How Joseph booked 40% gains in 2016
One thing I am very proud of myself in 2016 is that I booked 40% gains in stock market! For those who are new to investing, an average gain in the stock market (if you invest in US index) is about 7%-8%!
According to the rule of 72 (see AccountingCoach), if you want to know how much time needed to double your money, divide 72 by your investment rate. If my case, if I can maintain a 40% gain in stock market in 2017, then it only takes me less than two years (i.e., 72/40 = 1.8) to double my original principal!
Image courtesy: AccountingCoach
If we want to know someone's investment success, we must know two major things: what's this person's investment philosophy, and what investment instrument (e.g., stocks, ETF, or options) this person uses to achieve this outcome.
My investment philosophy is very simple: I use time-tested or research-based principles to guide my investment. Specifically, I want to ensure that this trading philosophy has been used and validated by other people. Two investment styles emerged from my research: value investing and momentum investing.
When talking about value investing, it is very easy to think about legendary investor Warren Buffet. If you do not know why Buffet is a value investing guru, let's use an example. If you invest $1,000 in 1964 when Buffet took his company Berkshire Hathaway with a share price at $19(!!), it would be worth 11.8 million in 2015 according to Business Insider.
Given his extraordinary success, many people have attempted to figure out why Buffet can get this return and find his unique approach. I am in no position to say that I know how Buffet gets the results and can replicate it. Instead, here are several of his quotes that are relevant to my value investing:
- Price is what you pay. Value is what you get.
- It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Therefore, my value investing priority is:
- Investing a wonderful company at a fair price;
- Investing a fair company in a wonderful price (if I believe the situation will change).
You may see that I do not fully follow what Buffet says.
To be fully transparent, my investment philosophy does not follow ALL Buffet says. For example, Buffet said:
Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.
But given my desire to get better return, I leverage my investment with options, which we will talk about later.
Momentum investing is a less-know investment philosophy to common investors. I was not convinced to use momentum investing until I read two books: Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk by Gary Antonacci and Quantitative Momentum: A Practitioner's Guide to Building a Momentum-Based Stock Selection System (Wiley Finance) by Dr. Wesley R. Gray and Dr. Jack R. Vogel.
The idea is very simply but may not be easy to carry out. Momentum investing is based on the trend of market or individual stock: if one stock outperforms other stocks, the trend will continue (i.e., the stock price will be increasing). In other words, as Eugene Fama and Ken French, the fathers of the efficient market hypothesis, said:
Stocks with low returns over the past year tend to have low returns for the next few months, and stocks with high past returns tend to have high future returns.
The following figure is the simulation results on AlphaArchitect by Dr. Gray. He ranked stock returns to determine momentum winner and loser, and plot out their return. As you see, past performance tends to continue and trend higher.
Image courtesy: AlphaArchitech
You may be wondering stock market returns based on value investing and momentum investing. According to Larry Swedroe and Andrew Berkin at AAII, the annualized return for momentum investing is 9.5%, which is higher than value investing (i.e., 5%)
Given the return of momentum investing, I also allocate money using this investment strategy. Similar to what I do with value investing, I leverage momentum investing with options.
Conservative does not seem to go along with speculation, but hear me out. Speculation means that you want to get extra return while bearing a significant amount of risk. But how speculation can be conservative? Well, there are several ways: 1) possibility of price movement, 2) asset allocation, and 3) adaptive trading plan.
If you are familiar with option trading, here are strategies I normally use: 1) revised iron condor (with debit spread to hedge and increase return), 2) bearish butterfly, and 3) earning trades.
I will talk more in the future articles.
For value investing and momentum investing, they normally buy stocks and rebalance every month or every quarter. When I started to learn these two investing approaches, one thing occurred to me: if these approaches are proven to have alpha, why can't we leverage it with options? For those who do not know options, investopedia has a concise explanation:
An option is a financial derivative that represents a contract sold by one party (the option writer) to another party (the option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).
I allocate 20% on value investing, 20% to momentum investing, and 60% reserved for conservative speculations. I normally do not fully invest in my account. In fact, among all the value and momentum stocks, I only invest those who I have a feeling or prediction.
My bread-and-butter trades are bearish butterfly and revised Iron condor, and these two techniques requires additional explanation. I plan to write more in these series in 2017.