Having a philosophy and a process of investing is very important. The cores of our approach are to control our emotions and make a series of well thought out good investment decisions.
If we can control our emotions, then we can focus on a good analysis and portfolio construction. If we do not control our emotions, then we will fail to beat the markets or control risk like 80% of other investors fail.
Three Types of Portfolios
Let’s start with a thought on portfolio construction.
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.
All Stock: Own 20-30 stocks and keep a very close watch on each company. Theoretically, this is enough diversification. But, we are fallible and most people should not attempt this. This is essentially the way that Warren Buffett did it.
All ETFs: Own between 5 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 effectively and generate very good returns for people who are good asset allocators.
Stock + ETFs: Own 5-8 ETFs and at least a dozen stocks (though about 20 is optimal). This is the way I invest and believe that most people should invest. It offers great opportunity to build a smartly diversified asset allocation, as well as, keep the explosive upside of your top stock picks.
The PowerShares QQQ (QQQ) is the core ETF holding that everybody should use as their core holding and for making quick buys on deep correlated stock market corrections. The QQQ is tied to the leaders of the modern economy and has beaten all other diversified ETFs since 2002. I talk about this ETF here:
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
- Position Trades: Most of our trades fall into the “position trade” category. These trades are measured in quarters and years.
- Swing Trades: We make a handful of these opportunistic trades that typically last for weeks or months.
- Day Trades: These are very short-term trades, generally lasting minutes, hours or days.
WE DO NOT DAY TRADE because it is proven that around 80% of day traders lose.
We are primarily position traders. That is, when we buy an ETF or stock, we do it with the intent of holding it at least a few quarters and generally several years. Our target prices are based 3 to 5 year time horizons.
A 3 to 5 year time horizon offers enough visibility, without being too distant. GREAT companies can execute over that time frame and generate profits that the stock market recognizes and eventually bids up so that we are very profitable on the position trade.
Famous position traders include Peter Lynch, Warren Buffet and almost any other famous trader you have heard of.
Depending on how aggressive you are, your technical trading skills and amount of capital, you might choose to swing trade a portion of your portfolio.
Most professional traders will trade between 5% and 20% of their total investment portfolio. Only inexperienced or hyper aggressive traders will attempt to swing trade more. I recommend 5-10% in your early years attempting to swing trade.
The swing trades that I have seen work best are geared towards short-term catalysts, for example, company announcements on contracts, FDA approvals or earnings, that the stock market is not bidding up yet.
Successful swing trading marries a fundamental understanding of a company (or sometimes industry, commodity or nation in the case of ETFs) with a strong technical trading approach.
The reason that you need both fundamental and technical grounding for swing trading is to avoid costly mistakes, i.e. when the market moves against you. You can dramatically lower your risk by having both fundamentals and technicals on your side.
Here we use a wide range of technical analysis on top of my fundamental analysis, including Elliott Wave Theory which is a pretty good way to measure the “madness of crowds.”
Use Limit Orders
Investing can get emotional. This is particular relevant with swing trading. To fight that, we make extensive use of “limit” orders and stop losses for shorter term trades.
Our defense with position trades stems from understanding fundamentals and having a slow scaling in process that often includes selling cash-secured puts.
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 – BY BEING IN THE STOCK MARKET, YOU ARE ALWAYS TAKING AT LEAST 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.
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 ETF trade sizing approach:
|Type of Trade||Stock Trade Size as % of Portfolio||ETF Position Size as % of Portfolio|
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.
When Trading, Always Remember, Nobody’s Perfect
Remember, volatility is normal. Learn to benefit from it. Volatility is where you will find your best opportunities.
- “Volatility caused by money managers who speculate irrationality with huge sums will offer the true investor more chance to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times” Warren Buffett
- This great emphasis on volatility in corporate finance we regard as nonsense” Charlie Munger
- “Opportunities to purchase what we deem to be attractively undervalued companies occur more frequently when stock prices are volatile.” Chuck Royce
- “We steer clear of the foolhardy academic definition of risk and volatility, recognizing, instead, that volatility is a welcome creator of opportunity” Seth Klarman
- “Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.” Warren Buffett (again, and again, and again here).
- “If you make more money when you are right than you are hurt when you are wrong, then you will benefit, in the long run, from volatility [and the reverse]” Nicholas Taleb
- “Pick any Company you want – the price is very volatile over short periods of time. It does not make sense to me that their values are nearly as volatile as the prices and therein lies what should be a great opportunity” Joel Greenblatt
- “You can get lulled to sleep when markets haven’t been volatile, which likely means it’s time to take some chips off the table” Kevin O’Brien
- “The true investor welcomes volatility” Warren Buffett