April 8th, 2010

Focus On Portfolio Rather Than Individual Stock Risk

A reader asked “I’ll presume of course, that you do keep a stop loss order set? How do you set yours – do you keep yours set at the closest price where there was a major/minor peak?”

My initial response was going to be a direct “I don’t believe in stop losses” but, as I thought about it some more, I realized that a more lengthy answer was necessary and warranted. StreetAuthority.com, a financial publishing firm that aims to level the playing field for small investors by giving them access to the ideas and insights of some of the country’s top investment researchers, analysts and writers, offers the following information on stop losses:

“almost all trading experts will tell you that stop losses are an important part of trading discipline, as they can prevent a small loss from becoming a disastrously large one. What’s more, by diligently setting stop losses whenever you enter a trade, you end up making this important decision at the point in time when you are most objective about what is really happening with the stock.”

At some personal risk, I’ll take the other side of that discussion. Rather than being a discipline, I believe stop losses actually indicate an absence of discipline. I believe stop losses are used by short-term traders as a crutch for gambles that don’t pay off the way the trader expects. If you’re an investor and look at stock investing in terms of cash and risk management, you follow an actual discipline to reduce the risk of suffering a devastating impact on your portfolio from any one individual stock moving against you. Here’s one way of doing it:

  • Follow a “single decision” trading discipline. The market dictates 50% of the movement of most stocks so the focus should primarily be on timing the market. When the market goes up, most stocks will also go up (face it, you’re not really a genius picking a winners, it’s the market that makes stock picking so easy). There’s little risk that an individual stock will fall significantly when the market is trending up.
  • Industry Sector dictates 30% of the typical stocks movement. If money is flowing into retail or banking or semiconductor industry stocks, for example, then most stocks in the industry will move up in tandem. By concentrating your holdings into industries then in vogue you further minimize the risk of suffering a surprise, significant loss to your portfolio.
  • Inoculate your portfolio against devastating surprise losses by diversifying into a large number of individual stocks. After deciding what percentage of cash you want to put at risk, target each individual stocks in the portfolio to be less than 5.0% of the portfolio’s total value.

If you follow this discipline, you should try to hold each positions until any of the following events triggers a sale:

  • the direction of market’s momentum turns negative
  • the industry is no longer a leading group
  • you quickly discover that a stock recently purchased fails to perform as expected (i.e., falls about 10% sometime with first 4 weeks of owning it)
  • the stock becomes subject to M&A activity
  • the stock has an unexpected adverse corporate event such as accounting restatement, fraud, major litigation, strike or management restructuring.

Stop losses insure against a very specific risk, the risk that an unforeseen corporate event drives the price of an individual stock lower. By actively managing a portfolio and continuously monitoring it’s performance daily against the S&P 500 you have the advantages of stop losses without the associated negative consequences. The only way of introducing stop losses into this discipline without running the risk of being accidentally stopped out of a position is to use wide (15-20%) trailing stop losses on each position that trigger only should a stock decline 15-20% below a recent high.

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  • Manoj

    Hi joe
    Excellent post, I learned (50-30-20) rule from you. For market (50%)
    part moving avergaes & your posts
    keep us informed. My questions are-
    1) How can small investor like me keep track which sector(s) are currently favoured and money has starting going out of them?

    2) How to pick stocks from favoured sector?

    Thanks
    Manoj

  • Joe

    Manoj, I could give you a smart answer like "I'll write about favored sectors here".

    But a pretty good source is in IBD. Look at the industry groups that have advanced 50 positions in ranking over the past several weeks and are still below 70-100 in current ranking.

    Once you have found a sector (the best ones are those including 10 stocks or more) you have to scroll through all the charts to see whether they have formed similar patterns (consolidations, breakouts, reversals) and pick the ones that meet your criteria (most volatile, highest dividend, etc.).

  • DG

    (wow) Thanks for your thoughts and the full response Joe.