Tame Trading an easier way to trade

It's risky business, your life, your loves, your investments!

Do you remember the 1983 movie, Risky Business? In it, Tom Cruise plays an enterprising teen named Joel who takes a huge risk when, with the help of a beautiful young prostitute, he converts his parents' home to a brothel while they're away on vacation. His enterprise goes swimmingly well at first, but then goes terribly awry. Only with luck does Joel avert total disaster and, amazingly, come out smelling like a rose.

Ahhhh...if life only worked that way. If only we could take those big risks and have them pay off big, or at least turn out reasonably well. It's especially tempting to think we might pull that off with our investments. Maybe get lucky. Or maybe not. Let's not forget that Risky Business is a Hollywood fiction.

What does all this have to do with building wealth? Well, if you're serious about getting the wealth you want you're going to have to come to grips with "risk." Specifically, you'll need to know the amount of risk in your investments, as well as the amount of risk you can emotionally tolerate before going sideways. To succeed, you'll need to balance the two.

Fortunately, knowledge takes you out of the dark and neutralizes fear. And fear is your worst enemy. In its grip, you can't make a good decision. That's why today we're going to look at the risk in our lives and investments, reflect on how we feel about it, and make a risk-tolerance plan that's both comfortable and effective for the longer term.

Here's why this is important. Naturally, you're not going to invest in anything that you know will lead to losses. But, unavoidably, today's best investments will give you some short-term losses, and in order to make much larger long-term gains you'll have to endure them. That's how Dow Double Diamond works. It's what we call taking one step backward before taking two steps forward.

The important thing is to know in advance what you're dealing with, so you're not taken by surprise and then driven to mistakes. One of the biggest mistakes is to quit in an emotional moment when you're upset by losses. Quitting just guarantees that your loss will be permanent, and it puts you farther from your goal. Fortunately, preventing this common error is easy when you know in advance just how much risk you can tolerate.

Life is, as Joel discovered, risky business. You take risks every time you get into a car. Participate in sports. Or step out of a shower. Think back: you took a risk when you chose a college or entered military service; when you decided on a career path; when you dated; most certainly when you chose a life partner; and of course with your investments.

There is, indeed, some risk in every action. Most of us readily accept these everyday risks, but it gets a lot more complicated when it comes to our money. Money represents freedom, power, security, even our sense of who we are. We don't want to lose or diminish these things. But without knowledge, we unwittingly enter into a kind of emotional mine field. And if we're unaware, quite unexpectedly our wealth dreams can blow up and vanish into thin air.

We don't want that to happen, so let's get some risk knowledge, and let's also reflect on how we'll react to short-term losses. I think we're all willing to endure some short-term downside risk for a much greater long-term reward, but how much? That's what we need to find out. Let's look at the risk in some popular investments, and also gauge the risk-to-reward ratio for Dow Double Diamond.

You're probably not inclined to invest in real estate. Most experts agree that in recent years a "real estate bubble" has developed, and in 2006 we could see a popping of that bubble. Once deflated, it could take years for prices to rebound.

Most likely you are not considering bond investments. The current rising interest rate climate is unfavorable to bond prices. And even though the rate hikes will soon come to an end, it'll be some time before bonds do really well again. And even under the best of conditions, they don't generate returns that can build wealth quickly.

Gold and other precious metals are a possibility, but do you feel comfortable with them? Do you feel you can gamble your future on them? The problem with this investment class is that it performs well just once in a while, and then does poorly the rest of the time. Unless you're an expert in the field, it's just not a practical wealth-building vehicle.

Buying and holding stocks today is probably way too risky for you. From 1982 to mid 2000 we saw a great bull market. But since then, technically speaking, we've been in a bear market. Yes, the Dow has climbed back pretty close to its 2000 high, but consider that 2005 was a down year. Also consider that many experts are saying that in 2006 we're likely to see another leg down in what will eventually be a 10 to 15 year bear market.

And look at this: Since 1929, there have been 8 major bear markets with a 20% decline or more. Had you bought the Dow at the high just prior to these bear markets, you would've suffered an average 42.75% decline, and you would've needed an average 82.23 months just to break even. That's 7 years of making no money for each bear market, for a total of 56 zero-gain years out of the 76 years since 1929 (so much for the buy-and-hold strategy)!

By contrast, Dow Double Diamond looks very attractive, and not just this year but every year. I'm biased, of course, but with this vehicle we don't have to worry about interest rates, the price of gold, whether corporate profits are good. Whether the consumer is confident. Whether the real estate market is stretched. Whether we have war or peace. Or even which way the Dow is headed. None of that matters because our plan trades in both directions and profitably captures a majority of the Dow's short-term moves. It's what we call an "all weather plan."

Still, it would be unfair to talk about major bear markets in the Dow without also considering the major down periods for the Dow Double Diamond. So I asked Jim if he would help us do a "compare and contrast." And here's what he found out...

Jim examined the DDD plan from 1997 through 2005 and noted every drawdown of 4% or more. Why start at 1997 and use only a 4% or greater loss? First, 1997 is the furthest year back for which we have accurate data, and looking back any farther would be inappropriate anyway, since Jim designed the DDD plan for the modern period (Dow above 5,000). Second, for those trading DDD with 5x leverage, a 4% cash loss represents a 20% leveraged loss, and that matches the "20% or more" bear market criteria we're using for the Dow.

Okay, since 1997 the DDD plan had 10 declines of 4% or more. The average loss was 10.9% and it took 7.26 months to recover back to the break-even point. Now, let's make a straight-up cash comparison: While Dow investors needed 7 years to make up an average 43% bear-market loss, DDD investors needed 7 months to make up an average 11% bear-market loss.

Expressed another way, The DDD plan has shown itself to be 4 times more favorable than buying-and-holding the Dow on losses. And 12 times more favorable on break-even time. I think we can take those stats to the bank.

But what about leverage? At 2x, the DDD plan's 10.9% drawdown becomes 21.8%. At 3x it becomes 32.7%. And at 5x, it becomes 54.5%. If you're using leverage, that's what you'll have to endure. And for what gain? (update: nearly 4-year returns, combining back-tested and live trading results from July 2002 thru April of 2006, show compound annual growth rates of 34%, 52%, and 86% for DDD at 2x, 3x, and 5x investing respectively).

Keep in mind that, while back-tested and past results are not necessarily indicative of future returns, all of our stats show the greatest DDD returns were produced by the 5x trading despite the drawdowns. The second greatest returns were produced by the 3x trading despite the drawdowns. The 3rd best returns were produced by the 2x trading despite the drawdowns. And the 4th best returns were produced with 1x, or straight cash trading.

As you can see, higher gains come with leverage, and the highest gains come with the highest leverage. But bigger drawdowns also come with leverage. And you can't get the greater 2x, 3x, and 5x returns without also enduring their higher drawdowns, as well as the average 7-month recovery time to break even.

Can you do it? Only you can answer that question. Obviously, if you quit in an emotional moment before your account has a chance to recover, you lose. But if you persevere, history is on your side to go on to attain the potentially very high annual DDD returns that will build the fortune you want, and probably a lot faster than most other investments.

Think it over. With reflection and your newfound knowledge, you might find that some of your fears are unfounded. You might discover you can handle more short-term risk than you previously thought you could. Or you may discover you've been taking too much risk and need to make an adjustment.

Look at the numbers and ask yourself, What size loss can I emotionally endure? What approach will enable me to persevere so that I can attain the DDD returns I need to reach my goal on time?

Once you have the answer, you can choose a DDD allocation plan (among the 2x, 3x, and 5x approaches) that you can comfortably live with. One that will enable you to continue with the plan through good months and bad, until the day you arrive at your wealth goal.

To sum up, you need to know the risk in your investments, and you need to know your emotional risk tolerance. When you know those two things--and you act according to this knowledge--you'll be giving yourself the greatest chance for success. For you, life may be still be risky business, but like the movie character, Joel, you'll come out smelling like a rose!

Happy New Year! I'll see you next month.

Sincerely,

Dick Sanders