No. of Recommendations: 4

Take a look at that price chart for Ultrapetrol’s 9’s of ’14 and ask yourself this question: At what price would you like to have bought that bond? Right at the bottom, of course, somewhere around mid-70s. Now ask yourself this. Where did you actually buy it? I don’t know about you. But I have to confess that I did what --retrospectively-- was a poor entry. I got in 02/09/12 on five at 92.219 instead of the 20 points lower that subsequently became available, which raises a whole bunch of questions about how one runs one’s game.

#1, Why did I buy when I did, and in the size I did?
#2, Why didn’t I average down when prices moved against me?
#3, When prices did recover, why didn’t I average up?

Permit me to work through those questions one at a time.

Currently, in a whole bunch of TMF’s forums, there are multiple threads focused on guessing the direction of interest rates. Some are thoughtful. Some are sloppy. But all of them are bullsh*t, because no one can predict the future. They are attempts to model things that cannot be modeled with enough accuracy to make trades based on them, much less leveraged trades, as the idiots at LTCM and other quant shops found out. A model that offers precision, but is based on bogus assumptions, blows up accounts.

Faulty models can work well if you know that the Fed is backstopping you, that you can privatize profits and socialize your losses. But if you’re just a small trader/investor, you have to eat your losses, and if they are too big, you’re out of business. So you have to bet in such a way that you will never get yourself thrown out of the game. No single position, nor any group of positions, can ever be permitted to be so large --or so correlated-- that you are ever at risk of suffering losses from which you cannot recover. On a mid-sized, $500k bond account, a five-bond position on a spec-grade issuer might be a bit conservative, given that ‘exposure’ isn’t the same thing as ‘risk’. But, also, you won’t get yourself into too much trouble if you do cap your exposure to any single, spec-grade issuer at five bonds max. So, that’s what I did. I pulled their financials, confirmed that that the business was viable and had enough assets to pay off creditors, and put on a five-bond position at 92 something, for a YTM of 12.4% and a positive, tax-and inflation adjusted YTM of 4.7%.

OK, so far, so good. Some money was put to work, and I went looking for my next position. When prices did begin to move against me, I had three choices: Get out, Sit tight, or Add. Were I a bond trader --rather than a bond investor--I would have gotten out for that being the only rational play. Were I an aggressive value investor, I would have added. But, as a general policy, I do not average down. I accept the fact that my entry wasn’t optimal, and I stick with it, because to add would be to increase my exposure beyond my self-imposed limits. I can afford a total loss on any five bonds and even total losses on many five-bond positions. But I can’t afford to start losing tens and fifteens, especially if the reason why one position is going under is the same reasons other positions will go under. So my working policy is to ignore the level and direction of interest-rates and to buy each bond as if it were a put. Is the premium cheap relative to risk? Buy the bond in a size I can afford to lose. Is the premium dear relative to reward? Avoid the bond.

How did that trade turn out? I was called two days ago at 101.175, and my workout was a YTM of 16.1% over my holding-period. So, out of sheer dumb luck, I squeaked out on yet another trade that could have gone very badly. Also, if it had been managed differently, it could have been hugely profitable. But that’s the game, right? You make the best decision you can at the time the decisions needs to be made, and then you stick to your original plan. Can plans be changed? For sure, and they have to be changed as conditions change. But you don’t change them mid-trade. The reasons you got in are the reasons you get out, and if they haven’t changed, though prices might have, you stick to the plan. But I can accuse myself of jumping in too early, which is a mistake I’m constantly making, but which is very hard to overcome, because it requires the ability to wait and wait and wait until prices do come to you, and that’s a hard thing to do.

But I’m getting better at it, and, yesterday, I backed away from several things in several markets, saying to myself, “Patience, patience. Let prices come to you.” Maybe they will. Maybe they won’t. But if I’m buying only the very best opportunities in terms of their risk-reward profiles, I won’t be getting myself thrown out of the game for having bet too big, too soon, or too late. Timing. It’s all a matter of timing, of reacting appropriately to prevailing conditions rather than trying to predict what conditions will be. As Peter Lynch often said, “If I spend 15 minutes a year trying to predict the direction of interest-rates, I’ve wasted 10 of them. So I just buy what needs to be bought, when it needs to be bought, and let others play their guessing games.”

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