Base Allocation

Having a philosophy and a process of investing is very important. The cores of the Fundamental Trends approach is to control our emotions and make a series of well thought out good investment decisions.

If we can control emotions, then we can focus on a good analysis and portfolio construction. If we do not control our emotions, then we wil fail like 80% of investors do. 

Three Types of Portfolios

For those who own equities, there are three general ways to build a portfolio that I have seen work to beat the indexes with less risk. Only you can determine which approach is best for you.

The first is to own 20-30 stocks that each make up 1% to 6% of your portfolio. This is an aggressive way to try to make long-term returns that crush the markets. Individual security selection and slowly building positions are the keys to succeeding with this approach. This is essentially the way that Warren Buffett did it. 

The next way to invest for long-term success is to own about a dozen stocks - again at 1% to 6% of total invested holdings - but then supplement the portfolio with several ETFs for diversification. This is the way that most people should invest because very few people can keep track of more than about a dozen companies. With a good tactical ETF approach, this blended way of investing can add portfolio stability and maintain most of the upside. 

The final portfolio construction approach is to use all ETFs and rotate them tactically to account for significant changes to the markets. With this approach you will generally own between 3 and 8 exchange traded funds. This approach is excellent for people who don't feel comfortable with single company risk. While it does not quite have the upside of owning individual stocks, it can mitigate risks very effectivly and generate very good returns for people willing to own more international ETFs than more Americans (the 80%) do. 

What Is Trading

Trading is something that most people have difficulty with. There are many different interpretations as to what trading is. I will break down what trading means to us.

Types of Trades 

  1. Position Trades
  2. Swing Trades
  3. Day Trades

The majority of our positions are in stocks and exchange traded funds, although we are also active in options. It is up to each individual to find their comfort zone and invest in what makes sense for them. We will try to help. Our forum is a great place to get and exchange information and thoughts.

  • Position Trades: Most of our trades fall into the "position trade" category. These trades generally last for years. 
  • Swing Trades: We make a handful of these opportunistic trades that typically last for months.
  • Day Trades: These are very short-term trades, generally lasting days at a time. FUNDAMENTAL TRENDS DOES NOT DAY TRADE.

The reason we primarily position trade is because effectively predicting short-term stock market moves is very difficult, if not impossible. What is more possible is identifying a good business and being able to buy it at a discounted price to its fair market value becuase markets are psychogically and emotionally unstable. The instability, or volatility, of the stock market is regular enough that by simply waiting for a good price on a good company, we can build a margin of safety and make good returns over time. 

Warren Buffett has talked repeatedly about the impact of "compound interest" on investing. By holding more of our investments for multiple years, we can get the impact of compound interest. 

Our goal with position trades is to double or triple our money in a 3 to 7 year time frame. The potential to at least double money within that time frame is a minimum expectation. We do not buy stocks that we do not feel can at least double within seven years. Our real goal is to triple money in that time frame.

If we "only" double your money in seven years, that is a 10.3% annualized return. See this definition and examples of the Rule of 72 for doubling a value. If we triple money in seven years, that is a 16.4% annualized return.

Building a Position

Most people mistakenly think they are trying to buy at absolute low prices. That's impossible to do. Accept that and you stand a better chance of making money through compounding returns.

I do not subscribe to "dollar cost averaging" because that is just scheduled investing. I believe in scheduling savings, however, when you buy the actual investment depends on the pricing and price trend of the asset. 

We generally want to build a position with 2 to 4 buys in small increments. By doing this we can get a good low cost basis and spread our risk out over different points in time that correspond to different information being available. By scaling into our investment positions we can mitigate our risk.

Use Limit Orders

Investing can get emotional. To fight that, we make extensive use of "limit" orders to set up buys.

Limit orders allow us to identify levels of value and levels of asset price support. Each asset on our "Very Short List" and "ETFavorites" has a range of prices that are good buy prices. You can determine how aggressive or conserative you want to be by picking whether to use the high, middle or low-end of the price ranges for setting limit orders.

The buy price ranges are consistent with looking for a blend of margin of safety and investment opportunity. The lower you buy, obviously the greater margin of safety. You need to answer for yourself how much safety you need.

In general, I recommend buying a small starter position near the high-end of the buy range and a bigger position at the bottom of the buy range. By establishing a buy limit near the high-end of the buy range, you can often gain as these holdings are recognized as valuable and don't generally trade low for long.

It is okay to only buy the low-ends of the buy range and simply wait for the very bad days and weeks to be a buyer. In fact, I think that is a great strategy for patient investors who are only willing to take moderate levels of risk.

Remember August 24th, 2015? The S&P 500 suddenly dropped 1000 points in one morning. Those who had limit orders set up bought in the first half hour of trading that day and were up 10% within a month. You should expect more sudden events like that as more people are brainwashed into thinking that algorithms and indexes are the way to invest.

Using limit orders for your buying strategy beats sitting around in front of a computer watching green and red numbers that mean little to nothing. Because the computer driven robo-market is calm except when it explodes with volatility, using limits allows us do other things - like live our lives - while we wait for buying opportunities.

Position Sizing

Scaling into a position requires having an standarized sizes for what we are buying. By having a scale that we follow, we can build our portfolios in a consistent and logical way. That will help us when it comes time to sell. 

In general here is my stock and option trade sizing approach: 

Type of Trade Stock Trade Size as % of Portfolio ETF Position Size as % of Portfolio
Starter Position 1/2% 1-2%
Half Position 1% 3%
Full Position 2% 6%
Double Position 4% 12%

Only you know the structure of your portfolio, so, position sizing is up to you. I recomment going slow. The only real exception to building positions slowly over months is when there is a blow-off bottom and you are willing to accept the pricing as a long-term entry.

Option Trading: Selling Cash-secured Puts

Option trading requires education. Get it here: http://www.cboe.com/learncenter/. If you are not practiced at option trading and want to be, start by paper trading a play money account online. Once you are comfortable, make a few small option trades.

When you sell a cash-secured put, you are agreeing to be obligated to buy a stock or ETF at a particular price in a certain time frame if it trades below the agreed upon price called the strike price. The person or entity you agree to buy from pays you a premium in order to accept the risk of possibly having to buy the stock or ETF. In this way you receive income right way for only committing to potentially buy the stock or ETF.

The "cash-secured" portion of the transaction simply means keeping money in cash or money market so it's available to buy the stock or ETF later if necessary. The premium is essentially the return on holding that money in cash or money market. Often you can generate a significant amount of income with this strategy.

Selling a cash-secured put is like setting a limit order but getting paid to do so. Think about that. What makes this strategy work is only selling puts on stocks and ETFs that you'd be happy to own at the agreed upon strike price. Never sell puts because you see a big premium. Sell puts because you want the asset.

I like to build a stock or ETF position by selling cash-secured put options. It is completely up to you whether you do this. However, I highly recommend following the link above and learning about what this income generating, risk reducing trade is all about.

When I build a position, I will generally start with either by selling a cash-secured put or pairing a stock purchase with a selling a cash-secured put. I generally prefer the paired method since I know I'll get to own at least some of the asset I'd like, however, it is tough to do this in small accounts. 

Option Trading: Buy LEAPs

Once again, visit the CBOE website for educaiton on options.

LEAPs are long-term call options on a stock or ETF. That means we have the right (but not the obligation), to buy a certain stock or ETF at a certain price in the future. These options are long-term in nature and generally expire at least one year into the future and upto about two-and-a-half years. 

This strategy is aggressive. It is designed to be used for those occasional large stock market sell-offs or sell-offs in a stock when we want to take leverage on a rebound or on growth. 

An example of when this strategy was extremely effective was in the spring and summer of 2009 after the financial crisis had bottomed out. People who bought LEAPs on the SPY or QQQ stock market ETFs did much better than people who just bought SPY or QQQ. Why? Because they were able to buy the options for a fraction of the price of the ETF and hold long-term as those indexes soared in value. 

This strategy is ideal for periods after a stock market crash and when the economy is expanding out of a recession, i.e. like 2009. We should keep an eye out for the next opportunity to take leverage on the stock market. If we allocate some of our money to LEAPs we can very lazily make a lot of money as the Federal Reserver and government stimulate the economy back to good health. 

Nobody's Perfect

No service is perfect. Even though my public track record is very good (see TipRanks), I have made mistakes, often being early or late to the party. That is the life of an investor. We do not seek perfection, we just work to make a series of good decisions over time while systematically managing risk.

Remember, volatility is normal. Learn to benefit from it. Volatility is where you will find your best opportunities. 

Kirk