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Thank you for accessing this Pitfall #1 and #2 page.
When you hear of someone making a huge killing in the market on a relatively small trading account, more likely than not it was a fluke: The trader was not using sound money management techniques. The trader probably exposed his trading account to obscene risk due to an abnormally large trade size. The trader may have just gotten lucky and experienced a profit windfall. Trading like this means it's just a matter of time before huge losses dwarf the wins, and the trader is devastated emotionally and financially.
Money management in trading involves specialized techniques combined with your own judgment. Not adhering to a sound money management program can find you exposed to a deadly risk of ruin, and, worst of all, most probable equity bust. Keeping this in mind, you may find a few essential money management techniques can make a big difference to your bottom line. Here are some things to remember when it comes to money management.
CALCULATING PROPER TRADE SIZE
If you are trading the exact same number of shares or contracts on every trade, you may not be calculating the proper trade size for your own risk tolerance. Trade size can vary from trade to trade because your entries, stops, and account size are constantly changing variables.
To help reduce your risk exposure, the first step is for you to believe you need this sort of program. Usually, this belief comes from suffering a few large losses that make you want to change. This kind of experience can enable you to see how the wrong trade size and lack of discipline can sabotage your trading results.
Calculating proper trade size is a relatively simple process and can ultimately reward you with greater profits and more efficient risk control. In Active Model Positions, I calculate the maximum trade size using a proprietary algorithm.
Sorting out the criteria for a coherent money management plan is a complex, detailed job. Using a spreadsheet to keep track of the logic helps ensure nothing has been omitted.
With a little planning, you can develop a logically sound money management system. Historically, too much emphasis has been placed on the development of profitable entry and exit rules, whereas the determination of the proper number of contracts or shares to trade has been treated as a distant afterthought.
An individualized money management algorithm (using a spreadsheet program such as Microsoft Excel) will control the equity growth of any positive-expectancy system as a direct function of using correct position sizing. Risking too large a portion of trading capital per position will eventually cause even the most profitable trading system to fail.
The second advantage to developing your own position-sizing strategy is to preserve trading capital during periods of extended drawdown or losing trades. This saves you the money to trade when things finally turn around. Unfortunately, many traders inadvertently lose their hard-earned trading capital as a result of improper position sizing. This becomes painfully obvious when they have risked too much capital over an extended series of losing trades.
I developed an effective money management algorithm using Excel 5.0. It is based on the theory of using volatility-derived stop-losses as a logical method to allocate capital. The logic behind using a volatility-based stop compared with a fixed-dollar stop is that the volatility-based stop can dynamically adjust to changes in a stock's recent price noise. This contrasts to trading with a fixed-dollar stop, which ignores volatility by forcing the placement of an externally derived, subjective stop without considering the underlying trade's true character.
As an example, assume stock XYZ has traded within a range of $10 to $12 per share over the last 14 days, with an average price during that time of $11 per share and a standard deviation of $2. A stop-loss could be placed at the time of entry such that it is so far away that it will never be touched except during rare events which cannot be predicted in advance. The stop loss is the core of any system. If the stop is vulnerable, so is the entire system.
If the position is losing, add (scale) on to the positions (pillar/pyramid) if the Bullish/Bearish pattern is still valid (re-design the system), but if the pattern is destroyed, swallow your pride, close the position and take a loss.
When the trend has caught up, setting the stop at this $4 per share risk acts as a useful proxy of the stock's recent two-week normal price fluctuations. A stop-loss placed at this level is now less likely to suffer whipsaw losses solely because of a stock's normal price volatility.
My algorithm allows a portfolio to grow at an above-average rate of return while consistently controlling risk. You should examine the assumptions inherent in my model and make changes in the values to reflect your own overall risk tolerance and trading philosophy
My algorithm is based on the following personal assumptions:
1. The maximum number of open positions is limited to 8/per major sector (Stocks/ETFs, Intrest Rate sensitive Instruments and Commodity Futures).
2. The optimal trade-size should be 50% of the capital risked for 2 positions or 25% for 4 or 4% for 24 or 2% for 48 positions in the portfolio which is what the optimum kelly criterion approaches for systems which have a Portfolio Reward Risk Ratio (PRRR) of 2.0 and %wins of 50. The typical portfolio% risked for all positions (FOREX, 1-month, 3-month, 6-month & 12-month Money Market instruments, Stocks and Index Shares and Commodity positions varying depending on the contract involved; longer-term (1-30 years) Bonds and T-Notes) is 0.5% of total equity, assuming that the system has a positive Expectancy and Profit Factor (W:L Ratio)is greater than 1.0. Keep the max. # of positions to 8 for each of stocks, forex and futues. There is no reason to have more than 8 positions for each of stocks, forex and futures. Its far easier to buy the indices. This is a numbers game. The Dow has only 30 positions as its components. HOLDRs funds such as BBH, HHH and TTH have as few as 20. Why is it then, that so many investors go through the trouble to have 20 and 30 positions for stocks in their own portfolios? You dont need to be a statistician to figure out that the more positions you have the more your portfolio will begin to behave as an index. That investor would be better off to buy the indices themselves because most indexes will beat 80% of all managed funds. But if you are in the rest of the brave 20%, use the 0.5% equity risk model and never risk more than 1% for 24 positions, assuming a 24% DrawDown at a losing streak with 1 in 26667 odds of ever occurring will consist of 24 consequtive losses.
Focus investing
While there are a handful of exceptions such as Peter Lynch, the overwhelming majority of great investors that I'm aware of practice focus investing. They invest infrequently, only when they're highly confident that the odds are heavily in their favor, and then they bet big. (Not surprisingly, research shows that the same approach works in other endeavors such as poker or betting on horse races. For more on focus investing, see Bob Hagstrom's excellent book, The Warren Buffett Way.)
Berkshire Hathaway's (NYSE: BRK.A) Warren Buffett and Charlie Munger have commented on this topic in recent annual meetings (Wesco (NYSE: WSC)). Munger commented, "If you took out our 15 best ideas, most of you wouldn't be here.…We have this investment discipline of waiting for a fat pitch."
Buffett added:
I keep xeroxes from annual reports 50 years ago. [Some ideas were] just so obvious. I knew when I sat with the CEO of GEICO 50 years ago that it was a big idea.
If we start buying a stock, we want to go in heavy. I can't think of a stock where we wanted to quit.
We've made some big mistakes starting to buy something that was cheap and within our circle of competence, but trickled off because price went up a bit. Good ideas are too scarce to be parsimonious with.
You don't have to be right on everything or 20%, 10%, or 5% of businesses. You only have to be right one or two times a year. You can come up with a very profitable decision on a single company. If someone asked me to handicap the 500 companies in the S&P 500, I wouldn't do a very good job. You only have to be right a few times in your lifetime, as long as you don't make any big mistakes.
It seems so obvious that it makes more sense to buy more of your best idea than add a 100th position to a 99-stock portfolio, yet the average mutual fund holds more than 100 stocks. In almost all cases, this is foolish "deworsification" and reflects closet indexing rather than prudent money management. Munger agrees, noting that "What's funny is that most big investment organizations don't [look for the fat pitch]. They hire lots of people, evaluate Merck vs. Pfizer and every stock in the S&P 500, and think they can beat the market. You can't do it. Very few people have adopted our approach." Buffett added: "Ted Williams, in his book The Science of Hitting, talked about how he carved up the strike zone into different zones and only swung at pitches that were in his sweet spot. Investing is the same way."
Pitfall #2. Planting too few seeds. This one goes hand in hand with the first pitfall. The key here is diversification and following several markets. I watch for over 200 markets and look for profit opportunities in each one as they occur. PLANT MORE SEEDS AND YOU CAN ENJOY MORE WINNERS.
Diversify, But Don't Overdo It
It's surprisingly easy to buy too many stocks. Probably the first investment advice you ever received was to diversify. It's likely no one has ever told you that you can overdo it.
Novice investors do well to invest in the indices themselves: The Dow Jones Industrial Average, The NASDAQ Composite Average or the S&P 500. These indices are in fact well-managed portfolios of the leading companies in the world's most powerful industries.
There's a good reason that the majority of money managers can't beat the annual gains returned by these indices. An index is a basket of funds that are managed by an unforgiving set of rules. For example, the NASDAQ 100, which can be purchased with the stock symbol QQQ, consists of the top 100 NASDAQ-traded stocks weighted by market cap. When a company falls below the 100th largest company, it falls from the list and a new one takes its place.
That's a very simple formula and it's proven an extraordinarily powerful investment regimen. There are plenty of stocks that offer substantial diversity, such as QQQ, HOLDRs and SPDRs, without the damaging expenses of a mutual fund.
It is unlikely that you'll make better timing and investment choices over the years than the simple formula of the NASDAQ-100. However, if you are one of the bold 20% who dare to try and succeed then you'll have to follow a different plan.
Position sizing
OK, let's say you're convinced that focus investing is the way to go, and you've found a stock about which you're trembling with greed. What percent of your assets should you invest in it? 2%? 20%? (Or, given the cheap, easy leverage these days, 200%?) The answer depends on a number of factors such as your tolerance for volatility, the expected upside, and the potential downside. Generally speaking, my ideal portfolio would have 8-17 well-diversified 50-cent dollars (e.g., stocks trading at half of my conservative estimate of their intrinsic value), 8-17 forex positions and 8-17 futures positions, of which roughly five were 2% positions and rest were 1% positions.
I did not pick this range of 8-17 Stocks/Fx/Futures arbitrarily. In Joel Greenblatt's brilliant book, You Can Be a Stock Market Genius, he provides the following statistics (see pages 20-21):
* Owning 2 stocks eliminates 46% of nonmarket risk of just owning one stock
* 4 stocks eliminates 72% of the risk
* 8 stocks eliminates 81% of the risk
* 16 stocks eliminates 93% of the risk
* 32 stocks eliminates 96% of the risk
* 500 stocks eliminates 99% of the risk
Once one has a well-diversified, balanced portfolio of stocks, adding additional stocks does little to reduce risk, yet there's obviously a big penalty in terms of performance if one's best ideas are 1% positions instead of 2% positions.
Keep in mind, however, that there is no right answer. I know many fantastic money managers who own a few dozen stocks and some who own only a half dozen, but 8-17 is the level at which I'm comfortable. You need to find your own comfort zone.
Here's a proven strategy I recommend for the absolute beginner. Start with 100% of your holdings in QQQ. It's an index. It's not exciting, but it's safe, diversified, growth-oriented and will beat 80% of all managed funds. Then, explore the market for months using my subscription and a few tracking portfolios.
When you've proven your savvy in your tracking portfolios it's time to make a move to individual stocks. Keep the number to 8 or less for the first $100,000 you've pulled out of QQQ. Keep it to 12 or less for the next $500,000. Again, there is no reason to have more than 17 positions for over a million dollars. It's far easier to buy the indices.
There is a diversity of kind as well as number. Sticking to 8 stocks for $100K of gain is fine, but not if they're all networking stocks. The reason for this is simple. Stocks within an industry tend to move with each other, so when a downturn hits technology you'll need positions rising in utilities, drugs, consumer good or others to reduce the impact. Of course, you'll have the stop loss rule so the damage will be minimal.
Diversity, like buy-and-hold investing, is a cardinal sin that must be bent, not broken, if you are going to have above-average returns.
When Crystal Balls Break
I'll be the first to admit that my crystal ball is broken.
The lousy thing cannot help me predict the future at all. It did not tell me, for example, that Merck (NYSE: MRK) would find sufficient trouble with Vioxx to justify an instant, worldwide, and early complete withdrawal of the drug. In late November of 2003, the company faced questions about its pipeline. I took the opportunity to buy a small position in Merck, believing that my price of $41.23 represented a decent price for the firm. The company was below any price it had been since 2002. I believed that I was finding a solid company at a fair price.
That was before the Vioxx incident. Like many other investors, my account got hit when Merck announced its withdrawal. Fortunately, through the power of diversification, a single-company problem like Merck's had a muted effect on my portfolio, and all in all, I'm holding my own.
Diversification, when done right, is the only free lunch (or nearly free lunch, at least) in investing. There are no guarantees, of course -- even well diversified portfolios can lose money. And although in theory it's possible to make more money by investing in fewer stocks (diversification spreads out your gains as well as your losses), virtually all investors -- especially value investors -- are willing to give up the occasional wild upside for protection against the inevitable one- or two-stock plunges that wreck undiversified portfolios.
Two simple rules
There are two key rules of proper diversification as it applies to the value investor, and those rules must be followed to keep diversification from turning into di-worse-ification. The first key rule is that the companies must be in separate and unrelated business lines. Computer chip makers Advanced Micro Devices (NYSE: AMD) and Intel (Nasdaq: INTC), for example, are in substantially similar businesses, so owning both would not help an investor's diversification. Owning one of those computer chip companies along with Pepsi (NYSE: PEP), whose Frito Lay division makes potato chips, on the other hand, would be sufficient business separation.
The second key rule is that an investor must keep each company's value in mind when making each individual purchase. In other words, don't use diversification as an excuse to stop hunting for values. Google (Nasdaq: GOOG) may be in a totally separate business from United States Steel (NYSE: X), but that doesn't mean that either one of them would make a particularly good investment at any price. I use a 12% discount factor to determine valuation. That 12% represents my required rate of return -- the total return over time that I would expect to receive if a company I own managed to meet my operating and growth expectations. Using that number, which is moderately high as discount rates go, to help determine my purchase price keeps me focused on not overpaying for any given company. Were I to ignore valuation, my expected return would suffer.
The rubber hits the road
With those thoughts in mind, it is relatively straightforward to set up a pretty well diversified portfolio and have a measure of protection against individual company problems. For an example, take a fictional investor who had an equal dollar stake on Dec. 31, 2003 in these 10 companies: insurance company Allstate (NYSE: ALL); pipeline company Kinder Morgan (NYSE: KMI); clothing retailer Gap (NYSE: GPS); software giant Microsoft (Nasdaq: MSFT); mortgage finance giant Freddie Mac (NYSE: FRE); mall operator General Growth Properties (NYSE: GGP); restaurateur McDonald's (NYSE: MCD); the aforementioned Merck, home improvement warehouse Home Depot (NYSE: HD); and waste collection company Republic Services (NYSE: RSG).
The following illustrates the year-to-date performance of such an investor's portfolio, as of market close on Oct. 18:
Portfolio
Ticker 12/31/03 Price 10/18/04 Price YTD Dividends YTD Total Pre-tax Return
ALL $43.02 $48.06 $0.84 13.67%
FRE $58.32 $65.50 $0.90 13.85%
GGP $27.75 $32.39 $1.26 21.26%
GPS $23.21 $19.87 $0.07 -14.09%
HD $35.49 $40.18 $0.24 13.89%
KMI $59.10 $64.04 $1.69 11.22%
MCD $24.83 $29.20 $0.00 17.60%
MRK $46.20 $30.90 $1.12 -30.69%
MSFT $27.37 $28.44 $0.08 4.20%
RSG $25.63 $29.57 $0.24 16.31%
Total 6.72%
In spite of Gap's meandering, Microsoft's stagnation, and, yes, even Merck's Vioxx problems, this account would have held up quite well. Compared to the S&P 500, as represented by "Spiders," which are shares of an ETF that tracks it, this portfolio absolutely shined. During the comparable period, the Spiders moved from $111.28 to $111.68, and paid $1.28 in dividends, for a year-to-date total pre-tax return of about 1.51%. Just prior to Merck's Vioxx-induced stock collapse, it closed on Sept. 29 at $45.07. Had Merck's price remained constant in the absence of the Vioxx recall, this portfolio would have shown a year-to-date total pre-tax return of about 9.79%. While Merck's impact still hurt, its blow was reduced by the risk-reducing power of diversification.
Wait a minute! you say, or at least think. Isn't the S&P 500 the epitome of diversification? Why not just buy it, or at least hold a whole bunch of stocks, to maximize the diversification benefit? Good thinking, as it brings up an important question: At what point is diversification too much of a good thing, in the sense that it ends up diluting an investor's hard-won returns?
Well, technically you're diluting from the moment you add a second stock, but academia has indicated that the bulk of diversification's benefit comes in the first 8 to 17 stocks. Tying this into Rule #2 -- don't forget to hunt for value -- doubles the support for holding a moderate number of stocks; it's hard for a thorough, value-investing type to find and keep abreast of too many bargains in the first place. Bottom line? There's no single magic number, but a value investor would do well to stay within the bounds of his or her research capabilities.
Words of Wisdom
Don't just take my word for it. Legendary value investor Benjamin Graham had this to say, via his now-classic volume, The Intelligent Investor, on the subject: "There is a close logical connection between the concept of a safety margin and the principle of diversification... Even with a margin in the investor's favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss -- not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses...."
To paraphrase the master, the individual companies matter, but in the end, it's the total portfolio that has to pay the bills. Value investors, like us, look for ways to improve their risk-adjusted returns. Proper diversification is one method by which investors can reduce the risk to their portfolio as a whole without significantly compromising their overall expected returns, making it a key tool for any value investor's kit.
Have an Accumulation Plan
You may be the type of swimmer who takes a 25-yard running jump into the pool. And it's fun. When it comes to your portfolio, it's better to test the waters carefully and repeatedly. Every position starts out as a short-term trade. But when you pick a winner, you've got to add on. The best time to add on is when a stock in a strong long-term uptrend retraces to a lower price. A healthy trend is characterized by a 2-steps forward, 1-step back price movement. The price will go up 10% in a period of weeks or days, then step back 5%, then repeat this action over and over.
Sizing common stocks
I typically will not add a common stock position to my portfolio unless I'm willing to make it a 5% position. If I don't feel confident enough to invest at least this much, that's a good signal I shouldn't own it at all. Once this initial position is established, I cross my fingers and hope that the stock goes… down. Yup, you read that right, down! Why? Because I want to buy more and make it a 10% position but need a bigger margin of safety to do so.
Sizing shorts
Though I do some shorting, it's an awful business for many reasons, one of which is that one shouldn't do it in size, as losses are potentially unlimited. If a stock is a 7% long position at $15 and drops to $5, it will cost you nearly five points of return, but it won't put you out of business, you aren't forced to sell at the bottom, and -- if you have real guts and conviction -- you can buy more.
But what about a 7% short position at $5 that jumps to $15? That costs you 14 percentage points of return and you may be forced to cover to prevent further losses, even if you have more confidence in the position. Thus, you can see why I rarely make a short position larger than 1% and prefer a basket of even smaller positions.
Sizing options
Given the implicit leverage of options, I tend to make them small positions -- generally 0.5%-2.5%, though it's hard to share any rules of thumb since some long-dated, deep-in-the-money options are very similar to the underlying stock, while short-dated, out-of-the-money options are highly speculative.
Speculations
One might ask why a conservative value investor like myself would ever invest in something highly speculative like Forex and Futures, but I'm willing to make such investments in my portfolio as long as I'm confident that the expected value is much higher than the price I'm paying. Consider an investment with the following expected one-year payoffs:
* Loss of entire investment: 60% chance
* No gain or loss: 10% chance
* 2x gain: 10% chance
* 5x gain: 10% chance
* 10x gain: 10% chance
The expected value of a $1 investment given these probabilities is $1.80, a fabulous return, but let's assume you could only make this investment once. Would you do so, knowing that there's a 60% chance that you'd lose it all? Try explaining that to your investors (or worse yet, your spouse)!
If you did make the investment, how much of your portfolio would you risk? This is not a hypothetical question; in the past few weeks, I faced a very similar choice and chose to invest 2% of my portfolio.
While there's little doubt that focus investing is likely to yield the highest long-term returns, there are no hard and fast rules about how concentrated one's portfolio should be -- it depends on tolerance for volatility, availability of other investment options, the confidence in one's analysis, and many other factors.
When you pick a winner using my subscription, it's best to take a small position first, perhaps as little as 25 shares. When you take a position in a stock you take not only a financial position, you take an emotional one as well. Surely you've noticed your ability to detect your stock symbols from a CNBC screen almost 50 feet away in your favorite watering hole. You're vested. The only way to make money in the market is to pick stocks that trend upward. They have many other characteristics (fundamental strengths and public sentiment), but their primary characteristic is the ability to take 2-steps forward and 1-step back in price action. When that stock steps back, add to your position. Perhaps it's another 25 shares if the information you're finding is convincing.
Pyramiding
I only make strong commitments to financial instruments that give me a lot of positive feedback. As a winning decision is confirmed, I add even more to my total positions. That is, I pyramid. The process of pyramiding is one of the oldest and most successful strategies in investing.
For example, if I take a 300-share position at $12 in a stock that I believe is trending up, and that stock goes to $14, I have received my first confirmation of that trend. I add 150 shares to that position. Over the course of weeks, as the stock reaches subsequent price points, I add another 50, and so on. So I have a total of 500 shares committed to this position and I notice some weakness in the trend, I start closing out just as carefully as I got in.
Similarly, if I take a 300-share position at $12 in a stock that I believe is reversing its downtrend, and that stock goes to $10, I would buy 600 shares on a valid buy signal, and when it subsequently goes to $14, I would again add on to the position with 100 shares and so on. So I have a total of 1000 shares committed to this position and I notice some weakness in the trend, I start closing out just as carefully as I got in. The key point is that, always end up with the least number of positons (shares) at the top of the pyramid.
Pyramiding up or doubling up is the hallmark of a losing investor, because as you pyramid up and when the prices retraces goes past your entry point, it wipes out your profits as there will be more losing positions than winners overall for that stock. An investor with Position Cost Averaging strategy who buys a stock at $12 and sees it go to $10 will think, "I thought it was a good buy at $12, it must be a steal at $10!" and correctly so, as long as your system design is still sound, i.e., your bullish/bearish pattern on which the system design is based on is still valid. If the pattern is destroyed, then you will be automatically stopped out of your long or short position.
This winning psychology has everything to do with investment principles. Buying stocks is much different from buying any other type of item. In fact, there is an inherent (intrinsic) value to a stock, which only the most enlightened are able to discover, outside of the price the general public is willing to pay for it, and then the most enlightened teaches the general public about the value of the stock, but the general public is in general too late to grasp the significance of the stock and left with holding an empty bag. That is why the Contrarian theory which is a weaker form of the Efficient Market Theory, works. The free market is ruled by those who can plan long-range. The better the mind the longer the range of planning.
A winning position is much like a precious crop whose value you must nurture by tending it.
Pyramiding is the process of easing into and out of positions. In a perfect world, we would always pick the stocks that are moving the quickest, throw everything we have at them and exit at exactly the right moment. However, in the real world we must be more cautious.
Pyramiding allows you to move into those positions that allow you time to confirm a stock's prevailing trend.
Let's say that you have $10,000 to spend on a stock that costs $10 a share.
Pyramiding into the stock would mean buying only 300 shares on day one. As time goes by and you see confirmation of an upward trend (that is, it goes to $11 and $12), you add to your position (an additional 150 shares) and then adding 50 on to that that position (now at 500) and so on, ending up with the least number of positions at the top.
On some stocks like CSCO and MSFT, this process can go on for years, provided that you have the financial resources to increase your investments.
Eventually, the trend ends. Pyramiding out means closing positions just as cautiously as you got in.
Using pyramiding, you allow your winners to run and you limit your losses right up front using the stop loss of your system. Also, there are as many variations on this technique as there are investors. Some people will pillar up, i.e., add the same amount of shares to the top of the pyramid which now will resemble a pillar. Some investors will add fractional amounts.
Even best stock pickers are often wrong about individual stock selections. Their portfolios exhibit superior performance because they cut their losses early and they let their winners run.
Trading opportunities in the forex market deserve serious consideration as a diversification strategy for your portfolio.
Trading currencies is not rocket science. Currencies tend to follow fairly strict rules, and are therefore more predictable than other markets. The merits of currency trading, include enormous liquidity and not the least of which are the slow deliberate trends.
Experienced traders often remark that the foreign exchange markets are a technician's delight, as they adhere more closely to the technical indicators than other securities. There is less random noise (that is, volatility) in the forex markets, and trends there are generally of the long-term nature.
While online equities and futures trading have enjoyed exponential growth and widespread notoriety over the past few years, online foreign exchange trading is only now gaining popularity among seasoned active traders, Commodity Trading Advisors (CTAs), and other professional money managers.
Until recently, large international banks dominated the foreign exchange (Forex or FX for short) market, only allowing access via telephone trading to a select few such as Fortune 1000 companies, large funds, high-net worth individuals, and so on. But now, the tide has turned and finally there are established online trading firms that provide individual investors with direct access to the largest, most liquid financial market in the world.
DIVERSIFY YOUR DIVERSIFICATION STRATEGY
In addition to the market's trading opportunities, foreign exchange can be a solid diversification component in your financial portfolio. Most diversification strategies involve a combination of sector allocation, foreign and domestic equities, and fixed income. Some participants have branched out into precious metals and/or energy products; however, few traders consider expanding into forex. Why?
The reason may be in the simple fact that in the US, investors tend to be underexposed to foreign exchange. Unfamiliarity typically breeds misconceptions, and foreign exchange in the US is no exception.
RISKY BUSINESS?
Is forex as risky as everyone thinks? One way to measure risk is to compare a financial product's risk relative to its return. If you take the time to compare an investment in forex to common investments such as equities and fixed income, you will find that from a risk/reward standpoint, forex investments provide respectable returns and should be considered viable portfolio diversification tools.
The rising popularity of foreign exchange trading over the past few years has been impressive. Equity traders fed up with trying to eke out profits in the brutal bear market environment have flocked to the fast-paced spot currency markets in record volumes. This rise in forex's popularity can mostly be attributed to the clear advantages that currency trading has over other markets. Unlike trading equities, foreign exchange offers traders true 24-hour trading, excellent liquidity (over $1.5 trillion a day), and great leverage (up to 400 to 1).
Another big factor behind the increase in retail spot exchange volume has been technically driven equity traders who are switching to currencies. The technical nature of this market makes it much easier for equity traders to switch to foreign exchange (also referred to as forex or FX) than to other markets, although FX does have its own nuances that must be understood.
Stockpicking can enhance a portfolio, but only to a certain extent. If you incorporate additional markets such as financial and commodity futures and FX, it can substantially enhance performance and reduce risk. The trader or investor who has chiefly invested in stocks and has not yet considered the possibility of diversification into other markets may find adding financial and commodity futures or FX to his or her portfolio a highly lucrative venture.
The past decade has witnessed stock prices rising to unbelievable highs and then sinking to multiyear lows. All too many investment and trading accounts have taken hits. By employing a more diverse array of assets and some basic trading tactics, a trader could potentially be at or near all-time equity highs today, instead of suffering extended drawdowns.
PRINCIPLE OF DIVERSIFICATION
Anyone who has attended an introductory finance or investment class is probably familiar with the principle of diversification, which posits that if you add additional investments to a long equity portfolio, the overall volatility of your portfolio can be reduced. Figure 1 summarizes the results of a 1987 study that showed the impact of the size of a portfolio on diversification. As the chart illustrates, the more equities that are added to a portfolio, the lower the volatility of the portfolio. Moreover, with a portfolio of just 15 stocks, nearly the same diversification effect can be realized as with a portfolio of 500 or more stocks.
One more concept that is important is that of undiversifiable risk, or the risk that cannot be eliminated by stock selection alone. No matter how many stocks are put into the portfolio, the portfolio will still witness a certain degree of volatility (about 18% per year, on average) due to equity market risk as a whole. This is because stocks, regardless of sector or capitalization, exhibit varying degrees of correlation.
Adding more stocks to a portfolio can eliminate much of the volatility and risk. However, there is always an undiversifiable level of risk that cannot be eliminated through stock selection alone.
To accomplish further risk control, three more tools can be employed: 1) a systematic trading model to control losses and objectify trading decisions, 2) diversification into additional market classes besides stocks, and 3) trading both long and short.
The needs of many investors were not being fully met by existing financial institutions:
The need to make it easier for the small investor to enjoy the advantages of a diversified portfolio that wealthy investors have always had.
The need to reduce the drain on investment profits by management fees, sales commissions, and capital gains taxes.
The need for more control over the securities their money was being invested in, something denied investors by ownership in mutual funds shares.
There is a need for an online brokerage which would enable people to invest in their choice of a number of diversified baskets of securities called Folios, instead of buying into a mutual fund. And to invest and monitor their investments in a way never before possible in the pre-cyberspace age.
FOLIOfn, Inc. is an innovative brokerage and financial services technology company that serves individual investors, financial advisors and financial institutions around the world. FOLIO Investing is the firm's offering for the individual investor.
FOLIOfn Investments, Inc., a subsidiary of FOLIOfn, Inc., is a broker-dealer (Member NASD/SIPC) providing unique online brokerage services that form the basis for the company's service and product offerings to all of its market segments. Its Web-based brokerage technology, protected by U.S. patents, enables the trading of fractions of shares, and allows very broadly diversified portfolios of securities to be purchased with limited investment amounts. Individual securities held within the portfolios in fractional shares can be bought or sold, just as whole-share positions can at other brokerage firms, giving investors of all sizes the control and benefits of direct stock ownership combined with the investment risk reduction of a diversified portfolio.
FOLIOfn's technology also has transformed the economics of securities trading, radically reducing costs. The firm's "window trading" system uses the same type of technology employed by ECN's, and internally aggregates and nets all trade orders in a given security from all client accounts prior to a given "trading window." The efficiency of this system allows the firm to offer the brokerage industry's lowest trading costs.
FOLIOfn markets its services through three channels. It provides its brokerage services to retail investors through its FOLIO Investing Web site. The firm also provides its portfolio management, trading, clearing and custody services to investment advisory firms, asset managers and Registered Investment Advisors through its FOLIO Advisor platform. The platform allows these users to very cost-effectively create, manage and administer custom portfolios for their clients, including highly advanced separately managed account offerings. FOLIOfn also makes its technology available to major financial institutions on a licensed basis. More than 800 institutions rely on FOLIOfn's technology to manage their clients' portfolios.
FOLIOfn was established in 1998 by current Chairman and CEO Steven M.H. Wallman, a former commissioner of the Securities and Exchange Commission who was widely recognized during his tenure as an investor advocate. The company is privately held.
When you hear of someone making a huge killing in the market on a relatively small trading account, more likely than not it was a fluke: The trader was not using sound money management techniques. The trader probably exposed his trading account to obscene risk due to an abnormally large trade size. The trader may have just gotten lucky and experienced a profit windfall. Trading like this means it's just a matter of time before huge losses dwarf the wins, and the trader is devastated emotionally and financially.
Money management in trading involves specialized techniques combined with your own judgment. Not adhering to a sound money management program can find you exposed to a deadly risk of ruin, and, worst of all, most probable equity bust. Keeping this in mind, you may find a few essential money management techniques can make a big difference to your bottom line. Here are some things to remember when it comes to money management.
CALCULATING PROPER TRADE SIZE
If you are trading the exact same number of shares or contracts on every trade, you may not be calculating the proper trade size for your own risk tolerance. Trade size can vary from trade to trade because your entries, stops, and account size are constantly changing variables.
To help reduce your risk exposure, the first step is for you to believe you need this sort of program. Usually, this belief comes from suffering a few large losses that make you want to change. This kind of experience can enable you to see how the wrong trade size and lack of discipline can sabotage your trading results.
Calculating proper trade size is a relatively simple process and can ultimately reward you with greater profits and more efficient risk control. In Active Model Positions, I calculate the maximum trade size using a proprietary algorithm.
Sorting out the criteria for a coherent money management plan is a complex, detailed job. Using a spreadsheet to keep track of the logic helps ensure nothing has been omitted.
With a little planning, you can develop a logically sound money management system. Historically, too much emphasis has been placed on the development of profitable entry and exit rules, whereas the determination of the proper number of contracts or shares to trade has been treated as a distant afterthought.
An individualized money management algorithm (using a spreadsheet program such as Microsoft Excel) will control the equity growth of any positive-expectancy system as a direct function of using correct position sizing. Risking too large a portion of trading capital per position will eventually cause even the most profitable trading system to fail.
The second advantage to developing your own position-sizing strategy is to preserve trading capital during periods of extended drawdown or losing trades. This saves you the money to trade when things finally turn around. Unfortunately, many traders inadvertently lose their hard-earned trading capital as a result of improper position sizing. This becomes painfully obvious when they have risked too much capital over an extended series of losing trades.
I developed an effective money management algorithm using Excel 5.0. It is based on the theory of using volatility-derived stop-losses as a logical method to allocate capital. The logic behind using a volatility-based stop compared with a fixed-dollar stop is that the volatility-based stop can dynamically adjust to changes in a stock's recent price noise. This contrasts to trading with a fixed-dollar stop, which ignores volatility by forcing the placement of an externally derived, subjective stop without considering the underlying trade's true character.
As an example, assume stock XYZ has traded within a range of $10 to $12 per share over the last 14 days, with an average price during that time of $11 per share and a standard deviation of $2. A stop-loss could be placed at the time of entry such that it is so far away that it will never be touched except during rare events which cannot be predicted in advance. The stop loss is the core of any system. If the stop is vulnerable, so is the entire system.
If the position is losing, add (scale) on to the positions (pillar/pyramid) if the Bullish/Bearish pattern is still valid (re-design the system), but if the pattern is destroyed, swallow your pride, close the position and take a loss.
When the trend has caught up, setting the stop at this $4 per share risk acts as a useful proxy of the stock's recent two-week normal price fluctuations. A stop-loss placed at this level is now less likely to suffer whipsaw losses solely because of a stock's normal price volatility.
My algorithm allows a portfolio to grow at an above-average rate of return while consistently controlling risk. You should examine the assumptions inherent in my model and make changes in the values to reflect your own overall risk tolerance and trading philosophy
My algorithm is based on the following personal assumptions:
1. The maximum number of open positions is limited to 8/per major sector (Stocks/ETFs, Intrest Rate sensitive Instruments and Commodity Futures).
2. The optimal trade-size should be 50% of the capital risked for 2 positions or 25% for 4 or 4% for 24 or 2% for 48 positions in the portfolio which is what the optimum kelly criterion approaches for systems which have a Portfolio Reward Risk Ratio (PRRR) of 2.0 and %wins of 50. The typical portfolio% risked for all positions (FOREX, 1-month, 3-month, 6-month & 12-month Money Market instruments, Stocks and Index Shares and Commodity positions varying depending on the contract involved; longer-term (1-30 years) Bonds and T-Notes) is 0.5% of total equity, assuming that the system has a positive Expectancy and Profit Factor (W:L Ratio)is greater than 1.0. Keep the max. # of positions to 8 for each of stocks, forex and futues. There is no reason to have more than 8 positions for each of stocks, forex and futures. Its far easier to buy the indices. This is a numbers game. The Dow has only 30 positions as its components. HOLDRs funds such as BBH, HHH and TTH have as few as 20. Why is it then, that so many investors go through the trouble to have 20 and 30 positions for stocks in their own portfolios? You dont need to be a statistician to figure out that the more positions you have the more your portfolio will begin to behave as an index. That investor would be better off to buy the indices themselves because most indexes will beat 80% of all managed funds. But if you are in the rest of the brave 20%, use the 0.5% equity risk model and never risk more than 1% for 24 positions, assuming a 24% DrawDown at a losing streak with 1 in 26667 odds of ever occurring will consist of 24 consequtive losses.
Focus investing
While there are a handful of exceptions such as Peter Lynch, the overwhelming majority of great investors that I'm aware of practice focus investing. They invest infrequently, only when they're highly confident that the odds are heavily in their favor, and then they bet big. (Not surprisingly, research shows that the same approach works in other endeavors such as poker or betting on horse races. For more on focus investing, see Bob Hagstrom's excellent book, The Warren Buffett Way.)
Berkshire Hathaway's (NYSE: BRK.A) Warren Buffett and Charlie Munger have commented on this topic in recent annual meetings (Wesco (NYSE: WSC)). Munger commented, "If you took out our 15 best ideas, most of you wouldn't be here.…We have this investment discipline of waiting for a fat pitch."
Buffett added:
I keep xeroxes from annual reports 50 years ago. [Some ideas were] just so obvious. I knew when I sat with the CEO of GEICO 50 years ago that it was a big idea.
If we start buying a stock, we want to go in heavy. I can't think of a stock where we wanted to quit.
We've made some big mistakes starting to buy something that was cheap and within our circle of competence, but trickled off because price went up a bit. Good ideas are too scarce to be parsimonious with.
You don't have to be right on everything or 20%, 10%, or 5% of businesses. You only have to be right one or two times a year. You can come up with a very profitable decision on a single company. If someone asked me to handicap the 500 companies in the S&P 500, I wouldn't do a very good job. You only have to be right a few times in your lifetime, as long as you don't make any big mistakes.
It seems so obvious that it makes more sense to buy more of your best idea than add a 100th position to a 99-stock portfolio, yet the average mutual fund holds more than 100 stocks. In almost all cases, this is foolish "deworsification" and reflects closet indexing rather than prudent money management. Munger agrees, noting that "What's funny is that most big investment organizations don't [look for the fat pitch]. They hire lots of people, evaluate Merck vs. Pfizer and every stock in the S&P 500, and think they can beat the market. You can't do it. Very few people have adopted our approach." Buffett added: "Ted Williams, in his book The Science of Hitting, talked about how he carved up the strike zone into different zones and only swung at pitches that were in his sweet spot. Investing is the same way."
Pitfall #2. Planting too few seeds. This one goes hand in hand with the first pitfall. The key here is diversification and following several markets. I watch for over 200 markets and look for profit opportunities in each one as they occur. PLANT MORE SEEDS AND YOU CAN ENJOY MORE WINNERS.
Diversify, But Don't Overdo It
It's surprisingly easy to buy too many stocks. Probably the first investment advice you ever received was to diversify. It's likely no one has ever told you that you can overdo it.
Novice investors do well to invest in the indices themselves: The Dow Jones Industrial Average, The NASDAQ Composite Average or the S&P 500. These indices are in fact well-managed portfolios of the leading companies in the world's most powerful industries.
There's a good reason that the majority of money managers can't beat the annual gains returned by these indices. An index is a basket of funds that are managed by an unforgiving set of rules. For example, the NASDAQ 100, which can be purchased with the stock symbol QQQ, consists of the top 100 NASDAQ-traded stocks weighted by market cap. When a company falls below the 100th largest company, it falls from the list and a new one takes its place.
That's a very simple formula and it's proven an extraordinarily powerful investment regimen. There are plenty of stocks that offer substantial diversity, such as QQQ, HOLDRs and SPDRs, without the damaging expenses of a mutual fund.
It is unlikely that you'll make better timing and investment choices over the years than the simple formula of the NASDAQ-100. However, if you are one of the bold 20% who dare to try and succeed then you'll have to follow a different plan.
Position sizing
OK, let's say you're convinced that focus investing is the way to go, and you've found a stock about which you're trembling with greed. What percent of your assets should you invest in it? 2%? 20%? (Or, given the cheap, easy leverage these days, 200%?) The answer depends on a number of factors such as your tolerance for volatility, the expected upside, and the potential downside. Generally speaking, my ideal portfolio would have 8-17 well-diversified 50-cent dollars (e.g., stocks trading at half of my conservative estimate of their intrinsic value), 8-17 forex positions and 8-17 futures positions, of which roughly five were 2% positions and rest were 1% positions.
I did not pick this range of 8-17 Stocks/Fx/Futures arbitrarily. In Joel Greenblatt's brilliant book, You Can Be a Stock Market Genius, he provides the following statistics (see pages 20-21):
* Owning 2 stocks eliminates 46% of nonmarket risk of just owning one stock
* 4 stocks eliminates 72% of the risk
* 8 stocks eliminates 81% of the risk
* 16 stocks eliminates 93% of the risk
* 32 stocks eliminates 96% of the risk
* 500 stocks eliminates 99% of the risk
Once one has a well-diversified, balanced portfolio of stocks, adding additional stocks does little to reduce risk, yet there's obviously a big penalty in terms of performance if one's best ideas are 1% positions instead of 2% positions.
Keep in mind, however, that there is no right answer. I know many fantastic money managers who own a few dozen stocks and some who own only a half dozen, but 8-17 is the level at which I'm comfortable. You need to find your own comfort zone.
Here's a proven strategy I recommend for the absolute beginner. Start with 100% of your holdings in QQQ. It's an index. It's not exciting, but it's safe, diversified, growth-oriented and will beat 80% of all managed funds. Then, explore the market for months using my subscription and a few tracking portfolios.
When you've proven your savvy in your tracking portfolios it's time to make a move to individual stocks. Keep the number to 8 or less for the first $100,000 you've pulled out of QQQ. Keep it to 12 or less for the next $500,000. Again, there is no reason to have more than 17 positions for over a million dollars. It's far easier to buy the indices.
There is a diversity of kind as well as number. Sticking to 8 stocks for $100K of gain is fine, but not if they're all networking stocks. The reason for this is simple. Stocks within an industry tend to move with each other, so when a downturn hits technology you'll need positions rising in utilities, drugs, consumer good or others to reduce the impact. Of course, you'll have the stop loss rule so the damage will be minimal.
Diversity, like buy-and-hold investing, is a cardinal sin that must be bent, not broken, if you are going to have above-average returns.
When Crystal Balls Break
I'll be the first to admit that my crystal ball is broken.
The lousy thing cannot help me predict the future at all. It did not tell me, for example, that Merck (NYSE: MRK) would find sufficient trouble with Vioxx to justify an instant, worldwide, and early complete withdrawal of the drug. In late November of 2003, the company faced questions about its pipeline. I took the opportunity to buy a small position in Merck, believing that my price of $41.23 represented a decent price for the firm. The company was below any price it had been since 2002. I believed that I was finding a solid company at a fair price.
That was before the Vioxx incident. Like many other investors, my account got hit when Merck announced its withdrawal. Fortunately, through the power of diversification, a single-company problem like Merck's had a muted effect on my portfolio, and all in all, I'm holding my own.
Diversification, when done right, is the only free lunch (or nearly free lunch, at least) in investing. There are no guarantees, of course -- even well diversified portfolios can lose money. And although in theory it's possible to make more money by investing in fewer stocks (diversification spreads out your gains as well as your losses), virtually all investors -- especially value investors -- are willing to give up the occasional wild upside for protection against the inevitable one- or two-stock plunges that wreck undiversified portfolios.
Two simple rules
There are two key rules of proper diversification as it applies to the value investor, and those rules must be followed to keep diversification from turning into di-worse-ification. The first key rule is that the companies must be in separate and unrelated business lines. Computer chip makers Advanced Micro Devices (NYSE: AMD) and Intel (Nasdaq: INTC), for example, are in substantially similar businesses, so owning both would not help an investor's diversification. Owning one of those computer chip companies along with Pepsi (NYSE: PEP), whose Frito Lay division makes potato chips, on the other hand, would be sufficient business separation.
The second key rule is that an investor must keep each company's value in mind when making each individual purchase. In other words, don't use diversification as an excuse to stop hunting for values. Google (Nasdaq: GOOG) may be in a totally separate business from United States Steel (NYSE: X), but that doesn't mean that either one of them would make a particularly good investment at any price. I use a 12% discount factor to determine valuation. That 12% represents my required rate of return -- the total return over time that I would expect to receive if a company I own managed to meet my operating and growth expectations. Using that number, which is moderately high as discount rates go, to help determine my purchase price keeps me focused on not overpaying for any given company. Were I to ignore valuation, my expected return would suffer.
The rubber hits the road
With those thoughts in mind, it is relatively straightforward to set up a pretty well diversified portfolio and have a measure of protection against individual company problems. For an example, take a fictional investor who had an equal dollar stake on Dec. 31, 2003 in these 10 companies: insurance company Allstate (NYSE: ALL); pipeline company Kinder Morgan (NYSE: KMI); clothing retailer Gap (NYSE: GPS); software giant Microsoft (Nasdaq: MSFT); mortgage finance giant Freddie Mac (NYSE: FRE); mall operator General Growth Properties (NYSE: GGP); restaurateur McDonald's (NYSE: MCD); the aforementioned Merck, home improvement warehouse Home Depot (NYSE: HD); and waste collection company Republic Services (NYSE: RSG).
The following illustrates the year-to-date performance of such an investor's portfolio, as of market close on Oct. 18:
Portfolio
Ticker 12/31/03 Price 10/18/04 Price YTD Dividends YTD Total Pre-tax Return
ALL $43.02 $48.06 $0.84 13.67%
FRE $58.32 $65.50 $0.90 13.85%
GGP $27.75 $32.39 $1.26 21.26%
GPS $23.21 $19.87 $0.07 -14.09%
HD $35.49 $40.18 $0.24 13.89%
KMI $59.10 $64.04 $1.69 11.22%
MCD $24.83 $29.20 $0.00 17.60%
MRK $46.20 $30.90 $1.12 -30.69%
MSFT $27.37 $28.44 $0.08 4.20%
RSG $25.63 $29.57 $0.24 16.31%
Total 6.72%
In spite of Gap's meandering, Microsoft's stagnation, and, yes, even Merck's Vioxx problems, this account would have held up quite well. Compared to the S&P 500, as represented by "Spiders," which are shares of an ETF that tracks it, this portfolio absolutely shined. During the comparable period, the Spiders moved from $111.28 to $111.68, and paid $1.28 in dividends, for a year-to-date total pre-tax return of about 1.51%. Just prior to Merck's Vioxx-induced stock collapse, it closed on Sept. 29 at $45.07. Had Merck's price remained constant in the absence of the Vioxx recall, this portfolio would have shown a year-to-date total pre-tax return of about 9.79%. While Merck's impact still hurt, its blow was reduced by the risk-reducing power of diversification.
Wait a minute! you say, or at least think. Isn't the S&P 500 the epitome of diversification? Why not just buy it, or at least hold a whole bunch of stocks, to maximize the diversification benefit? Good thinking, as it brings up an important question: At what point is diversification too much of a good thing, in the sense that it ends up diluting an investor's hard-won returns?
Well, technically you're diluting from the moment you add a second stock, but academia has indicated that the bulk of diversification's benefit comes in the first 8 to 17 stocks. Tying this into Rule #2 -- don't forget to hunt for value -- doubles the support for holding a moderate number of stocks; it's hard for a thorough, value-investing type to find and keep abreast of too many bargains in the first place. Bottom line? There's no single magic number, but a value investor would do well to stay within the bounds of his or her research capabilities.
Words of Wisdom
Don't just take my word for it. Legendary value investor Benjamin Graham had this to say, via his now-classic volume, The Intelligent Investor, on the subject: "There is a close logical connection between the concept of a safety margin and the principle of diversification... Even with a margin in the investor's favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss -- not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses...."
To paraphrase the master, the individual companies matter, but in the end, it's the total portfolio that has to pay the bills. Value investors, like us, look for ways to improve their risk-adjusted returns. Proper diversification is one method by which investors can reduce the risk to their portfolio as a whole without significantly compromising their overall expected returns, making it a key tool for any value investor's kit.
Have an Accumulation Plan
You may be the type of swimmer who takes a 25-yard running jump into the pool. And it's fun. When it comes to your portfolio, it's better to test the waters carefully and repeatedly. Every position starts out as a short-term trade. But when you pick a winner, you've got to add on. The best time to add on is when a stock in a strong long-term uptrend retraces to a lower price. A healthy trend is characterized by a 2-steps forward, 1-step back price movement. The price will go up 10% in a period of weeks or days, then step back 5%, then repeat this action over and over.
Sizing common stocks
I typically will not add a common stock position to my portfolio unless I'm willing to make it a 5% position. If I don't feel confident enough to invest at least this much, that's a good signal I shouldn't own it at all. Once this initial position is established, I cross my fingers and hope that the stock goes… down. Yup, you read that right, down! Why? Because I want to buy more and make it a 10% position but need a bigger margin of safety to do so.
Sizing shorts
Though I do some shorting, it's an awful business for many reasons, one of which is that one shouldn't do it in size, as losses are potentially unlimited. If a stock is a 7% long position at $15 and drops to $5, it will cost you nearly five points of return, but it won't put you out of business, you aren't forced to sell at the bottom, and -- if you have real guts and conviction -- you can buy more.
But what about a 7% short position at $5 that jumps to $15? That costs you 14 percentage points of return and you may be forced to cover to prevent further losses, even if you have more confidence in the position. Thus, you can see why I rarely make a short position larger than 1% and prefer a basket of even smaller positions.
Sizing options
Given the implicit leverage of options, I tend to make them small positions -- generally 0.5%-2.5%, though it's hard to share any rules of thumb since some long-dated, deep-in-the-money options are very similar to the underlying stock, while short-dated, out-of-the-money options are highly speculative.
Speculations
One might ask why a conservative value investor like myself would ever invest in something highly speculative like Forex and Futures, but I'm willing to make such investments in my portfolio as long as I'm confident that the expected value is much higher than the price I'm paying. Consider an investment with the following expected one-year payoffs:
* Loss of entire investment: 60% chance
* No gain or loss: 10% chance
* 2x gain: 10% chance
* 5x gain: 10% chance
* 10x gain: 10% chance
The expected value of a $1 investment given these probabilities is $1.80, a fabulous return, but let's assume you could only make this investment once. Would you do so, knowing that there's a 60% chance that you'd lose it all? Try explaining that to your investors (or worse yet, your spouse)!
If you did make the investment, how much of your portfolio would you risk? This is not a hypothetical question; in the past few weeks, I faced a very similar choice and chose to invest 2% of my portfolio.
While there's little doubt that focus investing is likely to yield the highest long-term returns, there are no hard and fast rules about how concentrated one's portfolio should be -- it depends on tolerance for volatility, availability of other investment options, the confidence in one's analysis, and many other factors.
When you pick a winner using my subscription, it's best to take a small position first, perhaps as little as 25 shares. When you take a position in a stock you take not only a financial position, you take an emotional one as well. Surely you've noticed your ability to detect your stock symbols from a CNBC screen almost 50 feet away in your favorite watering hole. You're vested. The only way to make money in the market is to pick stocks that trend upward. They have many other characteristics (fundamental strengths and public sentiment), but their primary characteristic is the ability to take 2-steps forward and 1-step back in price action. When that stock steps back, add to your position. Perhaps it's another 25 shares if the information you're finding is convincing.
Pyramiding
I only make strong commitments to financial instruments that give me a lot of positive feedback. As a winning decision is confirmed, I add even more to my total positions. That is, I pyramid. The process of pyramiding is one of the oldest and most successful strategies in investing.
For example, if I take a 300-share position at $12 in a stock that I believe is trending up, and that stock goes to $14, I have received my first confirmation of that trend. I add 150 shares to that position. Over the course of weeks, as the stock reaches subsequent price points, I add another 50, and so on. So I have a total of 500 shares committed to this position and I notice some weakness in the trend, I start closing out just as carefully as I got in.
Similarly, if I take a 300-share position at $12 in a stock that I believe is reversing its downtrend, and that stock goes to $10, I would buy 600 shares on a valid buy signal, and when it subsequently goes to $14, I would again add on to the position with 100 shares and so on. So I have a total of 1000 shares committed to this position and I notice some weakness in the trend, I start closing out just as carefully as I got in. The key point is that, always end up with the least number of positons (shares) at the top of the pyramid.
Pyramiding up or doubling up is the hallmark of a losing investor, because as you pyramid up and when the prices retraces goes past your entry point, it wipes out your profits as there will be more losing positions than winners overall for that stock. An investor with Position Cost Averaging strategy who buys a stock at $12 and sees it go to $10 will think, "I thought it was a good buy at $12, it must be a steal at $10!" and correctly so, as long as your system design is still sound, i.e., your bullish/bearish pattern on which the system design is based on is still valid. If the pattern is destroyed, then you will be automatically stopped out of your long or short position.
This winning psychology has everything to do with investment principles. Buying stocks is much different from buying any other type of item. In fact, there is an inherent (intrinsic) value to a stock, which only the most enlightened are able to discover, outside of the price the general public is willing to pay for it, and then the most enlightened teaches the general public about the value of the stock, but the general public is in general too late to grasp the significance of the stock and left with holding an empty bag. That is why the Contrarian theory which is a weaker form of the Efficient Market Theory, works. The free market is ruled by those who can plan long-range. The better the mind the longer the range of planning.
A winning position is much like a precious crop whose value you must nurture by tending it.
Pyramiding is the process of easing into and out of positions. In a perfect world, we would always pick the stocks that are moving the quickest, throw everything we have at them and exit at exactly the right moment. However, in the real world we must be more cautious.
Pyramiding allows you to move into those positions that allow you time to confirm a stock's prevailing trend.
Let's say that you have $10,000 to spend on a stock that costs $10 a share.
Pyramiding into the stock would mean buying only 300 shares on day one. As time goes by and you see confirmation of an upward trend (that is, it goes to $11 and $12), you add to your position (an additional 150 shares) and then adding 50 on to that that position (now at 500) and so on, ending up with the least number of positions at the top.
On some stocks like CSCO and MSFT, this process can go on for years, provided that you have the financial resources to increase your investments.
Eventually, the trend ends. Pyramiding out means closing positions just as cautiously as you got in.
Using pyramiding, you allow your winners to run and you limit your losses right up front using the stop loss of your system. Also, there are as many variations on this technique as there are investors. Some people will pillar up, i.e., add the same amount of shares to the top of the pyramid which now will resemble a pillar. Some investors will add fractional amounts.
Even best stock pickers are often wrong about individual stock selections. Their portfolios exhibit superior performance because they cut their losses early and they let their winners run.
Trading opportunities in the forex market deserve serious consideration as a diversification strategy for your portfolio.
Trading currencies is not rocket science. Currencies tend to follow fairly strict rules, and are therefore more predictable than other markets. The merits of currency trading, include enormous liquidity and not the least of which are the slow deliberate trends.
Experienced traders often remark that the foreign exchange markets are a technician's delight, as they adhere more closely to the technical indicators than other securities. There is less random noise (that is, volatility) in the forex markets, and trends there are generally of the long-term nature.
While online equities and futures trading have enjoyed exponential growth and widespread notoriety over the past few years, online foreign exchange trading is only now gaining popularity among seasoned active traders, Commodity Trading Advisors (CTAs), and other professional money managers.
Until recently, large international banks dominated the foreign exchange (Forex or FX for short) market, only allowing access via telephone trading to a select few such as Fortune 1000 companies, large funds, high-net worth individuals, and so on. But now, the tide has turned and finally there are established online trading firms that provide individual investors with direct access to the largest, most liquid financial market in the world.
DIVERSIFY YOUR DIVERSIFICATION STRATEGY
In addition to the market's trading opportunities, foreign exchange can be a solid diversification component in your financial portfolio. Most diversification strategies involve a combination of sector allocation, foreign and domestic equities, and fixed income. Some participants have branched out into precious metals and/or energy products; however, few traders consider expanding into forex. Why?
The reason may be in the simple fact that in the US, investors tend to be underexposed to foreign exchange. Unfamiliarity typically breeds misconceptions, and foreign exchange in the US is no exception.
RISKY BUSINESS?
Is forex as risky as everyone thinks? One way to measure risk is to compare a financial product's risk relative to its return. If you take the time to compare an investment in forex to common investments such as equities and fixed income, you will find that from a risk/reward standpoint, forex investments provide respectable returns and should be considered viable portfolio diversification tools.
The rising popularity of foreign exchange trading over the past few years has been impressive. Equity traders fed up with trying to eke out profits in the brutal bear market environment have flocked to the fast-paced spot currency markets in record volumes. This rise in forex's popularity can mostly be attributed to the clear advantages that currency trading has over other markets. Unlike trading equities, foreign exchange offers traders true 24-hour trading, excellent liquidity (over $1.5 trillion a day), and great leverage (up to 400 to 1).
Another big factor behind the increase in retail spot exchange volume has been technically driven equity traders who are switching to currencies. The technical nature of this market makes it much easier for equity traders to switch to foreign exchange (also referred to as forex or FX) than to other markets, although FX does have its own nuances that must be understood.
Stockpicking can enhance a portfolio, but only to a certain extent. If you incorporate additional markets such as financial and commodity futures and FX, it can substantially enhance performance and reduce risk. The trader or investor who has chiefly invested in stocks and has not yet considered the possibility of diversification into other markets may find adding financial and commodity futures or FX to his or her portfolio a highly lucrative venture.
The past decade has witnessed stock prices rising to unbelievable highs and then sinking to multiyear lows. All too many investment and trading accounts have taken hits. By employing a more diverse array of assets and some basic trading tactics, a trader could potentially be at or near all-time equity highs today, instead of suffering extended drawdowns.
PRINCIPLE OF DIVERSIFICATION
Anyone who has attended an introductory finance or investment class is probably familiar with the principle of diversification, which posits that if you add additional investments to a long equity portfolio, the overall volatility of your portfolio can be reduced. Figure 1 summarizes the results of a 1987 study that showed the impact of the size of a portfolio on diversification. As the chart illustrates, the more equities that are added to a portfolio, the lower the volatility of the portfolio. Moreover, with a portfolio of just 15 stocks, nearly the same diversification effect can be realized as with a portfolio of 500 or more stocks.
One more concept that is important is that of undiversifiable risk, or the risk that cannot be eliminated by stock selection alone. No matter how many stocks are put into the portfolio, the portfolio will still witness a certain degree of volatility (about 18% per year, on average) due to equity market risk as a whole. This is because stocks, regardless of sector or capitalization, exhibit varying degrees of correlation.
Adding more stocks to a portfolio can eliminate much of the volatility and risk. However, there is always an undiversifiable level of risk that cannot be eliminated through stock selection alone.
To accomplish further risk control, three more tools can be employed: 1) a systematic trading model to control losses and objectify trading decisions, 2) diversification into additional market classes besides stocks, and 3) trading both long and short.
The needs of many investors were not being fully met by existing financial institutions:
The need to make it easier for the small investor to enjoy the advantages of a diversified portfolio that wealthy investors have always had.
The need to reduce the drain on investment profits by management fees, sales commissions, and capital gains taxes.
The need for more control over the securities their money was being invested in, something denied investors by ownership in mutual funds shares.
There is a need for an online brokerage which would enable people to invest in their choice of a number of diversified baskets of securities called Folios, instead of buying into a mutual fund. And to invest and monitor their investments in a way never before possible in the pre-cyberspace age.
FOLIOfn, Inc. is an innovative brokerage and financial services technology company that serves individual investors, financial advisors and financial institutions around the world. FOLIO Investing is the firm's offering for the individual investor.
FOLIOfn Investments, Inc., a subsidiary of FOLIOfn, Inc., is a broker-dealer (Member NASD/SIPC) providing unique online brokerage services that form the basis for the company's service and product offerings to all of its market segments. Its Web-based brokerage technology, protected by U.S. patents, enables the trading of fractions of shares, and allows very broadly diversified portfolios of securities to be purchased with limited investment amounts. Individual securities held within the portfolios in fractional shares can be bought or sold, just as whole-share positions can at other brokerage firms, giving investors of all sizes the control and benefits of direct stock ownership combined with the investment risk reduction of a diversified portfolio.
FOLIOfn's technology also has transformed the economics of securities trading, radically reducing costs. The firm's "window trading" system uses the same type of technology employed by ECN's, and internally aggregates and nets all trade orders in a given security from all client accounts prior to a given "trading window." The efficiency of this system allows the firm to offer the brokerage industry's lowest trading costs.
FOLIOfn markets its services through three channels. It provides its brokerage services to retail investors through its FOLIO Investing Web site. The firm also provides its portfolio management, trading, clearing and custody services to investment advisory firms, asset managers and Registered Investment Advisors through its FOLIO Advisor platform. The platform allows these users to very cost-effectively create, manage and administer custom portfolios for their clients, including highly advanced separately managed account offerings. FOLIOfn also makes its technology available to major financial institutions on a licensed basis. More than 800 institutions rely on FOLIOfn's technology to manage their clients' portfolios.
FOLIOfn was established in 1998 by current Chairman and CEO Steven M.H. Wallman, a former commissioner of the Securities and Exchange Commission who was widely recognized during his tenure as an investor advocate. The company is privately held.