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Sunday, July 11, 2010

The "Three Sisters"

"The general who advances without coveting fame and retreats without fearing disgrace, whose only thought is to protect his country and do good service for his sovereign, is the jewel of the kingdom" - Sun Tzu, The Art of War"

I have related on many occasions, that in 2003 I began to develop my own personal "three sisters" portfolio management system.

What is the "three sisters"?

The “three sisters” is my portfolio strategy that can provide fantastic returns through trading, cash flow through investing, and a firm foundation to the other two accounts through savings. It allows for the accumulation of assets on three diversified fronts. I keep these “sisters” as separate accounts. When one of the “sisters” or accounts is having a hard time, then one of the other 'sisters' who is having a better time 'helps out' the other sister. There is the added bonus, that each “sister” or account, tends to give the other accounts “boosts” during good times. So let's move on, and discuss the first 'sister'.

The Trading “Sister”
"A ship is safe in harbor, but that's not what ships are for." - William Shedd

Of course, the "sexiest" of the three sisters? Is that of trading. Trading promises the possibility for fantastic returns, along with associated risk. Trading, is what any “market junkie” loves about the market. Pouring over charts, and planning plays. Entering trades and hoping for big profits.

Of course, there can be periods of drawdown. Drawdown is a losing trade or period of losing trades; and it is a fact and reality of life in trading. All too often, market educators fail to mention the inevitability of drawdown. Which is why you'll generally only hear the honest, and real traders will talk about their mistakes, and bad trades. So of the “three sisters”, this is one is by far, the most demanding. One mistake? And this 'sister' will take you to the cleaners. Since developing this strategy, I have had years where I enjoyed 356% returns (definitely my best to date). I have had years where I enjoyed 30% returns. One year however … it was 2003. Well, I have talked publicly about 2003. I ended the year down, -3.57% for the year. All of that good work I had built up over the course of months? Gone, because of one mistake.

I learned my lesson. I have never repeated that mistake. But at the same time, I was looking at a lot of hard trading work down the drain. You can't eat off of -3.57%.

Enter, the second sister. Investing.


The “Investing” Sister
"The Most Powerful Force in the Universe is compound interest." - Albert Einstein, attributed

I have talked for years, ad naseum that investing is not trading, and trading is not investing. So again, I will spare you that speech. I am aware that there are those who do not like the concept of investing. I'm not here to debate the pro's and con's of investing versus trading. That's an argument as old as fundamental analysis verses technical analysis. It is interesting to note however, that many accomplished traders use both fundamental and technical analysis. So to, rather than argue against a method of involvement with the capital markets? I do both. I trade, and I invest. Investing is simply another method I use to generate cash flow, and accumulate assets at low prices. And let's face it, the only thing that matters in the end, is performance.

However, since investing is much different than trading, it is important to note that I keep my investing accounts, separate from my trading accounts.

Investing is the second "sister" as it were, in the three sisters methodology. As an investor, I have also talked about the fact that I am a dividend investor. The root philosophy and the kernel behind my approach, was the “Dogs of the Dow” methodology using mid cap and large cap stocks. Again, I have talked at length about the strengths and weakness of this approach, and you can find those posted discussions for free. So I will not spend time here explaining or arguing for that approach.

But since I am a dividend investor? This allows for the freedom of receiving cash from dividends. Yields as high as 5% annual. Try getting that yield from a savings account, or even a Certificate of Deposit (CD) at the moment. Reinvesting the dividends if I so choose, thereby compounding the return on a single purchase of the stock itself. Over time, this can really, really add up. You in essence, receive more shares of the stock, for free

Reinvesting the dividends is done through brokers that engage in the DRIP or Dividend ReInvestment Plan. And when an investor engages in “DRIP” or the reinvestment of their dividends, they begin to unlock the power of compounding. At any time, DRIP can be turned off, and an investor can begin to receive straight cash dividends off of the assets that he has previously compounded.

And let me tell you, it's a very satisfying feeling, sitting in a beautiful restaurant in the heart of Querétaro Mexico, enjoying fine food and wine with friends. Knowing that you haven't look at the markets in two or three days? You haven't sat in your computer chair glued to the monitor having to manage short term trades? But you're still receiving cash dividends on stocks that have compounded their position size for you.

Yeah. That's a very good feeling.



The “Savings” Sister
"I save money when I'm working so that I never have to take a role simply to pay the bills.” - Gary Sinise, Actor

This is the sister that everyone wants to be friends with ... but no one wants to date.

Especially in the current environment. With the Fed prime fund rate essentially at zero, interest rates at financial institutions around the country have plummeted. When I began with this portfolio strategy, one could open up a money market account, and enjoy 4.1% interest on their money. I would at times take a percentage of my annual return, and feed it to my investing account.

Now, it's hard to find a long term Certificate of Deposit (CD) that offers 3.0%. But I think that really highlights the strength of the “three sisters”. Because really, you don't have to be earning a fantastic rate, for this sister, the “Savings” sister, to perform her job.

Because these 'sisters' or accounts, help one another out. And this 'sister' is by far, the most helpful in her purpose, or reason for 'her' existence.

The savings account is split into three purposes, and used for three separate reasons, and by different percentages at different stages in the accounts growth.

  • Drawdown Kill Switch Fund
  • Base Savings
  • Emergency Savings

If you are not familiar with my outline of money management principles, again, you can review that information for free. It will explain what I mean by both a “Drawdown Kill Switch” (Some call this the 'ruin level' of an account, that is a percentage of the account capital that the trader does not want to risk any more capital, and stops trading), and why I have a fund dedicated to supplementing an account, once the drawdown kill switch is tripped. To summarize briefly, if the trading account or investing account were ever to reach this “kill switch” level in terms of drawdown? Then a percentage of the savings account could be used to supplement the drawdown that the other account experienced.

Honestly though, that is only used in the beginning. I have not used my own personal drawdown killswitch fund in years. But it's still there, if need be.

In addition, everyone should have a base savings. In better times, the entire savings account would be earning interest, and I will soon talk about how the accounts 'feed' one another. Hopefully, a way can be found out of the current liquidity trap that has occurred in reccent years, and we can once again return to days of actually earning interest on our savings. What a radical thought eh? It should also be noted that I do keep physical metals, actual bullion as part of my base savings. But bullion cannot put food on the table.

Regardless, a percentage of the savings accounts are also used for emergency savings. I don't care what someone's level of wealth is, everyone needs to maintain an emergency savings fund. If you have $5,000,000.00, and you develop a critical, debilitating illness? Despite having good health insurance, you had best hope that you have access to liquid funds. There are any number of emergencies that can arise in our lives. I know, I've watched it happen. I've watched patients on cancer regiments have their retirement savings eaten up, despite having health insurance.

And yes, I keep this function as a part of my “three sisters” methodology, although at first it may not seem related to trading or investing. Because when I generate money in the markets, having these accounts as part of my portfolio strategy reminds me that no matter what sort of success I'm enjoying? Life is a precious, fragile thing, and I should do my best to prepare for unforeseen events.

Weighting, Performance and Metrics
"Performance is your reality. Forget everything else." - Harold S. Geneen

As I mentioned earlier, performance will differ, from year to year. I have had 356% return years. I've had years where I returned 30%. In my personal accounts for the current year of 2009, I'm up about 32% on the investing front, 40% on the trading accounts, and up 1.49% on the interest bearing accounts at the time of this writing. And yeah … then there was 2003. -3.57% yield. So yes ... performance differs from year to year.

As those who have taken to heart the outline of the principles of money management know, I keep strict track of my recent performance statistics. In fact, I believe this is one of the most glossed over aspects of money management.

So twice a year, I review the performance of the 'three sisters' accounts. I dedicate two days of the year, for this purpose. On July 1st and on December 24th of each year. On July 1st, I look for the accounts with the largest percentage returns, or profits. I start with a 3% baseline of the profits of the most profitable account, and feed it to the Dividend Investment account. If the most profitable account is the Dividend Investment account? Then I feed 1% of it's profits, to the savings account. Why? Because summer (usually) is a weak time period for stock prices. It's a way to assist my Dividend Investment account for what could be (though not this year) weaker prices. It is also a way to assist the dividend investment account, so that the account is in a position to better dollar cost average dividend prices by the end of the year, which is when the equities markets (usually) rally. It is also on July 1st that I find the stocks that have had the strongest gains in the portfolio, and turn the DRIP plan for that stock off for the summer and receive straight cash instead.

On December 24th, I again review what is my most profitable account. I start with a 3% baseline of the profits of the most profitable account, and feed it towards the Savings accounts. I take a 2.5% baseline of that same, profitable account, and feed it to either the 'first' or 'second' sister, but not the third 'savings' sister.

I did mention that those percentages are only a baseline. I also consider where we are at economically, and what accounts I feel will need the most help. In 2007, I talked quite publicly about the fact that I began pouring money from my savings accounts into my investing accounts based purely on the fact that I knew that those accounts were about to suffer massive drawdown, as I felt the equities market would suffer a severe downturn.

So there is an aspect of “weighting” the different 'sisters' according to the economic environment we find ourselves in. This aspect can become very discretionary.

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And there you have it. My very own personal "three sisters" portfolio management system.

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Note: This is not an investment or trading recommendation. The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. I am not a licensed trading or investment adviser, or financial planner. But I do have 14 years of experience in trading and investing in these markets. The Challenge accounts are run for the education of other traders who should make their own decisions based off their own research, and tolerance for risk.

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