A method for portfolio management is probably the most important concept to nail to have a high probability of successful investing. Improper portfolio management can ruin your performance, even if you have selected the proper investments. We'll cover several topics that will get you started on your path to active portfolio management in a conservative and intuitive way. These methods will put you way above the average novice investor in terms of skill and performance.
Portfolio Composition
Diversification. I'll say it again, DIVERSIFICATION. Why shouldn't you put all of your money in your favorite stock? Because there is one thing we can be sure of, we can very accurately predict that the market will be unpredictable. What if you invested in only tech stocks during the
dotcom bubble? You would've been completely wiped out.
Diversification of a portfolio can be accomplished by selecting a minimum of 5 stocks, each in different industries. Examples of industries include technology, energy, financials, healthcare, metals & mining, retail, etc. etc. Diversification also means that any one of your positions should not occupy a substantial portion of the portfolio. I like to keep an individual investment, and an industry, to less than 20% of my portfolio.
Diversification, a mundane topic, can be exciting to watch. On days when part of my portfolio goes down, another part of the portfolio goes up. To illustrate this fact, let's look at an example of diversification with an energy and airline stock. When oil prices go down, energy companies like BP go down, but airlines like LUV go up! The lower oil prices mean lower revenues for BP, but also lower fuel costs for LUV. Bingo!
Buying
A typical mistake for beginner investors is to find a stock we love and buy it all at once. This may work the first time (though probably not), but I can ensure you that you are not the one individual on the earth that can always accurately time the market. No worries though, we don't even have to try to. The way to work around the timing issue is to buy our position in increments. I typically use increments of 1/3. If I want 60 shares total of a company, I will buy 20, then another 20 as the price declines, then the final 20 as the price declines further. I don't always get to fill my desired position (3/3), but that usually means that I am making money because the share price is going up rather than down. Declines between 5% and 10% are typically good values to use between increments. Common Cents uses 7% to 10%.
Let's illustrate a model portfolio with actual numbers to get a better idea of how this strategy works. A model portfolio with a total value of $10,000 will include 5 positions of $1,650, and each position will be comprised of 3 increments of $550 each. But that only totals $8,250. One of the most important positions in everybody's portfolio, which will total $1750 in this portfolio, is CASH. Keeping cash on hand will allow us to take advantages of market volatility (see next section below). Also, cash goes down 0% when the market declines, so it is a good way reduce the impact of widespread market declines. Here are a couple of summary equations for portioning your portfolio:
Desired allocation for each position = Total portfolio value / (desired # of stocks + 1) Position increments = Desired allocation for each position / 3
Let's quickly review the example above. Desired allocation = $10,000 / (5 stocks+1cash) = $1,666 or approximately $1,650. Position increments = $1,650 / 3 = $550.
The desired number of positions and 1/3 increments are not hard and fast rules. They are just guidelines to get started. The number of positions can be increased (decreasing below 5 may not be the best idea), and the incremental buying strategy can be used with 1/2, 1/3, 1/4, or any other increment. However, it is important to consider transactional costs when selecting an increment.
Trading Around a Position
Trading around a position is how we use our cash on hand to take advantage of market declines. When trading around a position, you aim to repeatedly buy low and sell high. Easy enough, right? Well, actually it is. When Common Cents gets a full position (i.e. all 3 increments have been purchased) and the stock declines further, I will add another 1/3 to the position (totaling 4/3 of the desired position). If the share price moves up a substantial amount, typically between 5% and 10%, Common Cents will sell that last 1/3 of a position to bring the allocation back down to 3/3, or back to the "full position." The more this happens, the better. This helps to keep a cool head when the market is declining because, while the value of your portfolio is declining, you can view the lower share prices as a sale that you can profit off of! It can truly be a win-win for you, regardless of the market direction!
Common Cents Take: Buy in chunks as the share price declines. Trade around your position to take advantage of market volatility. And be diversified!! These strategies will drastically improve your chances of success when investing and will allow you to profit regardless of the market direction.
That does it for the basics. You should have all the tools you need to get your feet wet in investing. Just remember, assume you will lose all of your money when you first start, so don't invest more than you are willing to risk losing. Paper trading, where you keep track of your investments on paper without actually transacting, can be a useful way to get accustomed to the market without risking hard-earned greenbacks.
So go have fun and make some money! Investing can be extremely rewarding (and frustrating) both monetarily and personally. Use your tools, keep a check on your emotions, and absolutely never forget your COMMON SENSE!!!
