Investment — Part 2 — Optimization Strategies

This article is part of a series on investment strategies:
Part 1 | Part 2 | Part 3 | Part 4 | Part 5

Last updated: Sep 18, 2022

To extend the introductory discussion provided in Part 1, the following are a list of optimization strategies and tips that I am aware of, or have personally used to increase returns.

• Time is money: Longer time frames reduce your real profit

In this actual example, the considerably higher return of SOXL looks much less attractive after you account for the additional time necessary to exit the investment, which reduces liquidity.

Profit = Total amount of exit — Total amount initially invested

Annualized Profit = Profit * (Number of days invested / 365)

Example above: The higher return for SOXL is mitigated by the extra time needed to exit, resulting in a similar annualized return to TQQQ.

Thus, when evaluating potential strategies (or hearing stories about others’ wins), you should always look at annualized returns, which provide a more complete picture.

• Consider holding investments longer than a year: Complicating the above point, if you sell stocks (in the US) in less than 12 months, you will pay a greater short-term capital gains tax (~35%), than if you hold it longer than 12 months (~15%). Sometimes the difference makes it worth holding an investment a bit longer to get the better tax treatment. Short-term investments typically need to be timed well, and presumably are producing high enough returns (due to the added risk) to cover the added tax hit of around 20%. I typically ignore capital gains taxes unless I’m already close to the 12-month mark with a short-term investment. Long-term investments should already be more than several years, and the tax-decrease makes them even more attractive to have in your portfolio.
• All-time High (ATH): This is a standard metric which shows the highest point a stock has ever reached. 52-wk-high is similar. For most ETFs, the ATH continually breaks its own record as the market goes gradually up over time. This metric is extremely useful, is underutilized by traders, and can provide a barometer to how high or low a stock is. You can also utilize several of the recent low or high points over the last several years to see how low the dips go and how high the bubbles go (corrected for the overall growth path, see red arrow below). Related: See ergodicity which states that “average behavior can be determined from a collection of typical points, and that the system can’t be reduced to individual components.” The red line below shows a probable estimate of average behavior.

The red line shows the overall trend in value, with various dips and bubbles along the way. Every stock or investment vehicle can be viewed in this way, but it more accurate as a predictive measure if it is already diversified, such as in an ETF.

• Drawdown: A natural extension of ATH is drawdown, which is the percent below ATH the current stock value is. Example: Stock ATH was $100, now it is at $90, so 10% drawdown (-10%). If applied to an ETF with strong fundamentals (which will continue to go up with the overall stock market), drawdown percentage can be thought of as the “sale price”. Drawdown is by far the most important metric in my current investing arsenal. See below for how it can be used to understand the context of a current stock price.

Drawdown is a very useful metric to see how good the buy opportunity is, and it can be graphed for historical perspective. Graph made in ThinkOrSwim platform.

• Chart ranges: Use longer-term chart ranges (5 days for monitoring, 1–5 years for perspective). I am suspicious that trading platforms default to daily or hourly views on purpose to increase the sense of urgency and promote more emotional trading decisions. It is best to get a bigger-picture view and make your buy/sell decisions in advance. It is very disorienting and hard to see larger trends with charts with short time frames. A huge dip in a 5 day chart can look extremely minor when viewed on a 2 year scale.

Part of my personal dashboard in StockMaster iphone app. This was not the default layout, and has been customized to suit my personal trading style. Most dashboard default to daily or hourly charts which are almost useless for long-term trading.

• Be skeptical of business news and analysis: A great deal of the business and stocks news is geared to day-traders, is based on supposition and untested hypotheses, or has ulterior motives to manipulate investors. The first thing I do when I see an alarming headline is to check it with my own data, and I frequently disagree with their conclusions, or gain additional context on what might actually be going on.

The news headline is stale, suppositional, and out of context. You would never want to place a trade based on this information.

• Fluid capital: Have resources available to do things during a downturn. I told friends to buy the dip during the beginning of COVID, but they already had all their extra cash tied up in stocks (which were all down and couldn’t be exited.) In contrast, I had some cash saved and also refinanced a house to have cash to invest during the dip.
• Timing the market: You don’t need to “time the bottom or the top” exactly, just buy fairly low and sell after the desired return is reached. You can see what high or low points might be reached by looking at the trend chart history for the stock (see pic at top). If you buy in and it drops more, view it as an unexpected opportunity to lower your cost basis. You may have heard of an “inverted yield curve” which predicts the onset of a recession. A “predictor” that indicates that something “sometimes happens” within 2–3 years AFTER the event, for an event that happens every 5–6 years anyhow, is not a mathematically useful prediction. A dead clock is right twice a day, and guessing heads or tails is right 50% of the time. The stock market actually goes UP 20–30% after a yield-curve inversion — be skeptical of investing superstitions and numerology.

You don’t need perfect timing. Continue to buy if it drops more (to lower Cost Basis), sell when you get the desired return. Don’t cry over potential losses if you sell a bit early. Use ATH and % return to judge when it has gone up enough to sell.

• Use borrowed money: Let’s say you want to buy a 1M house. If you want to buy it all-cash, paid in full, you will probably never get the house. Even if you did, you would have sunk 1M in cash into it, just to get maybe 200k appreciation in 5 years. Alternatively if you put 100k down, and borrow 900k, you can still get the 200k appreciation in 5 years. So why use 1M to get 200k when you can use 100k to get 200k? It’s better to invest with borrowed money. As long as your profits exceed the cost of borrowing (e.g. loan fees and loan interest), then it is then well worth it. The same is true for stocks. Buying on margin, or buying a leveraged ETF are ways to use borrowed money.
• Margin: Margin is a loan that a brokerage gives you to buy stocks. The interest rates are often quite cheap (Robinhood is 2.5% as of this writing). I previously thought this was great to take advantage of, but I have recently discovered several disadvantages to be aware of, and I intend to downgrade my margin usage to at least 30% of my overall portfolio value.
  - Using margin locks up your money (less liquidity). If you had 20k of cash in your account prior to using margin, you could withdraw that immediately like a bank account. After using margin, it is locked up in the margin until such a time as you can stop using any margin. That means you need to wait until the stock market recovers and you can exit most of your investments before you can access your cash again.
  - Brokerages (particularly Robinhood) make it difficult to visualize and understand margin and margin maintenance. If your portfolio value drop sufficiently, you will be given a Margin Call. That means you need to either sell stocks immediately (at a loss and the wrong time) or deposit more cash (see above, not liquid). Robinhood has no documentation of how rapidly you need to fix a margin call, and the margin maintenance number is buried under settings screens. Furthermore, while sending scary alerts about hitting margin maintenance levels (i.e. don’t spend), they simultaneously tell you that you can spend 85k more on margin — talk about misleading.
  - Summary: Margin is not the same as a typical loan. With a loan you can keep a separate cash account that remains liquid, and you have time to pay back the loan. Margin locks up your cash and forces you to inject more cash or sell at a loss, and offers little useful guidance on how much of it you can safely use. Be very wary of it.

Newly added (but poorly designed) Robinhood feature showing the margin maintenance level (dotted line) with an alert that doesn’t indicate how much to pay to fix it, or solution paths.

• Move to a state or territory with less taxes: Many people move to Puerto Rico to avoid federal taxes and also higher state taxes. There are also state-tax-free states such as Texas, Florida, Washington or Nevada. If you don’t mind moving there and living there a large part of the year, it can add a beneficial bump to whatever strategy you’re using. Typically these locations have some downsides to actually living there that need to be considered.

* I am not a professional money manager, have no financial degrees, and you should make your own investment decisions. I do have a Ph.D. in a computer-related discipline and I like being skeptical of conventional wisdom, particularly when returns are low, conflict-of-interest high, and there is a deficiency of data showing causal relationships.