Portfolio Building Strategies for Stocks
Building a portfolio of stocks is not unlike building a
professional basketball team. You have to balance your supposed
superstars with a quality supporting cast, and you cannot
overload in one area. Balance, balance, balance. Especially if
you are like yours truly living off of your portfolio, wild
fluctuations, will kill your psyche, and your ability to operate
in a logical fashion. For us a stock portfolio consists of
around 10 holdings. For those of you who regularly trade along
with us at http://www.livingonlargecaps.blogspot.com, you know
that our holdings last for around four weeks. But even if you
hold stocks long term, or day trade, the philosophy of portfolio
building remains unchanged. The basketball analogy works if you
think about how many Michael Jordans you really need on one
team, the answer of course is one. At any given time, the stock
market will have a few hot sectors. Your superstars come from
these sectors, however, you can't overload your portfolio with
stocks from these sectors because, when they fall out of favor,
which they often due without warning, your portfolio will skid
along with them. So what you need is a supporting cast to prop
up your superstar, when the game goes against them. Your
supporting cast likely will shine when your superstars are
crashing, they need to be complementary. An example that is
relevant right now is the energy sector, and more precisely oil.
Oil stocks have had a grand bull market, while the overall stock
market is treading water, the oil sector has been hot. However,
there have been corrections along the way. And one of these
days, it will be more than a correction, it will be a trend
reversal. It is very expensive to try to guess the trend
reversal, as you will be wrong along the way many, many times.
Especially in a pure sector like oil. The factors that lead to a
bull market in oil are easily identifiable, and the news coming
out is either bullish or bearish, it really needs very little
interpretation. Now take a sector like insurance. On first
glance the recent hurricanes should be bearish for insurance.
However, insurance also profits from favorable monetary policy
and interest rates curves. It is also a defensive sector so
traders will buy insurance when they are worried about future of
the stock market. In other words, there are many factors that go
into an insurance sector bull market. And to complicate it even
further, insurance companies do not move in lock step fashion
nearly as efficiently as pure industries like oil. Oil stocks
are like a well regimented military unit. Back to our example of
portfolio building, the oil sector's bull market, has been
interrupted along the way. If you have been 100% in oil stocks
you actually would have done very well, however, your portfolio
would have had a tumultuous ride. A correction can last for up
to two weeks, and in that time your portfolio might have correct
up to 15%, a nail biting, ulcer inducing, dip in your net worth.
However, cushioning your oil stocks with say a stock that
upticks when the oil sector is going bearish on us, would have
resulted in a smoothing effect on your portfolio, and lessened
those nail biting periods filled with self-doubt, when you ask
why you even bother trading stocks, and that nine to five job
suddenly looks comforting. Some quick and fast rules we follow,
is no more than two holdings at any one time in related
sectors.. No more than 80% of our holdings are to be longs,
unless some longs actually go counter to the current trend. Such
as oil stocks, which actually are counter to the bulk of the
market. But if you have eight longs in say, insurance, banking,
retail, heavy machinery, technology, etc., then you must have
two shorts,. You will be surprised the smoothing effect that the
counter holdings provide. If you check your portfolio daily, and
let the gyrations effect your mood, it is important for clarity
of thought if nothing else. Always, always let the charts
decide, arm chair quarterbacking is expensive. Like guessing a
trend reversal, let the charts dictate and you trade
accordingly. In fact, I go so far as saying having an opinion is
expensive. I had thought oil was wildly over bought and highly
speculative for a long, long time. But the charts kept looking
good, so my opinion doesn't really matter, only the facts
displayed in the charts do. And yes, sometimes they are wrong,
which is yet another reason to diversify.