If it rallies further, sell the position.
4) Same as number 3, but reversed for shorting.
I would almost always scale in and out of positions as an institutional investor, rather than doing it all at once. I credit Jim Cramer for teaching me this. The real Jim Cramer is not the “lightning round, ” but the guy who scales in and scales out. The lightning round is binary — buy/sell. The real world is more nuanced — how much to buy and when?
But the real benefit of doing half is the psychology of the situation. Many investors suffer from fear, greed, and regret. Doing half short-circuits those responses. When the stock price moves in favor of profits, be glad of those profits. When the stock price moves against profits, reanalyze and either a) go flat, recognizing your mistake, and being grateful that it was small, or b) increase the bet to a full position, and be grateful that you didn’t put a full position on initially.
Scaling in and scaling out gives freedom to investors, and removing many of the psychological burdens that they bear. It doesn’t mean there won’t be losses. There will always be losses but they will be easier to bear, with no panic that leads to selling off at the lows, or buying at the highs.