February 3rd, 2011
The following continues yesterday’s posting on Assembling a Watchlist:
Acting on the Watchlist:
We don’t want to find The One Stock that is going to appreciate the most over the next 3-, 6- or twelve-months but we do want the sum total value of our portfolio to grow. Alternatively, we could exactly match the performance buy all 500 stocks comprising the S&P 500 Index by putting all our money into an index fund or the SPY etf. Our objective is, however, to have our portfolio grow somewhere between these two extremes: not as much as the best performing stock but faster than the benchmarket index. We do this be putting our money in stocks that move first, focusing on those that move the most, and minimizing the amount of money in stocks that are underperforming the benchmark index.
The Pot: Investors who buy a company’s stock using the fundamental approach described in yesterday’s post, consider themselves as having become an owner, albeit a very small fractional owner, of that firm. They track quarterly reports, look for news stories concerning the company and may even support the firm by purchasing its product or service to the exclusion of competitors.
On the other hand, I view a portfolio as a pot full of purchasing power. At certain times and under certain circumstances, the assets in the pot should to be very safe and contain mostly cash (2008 is a good example). At other times, you’ll invest the purchasing value in risky assets in the hopes that total value grows. You should be indifferent as to which stocks or industries comprising the pot so long as each of the risky assets in it grow or have the prospect of growing faster than the benchmark.
Diversification: The one truth that’s uncontroversial is that risk and return go hand in hand: assume more risk and you increases the opportunity for higher rewards, reduce the risk and your rewards for assuming that risk will be lower. At one extreme, a portfolio comprised of only one-stock will perform exactly as does that stock. At the other extreme, spreading risk over 500 stock will make the impact of any one stock on the total value of the portfolio nominal. How much you want your portfolio to grow will dictate the amount of risk you want to assume; how much risk you want to assume will dictate the potential reward you could see.
The Market: The basic truth that revolutionized my view of stock investing was Benjamin King’s 50-year-old principle: “50% of a stock’s price movement can be attributed to the overall movement in the market, 30% to the movement in its sector and only 20% on its own.” Stocks bought early in a market’s upward trend and held to the end of that market trend can produce huge returns; you’ll be lucky to breakeven on stocks bought at the end of a market trend; buying stocks when the market is trending lower is a fool’s game. When the market is approaching what could be the end of a market trend, the focus should be on assembling a Watchlist of stocks to buy at the beginning of the market’s next leg up.
- Orders vs. Alerts: Let’s go back to the 250 or so stocks in the Watchlist and the question of finding the right stocks on the list to buy. At the beginning of a market cycle, the portfolio will usually contain mostly riskless purchasing power, cash. By setting a trigger level for each stock in the Watchlist, you’re deciding at what price you think the stock begin a new upward trend. You can convert those trigger prices into action either through:
- Stop-Limit orders: orders that will automatically convert to limit orders when the stock actually hits your predetermined price (as a limit order, there’s no guarantee the order will fill at that price). Stop-Limit orders are the flip side of a stop-loss order that automatically converts to a market sell order should a stock you own decline to a certain price. If stop-loss orders insure against unanticipated losses, then stop limit orders help you buy stocks you feel are beginning to move early in their new trends.
- Alerts: rather than being automatically converted into an transaction, the stock price moving to a trigger level generates a message to you. What you decide to do with the message is up to you depending on how much cash you have, how many stocks you already have in your portfolio, how many stocks you may already have in that industry, how far along you believe the market is in its cycle. You are in total control; you can buy today at the trigger price, you can wait a few days to see if the trigger price holds, you can totally ignore the trigger and wait for the next stock trigger to be sent to you.
More to follow.