When to Take a Loss

Comedian and newspaper columnist Will Rogers had the stock market figured out a century ago: “If it don’t go up, don’t buy it.”

Alas, not every stock is a winner. Some are going to bomb on you, and knowing when to take a loss on stocks is a critically important part of investing.

Take a look at the chart below. As you can see, gains and losses are not equal. After taking a loss on stocks, you have to gain back more in percentage terms in order to break even.

Portfolio LossGain Required to Break Even

If you lose 10% to 20% in a trade, it’s not that hard to recover. It only takes 11% to 25% to get back to where you started.

But if you lose 50%, you need 100% returns to get back to break even. Or if you lose 97% — as you easily could in a risky trade gone wrong — you’d need a ridiculous 3,233% on your next trade just to get back to zero.

I like to think I’m a decent investor. But I don’t have a lot of 3,233% trades swirling around in my head.

Knowing When to Take a Loss on Stocks

OK, we’ve established why knowing when to take a loss on stocks is important. You don’t want to dig yourself into a hole you can’t reasonably trade your way out of.

But how, exactly, do you do it? Let’s go over two ways.

Position Sizing

Probably the single most important tool in keeping your losses under control is position sizing. I could write for days about the “correct” way to size a position and never fully cover the topic.

But I can summarize it here in a few words: The riskier the position, the smaller it should be. The safer the position, the larger it should be.

It really is that simple.

Let’s say you put 1% of your net worth into a risky options play. If it blows up in your face, it’s not going to wreck your finances. But if you put half your net worth into it and it blows up… you just permanently reduced your net worth.

So always be smart about position sizing, and never overweight your position on a risky bet.

Stop Loss Orders

A stop loss is a rule to automatically sell if a stock you own drops below a certain point. For example, you could have a stop loss in Apple Inc. (Nasdaq: AAPL) at $350. If the stock price falls below that price, you walk away. You don’t hold out and hope for a recovery.

Brokerage apps like Robinhood let you put a stop loss sell order on all of your stocks. That way you don’t have to watch them closely if you don’t want to, or if you go on vacation or something.

Stop losses are controversial. As a general rule, I’m a fan because they prevent small losses from snowballing into larger ones.

Of course, the downside is that you won’t get to participate in any recovery. Let’s say Apple drops to $350 before immediately turning around and soaring to $400. Well, you just missed all that upside.

The decision to use a stop loss goes hand in hand with position sizing and knowing when to take a loss on stocks. If you keep your position sizes small, a stop loss is far less important. A small position isn’t going to blow up your portfolio if it goes south.

But in a larger position, a stop loss is a great idea. If a stock or fund makes up a large portion of your portfolio, you need to make sure you don’t take losses that you will never recover from.

There is a science to setting the perfect stop loss, and I’ll get into that more in a later piece. But as a general rule, you should set your stops at points that are just below a “normal” trading range for that particular stock.

That’s the essence of knowing when and how best to take a loss on stocks. You should look to sell when something has fundamentally changed and get out before it’s too late.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital Management, a registered investment adviser based in Dallas, Texas.

How Diversification Works

I’m going to let you in on a little secret. For the first time in my investing career, I’m aggressively adding gold to my portfolio.

I’m not betting the farm on it, and I still have most of my cash in stock and options trading strategies. But in today’s macro climate, I think it only makes sense to add the yellow metal to the mix.

This brings up one of the most misunderstood concepts in investing: diversification. Today, we’re going to discuss how diversification works.

How Diversification Works

You understand the timeless wisdom of not putting all of your eggs in one basket. And that’s certainly a big part of how diversification works. But it’s more than that.

It comes down to correlation, or the degree to which two stocks or strategies move together. A correlation of one means the two move together in lockstep. A correlation of zero means they don’t move together at all.

And a correlation below zero means they actually move in opposite directions — when one goes up, the other goes down.

If you’re diversifying the right way, you’re looking for correlations as close to 0 as possible. But anything less than one is helpful.

And here’s why.

When you invest in multiple strategies that aren’t tightly correlated with each other, your risk and returns are not the average risk and return of the individual strategies. The sum is actually greater than the parts. You get more return for a given level of risk, or less risk for a given level of return.

Take a look at the graph below.

how diversification works

This is a hypothetical scenario, so don’t focus on the precise numbers. I literally just made them up. But know that it does work like this in the real world.

Strategy A is a low-risk, low-return strategy. Strategy B is higher return, higher risk.

In a world where strategies A and B are perfectly correlated (they move up and down together), any combination of the two would be a simple average.

If A returned 2% with 8% volatility and B returned 11% with 16% volatility, a portfolio invested 50/50 between the two would have returns of 6.5% with 12% volatility.

That is what you see with the straight line connecting A and B. Any combination of the two portfolios would fall along that line (assuming perfect correlation).

But if they are not perfectly correlated (they move at least somewhat independently), you get a curve. And the less correlation, the further the curve gets pushed out, meaning more return for a given level of risk.

The dot on the curve shows an expected return of about 8% and risk (or volatility) of 10%. On the straight line, that 8% curve would have volatility of about 14%, not 10%. And accepting 10% volatility would only get you a return of about 4% on the straight line.

This is why you diversify among strategies. Running multiple good strategies at the same time lowers your overall risk, and boosts your returns. The key is finding good strategies that are independent.

Running the same basic strategy five slightly different ways isn’t how real diversification works, and neither is owning five different index funds in your 401(k). Diversification is useless if all of your assets end up rising and falling together.

Active trading strategies can also offer the same benefits. You don’t have to dump your index funds and embrace active trading.

But incorporating a little active trading into the mix can actually lower your overall risk… so long as your trading doesn’t move in lockstep with the market!

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital Management, a registered investment adviser based in Dallas, Texas.

What To Do When Your Employer Cuts Your 401k Matching

The following first appeared on Money & Markets.

It’s rough out there. With much of America still closed due to the COVID-19 pandemic, the unemployment rate is the highest it’s been since the Great Depression. But even many Americans that still have jobs are seeing pay and benefit cuts.

401k matching is often one of the first things on the chopping block, and the 401k matching rules are clear. Unless the matching is part of a union contract, companies have the right to slash or eliminate matching, even mid year. This applies to both traditional 01k plans and the safe harbor 401k plans more popular with small businesses.

Reducing or eliminating the employer matching isn’t particularly popular, but it’s a lot less potentially unpopular than mass firings or pay cuts.

What Are the 401k Matching Rules?

If you work for a large company, matching is almost always completely at the discretion of the employer. They have absolutely no obligation to match. They do, however, have a ton of 401k matching rules concerning nondiscrimination. Essentially, they can’t match for the executives but not for the rank and file workers. They can eliminate matching so long as they do it for everyone.

Smaller businesses often offer safe harbor 401k plans, which avoid the nondiscrimination testing but come with their own set of 401k matching rules.  As a general rule, employers have to offer a dollar for dollar 3% match and a 50% match on the next 2%, or they can offer a flat 3% nonelective contribution irrespective of employee deferrals. (In other words, they “match” you even if you don’t contribute.)

But even here, the employer can suspend matching if the company is operating at a loss, provided they give 30-day notice and follow the “top heavy” requirements that prevent too much of the plans benefits from going to the executives.

What Should You Do If You Employer Quits Matching?

If your employer has eliminated matching for the year, you might be tempted to say screw it and quit contributing to your plan.

Well, if you’re in a financial bind due to the pandemic, that might be your best move. If you’re having a hard time paying your mortgage or putting food on the table, the retirement plan clearly isn’t your top priority.

That said, assuming your finances are stable, you should continue to plow every nickel you can into your 401k plan. In 2020, the contribution limit is $19,500 or $26,000 if you’re over 50. That’s your goal, with or without matching.

I’ll spare you the tired old lecture about how the stock market “always” rises over time. “Always” only holds true if your investment time horizon is 30 years or more. My reasoning here has nothing to do with the stock market.

It comes down to taxes. Every dollar you put into your 401k plan is a dollar the IRS can’t get its grubby hands on.

Let’s say you’re in the 32% tax bracket. You effectively earn a 32% “return” on the tax break alone, even if you leave the cash in your plan’s stable value fund essentially earning nothing. And that cash remains available to invest tax free for the rest of your working life. So, if you’re reluctant to chase the market higher here, that’s fine. You can still get the money into the plan, enjoy the tax break, and then just bide your time until there’s a pullback.

All of this would be true whether your employer matched you generously or didn’t match you at all.

So, if you’re employer had to cut back on your plans matching this year, don’t throw out the baby with the bathwater. It still makes sense to save as much as possible in your 401k plan.

All About the Bitcoin Halving

The following first appeared on Money & Markets.

I don’t normally like to hear the word “halving” associated with one of my investments. If your investment gets halved, you had better hope that there was a stock split. Otherwise, something went terribly wrong.

Of course, “halving” means something very different for Bitcoin and other cryptocurrencies. In case you missed it, Bitcoin just underwent a “halving,” the third in the cryptocurrency’s history, on March 11.

To understand what exactly that means, we need to do a quick refresher on what Bitcoin is and how it works.

Bitcoin runs on a blockchain, the open, distributed ledger that keeps track of every transaction made in the cryptocurrency. Because the ledger is distributed across every computer on the network, it’s nearly impossible to hack.

There is no centralized server in an office building somewhere that can be tampered with. Every transaction in the entire history of Bitcoin is recorded on every computer in the blockchain network and public domain to see. I can’t say it’s impossible to hack. I’m sure there’s some eccentric James Bond-villain hacker out there stroking a Persian cat and laughing maniacally as he hacks my account now.

But let’s just say it’s a lot harder than ripping my credit card number or hacking my checking account.

Nothing is Free

While Bitcoin was born of an idealistic, libertarian experiment, running the network isn’t free. It requires a lot of computational power and electricity usage to maintain the blockchain that supports Bitcoin.

While I’m sure there are some true believers out there that would do it for free, the rest are properly incentivized by being allowed to mine new Bitcoin. (In case you’ve wondered, Bitcoin mining actually does serve a purpose — the mining activity is what runs the payment system.) The algorithm that underpins Bitcoin rewards miners for volunteering their computer resources by giving them freshly mined Bitcoin.

This gets us to halving.

Halving is where the reward for mining gets cut in half. The same amount of processing generates half the number of new Bitcoins.

Why Does the Bitcoin Halving Happen?

We all know why gold and diamonds are valuable. They’re both rare.

Well, so is Bitcoin — by design. The supply of new Bitcoins is controlled by the mining process, and halving slows down the creation process.

By throttling the creation of new Bitcoin, the system avoids inflation.

Bitcoin prices fluctuate wildly due to supply and demand among traders, of course, just like gold, diamonds or any other finite commodity. But it can’t be printed at will by a panicked Fed Chairman.

It’s an Expensive Printing Press

Mining Bitcoin is wildly expensive and uses a ton of energy. A report last year found that Bitcoin mining globally used roughly the same amount of electricity as the entire country of Switzerland. The average cost to mine a Bitcoin was $6,851 before the halving. Now, the cost is around $13,000.

I know it’s folly to try to assign a fundamental value to something as speculative as Bitcoin, but I’m going to do it anyway. If it cost $13,000 to mine a coin, then the price needs to be $13,000 or higher to justify mining. At any price below that, the miner is actually losing money.

If the price of Bitcoin stayed below the cost to mine it for long, there would be no incentive to continue mining. As with any other business endeavor, you can’t operate at a loss forever.

This is where it gets interesting. If miners drop out, the number crunching that supports the blockchain gets easier and less energy intensive. This creates an equilibrium of sorts in which mining costs (what you can think of as the crypto’s “intrinsic value”) stay relatively close to market prices.

We’ll see what the future holds for Bitcoin. While Bitcoin itself has built-in inflation protection, there is nothing to stop inflation in the sheer number of competing cryptocurrencies. I like the concept of the cryptocurrency, but Bitcoin’s lack of monopoly power makes me stop short of betting the farm on it.

Still, it does have first mover advantage over the competitors. And if you’re looking for hedges against dollar devaluation, having a little Bitcoin along with some gold isn’t the worst idea.

Picking the Best Small Business Retirement Plan: SEP IRA vs. 401k

The following first appeared on Money & Markets.

If you’re like most small business owners, your main focus is simply getting business in the door. And with business conditions still extremely difficult in the post-coronavirus world, many small business owners are struggling to keep the lights on.

But if your business is stable and cash flowing, adding a retirement plan should be your next priority. Apart from your own retirement security and protection from lawsuits, having a proper retirement plan can help you to attract and retain better employees. So, today we’re going to consider the best small business retirement plan for your company, whether you’re running a one-man shop or employ dozens.

The Best Small Business Retirement Plan for a Sole Proprietor

We’ll start with the smallest of small businesses, the sole proprietorship (we’ll lump in single-owner LLCs and other entities here as well).

For the one-man shop, your best small business retirement plan options are the Individual 401k (also called a Solo 401k) and the SEP IRA.

If you make more than $285,000 in annual income or business profits, there is no functional difference between the SEP IRA and the Individual 401k. At that income level, you can max out either retirement plan at the full $57,000 allowed in 2020.

But at any income level below $285,000, the individual 401k is going to be the best small business retirement plan by a country mile.

Here’s why. With a SEP IRA, the maximum contribution is 20% of your net profit up to a maximum of $57,000. But let’s say your profit is only $100,000. The maximum you could contribute would be $20,000.

Now, let’s compare that to a solo 401k. In all 401k plans – be they individual or large company plans – you can contribute $19,500 via salary deferral or $26,000 if you’re 50 or older. But you can also contribute the same 20% of the net profit. So, on the same $100,000 net profit, you could contribute a total of $39,500 rather than $20,000.

So, for the one-man shop, there is no reason to ever choose the SEP IRA. The administration and investment options are generally going to be the same for both plans, yet the solo 401k allows for higher contributions for a given income level. For the sole proprietor, the individual 401k is the best small business retirement plan.

And if You Have Employees?

If you have employees, it gets a little more complicated. A proper company 401k plan can cost $5,000 or more to administer every year and comes with a mountain of paperwork. For many, this will still be the best small business retirement plan because employees are comfortable with it, and in some cases the owners can contribute as much as $57,000 per year. But those benefits come at a price in terms of high fixed cost and additional work for your payroll staff.

The SEP IRA is cheaper and easier to administer but it’s generally not ideal when you have employees. To start, there is no salary deferral. You can make employer contributions to your employee accounts, but these have to  be consistent throughout the organization. You can’t sock away 20% for yourself and only 3% for your employees.

The best small business retirement plan for many smaller firms with employees is going to be a third option called the SIMPLE IRA. A SIMPLE IRA “looks like” a 401k in that contributions can be a mixture of employee salary deferral and employer matching. But unlike a 401k plan, there are no real administrative costs.

The only real downside to a SIMPLE IRA is the lower deferral amounts. Employees can dump $13,500 into a SIMPLE IRA each year, which is significantly less than the $19,500 currently allowed for 401k plans. But most employees are unlikely to contribute the full $19,500 in any given year anyway, so that’s going to generally be a moot point for most.

If you’re a small business owner, you’ll obviously need to do a little more research than this. But this should at least get you pointed in the right direction.