Trading and investing is not gambling, hence we have to strategize instead of going all in all the time. While most of us know how it works, that is, to buy in tranches at different entry prices, it is quite uncommon to see traders consider the pros and cons of accumulating stocks at different rates. In this week’s post, I will explain the difference when you employ a lower risk approach compared to a higher risk one. In essence, when you choose either approach, you will gain or lose amounts proportionate to the amount vested. The important message I am trying to bring across is that a lower risk approach does not always work well especially in terms of maximizing opportunity costs, on the other hand, blindly deploying capital out of green might lead to stacked losses.
Accumulating during a downtrend
If you notice the simple model above, you would have noticed that the person who deployed capital in larger tranches eventually made the highest profits. Whereas the person who deployed capital more conservatively gained the least profits during the upturn. The purpose of creating this model is not to encourage traders or investors to buy in larger tranches but to understand that conservative strategies do have their downsides as well. An important reminder to ourselves is to decide on our strategies based on the amount of capital we have left in any given situation. While the all-in approach is highly discouraged, it still makes sense for persons with smaller amounts of capital as their absolute capital risk is still relatively manageable.
Accumulating during an upturn
Buying stocks during an upturn is an extremely deceiving affair. The word “affair” used in this context is apt as people committing adultery always feel the thrill and excitement despite its impending negative consequences as a result. That said, many investors especially those who recently committed capital in the US market would have felt an ending sense of security provided by the Fed thus, justifying their risky buy-ins despite dangerously high prices. As shown in the model above, employing capital in larger tranches will lead to higher paper losses during a downturn.
Deciding appropriate tranche sizes
As investors, it is crucial to understand that employing capital could mean locking up a huge chunk of your capital in intangible assets for a relatively long period of time. When deploying capital, try to prioritize practical aspects before thinking about potential yields. Personally, the most important criteria will be the availability of funds for non-investment purposes. The moment you fall for the mental scheme of breaking even sooner or earning higher yields, chances are that those choices will not lead to positive outcomes. As always, decide on your tranche sizes and price intervals based on capital allowance and time horizon.
Closing Thoughts
It is quite hard to explain these simple yet important concepts in a short post because the emotions attached to each scenario are extremely different from a few shapes and colors as shown on the models above. The reason why I felt this is an important topic is that many of us over or underestimate the extent to which the market can rise or fall, resulting in losses beyond one’s tolerance. On the flip side, taking on overly conservative approaches might not be ideal for some of us as well.
