An interview with SmartStops founders
Q: SmartStops appears to be a very ambitious project. How did it come about?
A: We firmly believe that the financial community
is grossly underserved when it comes to the subject of implementing effective exit
strategies. We have observed for many years that investors really needed more help
on their exits but no one really wanted to tackle that subject. More enticing to
pundits in the industry is telling people what they should be investing in and that
they should just Buy & Hold. Given our years of experience in the subject matter
and the change in paradigms about how our markets operate in the 21st century, we
decided to actually do something to fill the void regarding providing timely exit
advice for the average investor.
Q: Why do you feel that you are qualified to help investors with their exits?
A: Well, our team has probably devoted more time and effort to developing and testing
exit strategies than anyone else in the world. We’ve been doing that for more than
45 years in the financial industry and some on our staff have had their strategies
utilized by institutions and hedge funds.
Q: Why do you think exits are so important?
A: Well, obviously if you carefully stop and think about it, the exits are what
actually determine the outcome of your transactions. We realized that fact right
away but many people have never figured that out and still spend all their time
and effort on buying the best stock or buying whatever they trade at the best time.
Then they leave the exits more or less to chance and make silly mistakes that undo
all their hard work on the entries. Exits are also what control the risk on a trade.
Anyone can limit how much money they might lose by controlling their exit.
Q: You said that exits control how much money you might lose on a trade. Do they
also control how much you might make?
A: Unfortunately exits do not really control how much money you make although they
will certainly influence your profitability over a period of time. For example if
you buy a stock at $50 it is very easy to say that you will sell it if it drops
to $40 so you don’t wind up owning it as it drops to $10. Your control of that outcome
on the losing side is very near absolute. But if you buy it at $50 how do you make
it go up to $90? We may have a great deal of control on limiting the downside but
we have very little influence on the upside. We can try to be patient and have big
profits but what if those big profits never come? We still need to exit.
Q: What about Warren Buffett? He has often been quoted as saying that his favorite
holding period is “forever”.
A: We’ve always been a big fan of his and have carefully studied his actual transactions.
He might say that he prefers to hold positions forever but that is certainly not
what he actually does. For example he was invested in millions of shares of Fannie
Mae and Freddie Mack back in 2007. He sold those two positions well before they
became practically worthless. He is not only good at buying companies he also knows
when stocks need to be sold. If you want to be like Warren Buffett you need to do
what he does and not what he says.
Q: I take it then that you are not an advocate of a “buy and hold” strategy?
A: No. “Buy and hold” does not even qualify as a strategy because it is in fact
the absence of an exit strategy. Nobody should ever plan to hold a stock forever.
That’s not even possible. Your heirs will probably sell it promptly after you die
if you hold on that long. The key point here is that you should sell stocks when
you gain an advantage by doing that. Now the obvious question is: How will you know
when it is a good time to sell? As you can see we are right back to why we created
Q: But “buy and hold” is probably the most popular strategy around. Why is that?
A: Please don’t refer to “buy and hold” as a strategy. It’s not. It is simply avoiding
and ignoring the importance of having an effective exit plan. It is clearly a default
to depending on luck for timing your exit and we wouldn’t suggest that anyone should
ever count on being lucky as an investor. We assume that investors want to succeed
and eventually meet their investment goals. To insure that they do that they need
to wake up and assume control of their exits so they can control risk and improve
their results. Look at the most vocal advocates of “buy and hold”. They are typically
entities such as mutual funds that collect fees as long as you leave your investment
undisturbed. If you take your money out they stop earning fees. Is it any wonder
they constantly warn you that buy and hold is absolutely the best way to invest?
We can assure you that it’s not.
Q: What about building a diversified portfolio of stocks? Can you succeed using
buy and hold as long as you have a well diversified portfolio?
A: Diversification should help to spread risk but it does not make investing “safe”.
Even a diversified portfolio exposes you to huge “systemic” or “systematic” risk.
In 2008 many well-diversified portfolios experienced losses of 40% or 50% or even
more. When the market crashes diversification doesn’t help much. We did a study
of a portfolio of the ten most widely held stocks and that portfolio of ten stocks
lost 42% and many portfolios of less popular stocks did even worse. That same portfolio
using our SmartStops exit signals would have lost only 2.5% in 2008. (Yes, the decimal
was not misplaced. That’s two point five percent not twenty-five percent!) If that
money was put back in the market in early 2009 that portfolio would be making new
highs very quickly rather than hoping to someday recover to breakeven. Protecting
against big losses has more impact on profitability than most investors realize.
Protecting your capital is much more than just good defense. It really improves
profitability over time.
Q: Most investors seem to have a logical plan for entries but they rarely have a
good methodology for planning their exits. Are exits somehow more difficult than
A: Yes, exits are much more difficult to plan than entries. We believe it is the
issue of “control” that creates the difficulty. When we are preparing to enter a
transaction we get to dictate or specify the necessary terms for that entry. We
could do a careful analysis of the fundamentals and require specific ratios of this
to that. Then we could require that the stock be in a rising trend above the 50-day
moving average with increasing volume and then enter only when it makes a new twenty-day
high. We get to set all of these conditions (or even more) and if they are not met
we do not have to enter. We have control at the point of our entry. But once we
own that stock we are pretty much at the mercy of the market and we eventually have
to exit whether any of our preferred conditions are met or not. Our control is gone
and we will probably have to exit under less than ideal conditions. There can be
no doubt about it – exits are much more difficult than entries.
Q: Have you observed that investors tend to be reluctant to sell stocks at a loss?
A: Yes, we have observed that very frequently and so have many others. In fact,
in the academic world it has been named the “disposition effect”. It seems that
most investors are reluctant to dispose of stocks when they are losing money and
would prefer to sell stocks that are profitable. That tendency is the “disposition
effect” and is common among almost all investors. Investors would be best served
if they could overcome the “disposition effect” and learn to do just the opposite.
They need to acquire the discipline to hold on to winners and get rid of the losers.
If they accomplish that they will eventually wind up holding a portfolio of winners
instead of succumbing to the “disposition effect” which eventually results in holding
a portfolio of losers. Someone once pointed out that a portfolio of stocks should
be treated as a garden where you routinely pull the weeds and keep the flowers.
That’s good advice.
Q: Let’s talk about the logic behind the SmartStops exits. What can you tell us
about them without revealing your trade secrets?
A: We are willing to tell you more than you might expect. For starters the basic
premise is that “what goes down; goes down further”. This is an old and widely observed
trader’s maxim that clearly has a great deal of truth in it. Our research shows
that price weakness of particular magnitudes actually does beget further price weakness.
The problem of course is to be able to identify very promptly, price action that
demonstrates abnormal weakness. Stocks go up and down all the time on a nearly random
basis so it’s not unusual to see a stock decline now and then. We wouldn’t want
to sell every time we saw a stock drop by a small amount. The algorithms that we
designed for SmartStops are very complex but they have to be complex to recognize
the difference between normal price weakness and weakness that is abnormal and likely
to signal further price weakness. We also need to know that information as a price
level that can be projected into the future so that we know when to take action.
Each market day the SmartStops algorithms calculate a price point that, if it is
reached, will clearly identify that abnormal price weakness has occurred. Once abnormal
price weakness happens there is a very high probability that additional price weakness
Q: Once the abnormal price weakness begins, how far do the stocks usually go down?
A: There is no way to know. The odds are that the stock will continue to decline
but there is no way to estimate how long the weakness that was identified will continue.
A few stocks may turn around and regain their strength very quickly while others
may go down a very large amount. The safest way to proceed is to sell or hedge the
stock to protect against further losses. If the stock becomes strong again it can
always be repurchased.
Q: What would be the point of selling a stock and then buying it back again? That
doesn’t make good sense.
A: Actually it makes very good sense if you do it consistently. If you make a practice
of selling stocks when they are weak and only buying stocks when they are strong
you will avoid large losses while still participating in strong stocks that can
provide big profits. Occasionally this simple plan might not work but overall it
usually turns out to be a very profitable strategy. We were all taught that successful
investors cut their losses short and let their profits run. This is one way to make
sure you follow that good advice. There are very few investors that are smart enough
to be able to buy stocks while they are weak and then have them turn around and
become profitable. Fortunately it’s not necessary to perform that very difficult
task in order to make good returns. There is more than enough profit available by
simply buying strong stocks and then holding them only as long as they remain strong.
Q: What are the unique features that make SmartStops better than alternative exit
A: There are several features that make SmartStops more accurate and more effective
than alternative exits but it is the very logical way that these features are combined
that result in a product that is truly unique. For starters the algorithm takes
into account the current volatility of the stock so that the exits are set far enough
away to avoid the routine up and down price action that is merely random. If the
magnitude of the randomness increases the exit points automatically adjust farther
away to avoid being triggered by weakness that is not truly abnormal. The SmartStops
algorithm also has several different strategies available to apply depending on
the direction of the primary trend of each stock. The strategy that is applied to
a stock that is in an uptrend is substantially different than the strategy that
is applied in a downtrend. There is even a different strategy for stocks when they
are going sideways. By adjusting the exits to take into account the direction as
well as the changing volatility SmartStops can calculate exit points that are logical
and highly adaptive. These exit points are moved close enough to protect capital
but not too close where they might be triggered randomly.
Q: Percentage trailing stops are very popular. How do they compare to SmartStops?
A: Our testing shows that percentage trailing stops are either too close or too
far away. The most popular percentages are 8% and 10% and those are too close for
the markets over the last few years so they get “whipsawed” by price action that
has become normal. Wider exits such as 25% avoid getting triggered too frequently
but do a very poor job of protecting capital. Here is an example from some of our
research: We used the SPY as our test vehicle and ran the exits from March 1998
through April 2008. We bought and sold 1,000 shares of SPY each time and reentered
as soon as a new 20-day high was reached. Buy and hold over that period produced
a profit of $32,860 but the 8% trailing exits would have reduced that profit to
$20,610 and the 25% trailing exits would have reduced the profit to only $15,360.
For comparison, the aggressive SmartStops exits increased the profits to $53,890.
When we updated that study a few months ago buy and hold showed a loss after giving
back all the temporary profits it had in April 2008. The SmartStops model continued
upward to make new highs. There are many studies like this one on the web site that
clearly show the effectiveness of our unique SmartStops exits.
Q: What about using support levels?
A: Support levels are too subjective to even test. They also suffer in downward
trending markets where there is often no support to be found on the charts. In a
fast rising market the prices race upward while the current support level remains
fixed. The support levels fail to keep up with prices so they fail to protect profits.
I designed SmartStops to work well in up, down or sideways markets. It is completely
objective with no subjective chart analysis required.
Q: Thanks for the interview.
A: You are welcome. We encourage you to look at our SmartStops in Action page,
where you can see some live examples.