Ryan's Blog

Tuesday, October 11, 2005

Portfolio Building Strategies for Stocks

Building a portfolio of stocks is not unlike building a professional basketball team. You have to balance your supposed superstars with a quality supporting cast, and you cannot overload in one area. Balance, balance, balance. Especially if you are like yours truly living off of your portfolio, wild fluctuations, will kill your psyche, and your ability to operate in a logical fashion. For us a stock portfolio consists of around 10 holdings. For those of you who regularly trade along with us at http://www.livingonlargecaps.blogspot.com, you know that our holdings last for around four weeks. But even if you hold stocks long term, or day trade, the philosophy of portfolio building remains unchanged. The basketball analogy works if you think about how many Michael Jordans you really need on one team, the answer of course is one. At any given time, the stock market will have a few hot sectors. Your superstars come from these sectors, however, you can't overload your portfolio with stocks from these sectors because, when they fall out of favor, which they often due without warning, your portfolio will skid along with them. So what you need is a supporting cast to prop up your superstar, when the game goes against them. Your supporting cast likely will shine when your superstars are crashing, they need to be complementary. An example that is relevant right now is the energy sector, and more precisely oil. Oil stocks have had a grand bull market, while the overall stock market is treading water, the oil sector has been hot. However, there have been corrections along the way. And one of these days, it will be more than a correction, it will be a trend reversal. It is very expensive to try to guess the trend reversal, as you will be wrong along the way many, many times. Especially in a pure sector like oil. The factors that lead to a bull market in oil are easily identifiable, and the news coming out is either bullish or bearish, it really needs very little interpretation. Now take a sector like insurance. On first glance the recent hurricanes should be bearish for insurance. However, insurance also profits from favorable monetary policy and interest rates curves. It is also a defensive sector so traders will buy insurance when they are worried about future of the stock market. In other words, there are many factors that go into an insurance sector bull market. And to complicate it even further, insurance companies do not move in lock step fashion nearly as efficiently as pure industries like oil. Oil stocks are like a well regimented military unit. Back to our example of portfolio building, the oil sector's bull market, has been interrupted along the way. If you have been 100% in oil stocks you actually would have done very well, however, your portfolio would have had a tumultuous ride. A correction can last for up to two weeks, and in that time your portfolio might have correct up to 15%, a nail biting, ulcer inducing, dip in your net worth. However, cushioning your oil stocks with say a stock that upticks when the oil sector is going bearish on us, would have resulted in a smoothing effect on your portfolio, and lessened those nail biting periods filled with self-doubt, when you ask why you even bother trading stocks, and that nine to five job suddenly looks comforting. Some quick and fast rules we follow, is no more than two holdings at any one time in related sectors.. No more than 80% of our holdings are to be longs, unless some longs actually go counter to the current trend. Such as oil stocks, which actually are counter to the bulk of the market. But if you have eight longs in say, insurance, banking, retail, heavy machinery, technology, etc., then you must have two shorts,. You will be surprised the smoothing effect that the counter holdings provide. If you check your portfolio daily, and let the gyrations effect your mood, it is important for clarity of thought if nothing else. Always, always let the charts decide, arm chair quarterbacking is expensive. Like guessing a trend reversal, let the charts dictate and you trade accordingly. In fact, I go so far as saying having an opinion is expensive. I had thought oil was wildly over bought and highly speculative for a long, long time. But the charts kept looking good, so my opinion doesn't really matter, only the facts displayed in the charts do. And yes, sometimes they are wrong, which is yet another reason to diversify.

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