EVEN IMPORTED TRUFFLES and filet mignon can be ruined by a bad cook. Likewise, in investment portfolios, even the best trading ideas mean nothing without good technique. When you get right down to it, most people just want stock picks. But we’ve always tried to emphasize that it’s not what you trade, but how you trade that counts. No matter how skilled your stock-picking prowess, bad technique will prove ruinous every time.
As we wrote a few weeks back, investing is a game of speculation. No stocks come with guaranteed results. I’m from the school that says if you’re bullish on XYZ, buy it — mostly because the most influential decision isn’t necessarily which stock to buy, but how much of it to buy. Your position size shouldn’t be too big or too little, but just right.
The most obvious gaff investors make is betting too big. Even the best stocks fluctuate. Investors who put 10%, 15% or 20% of their assets in a single stock at a single price are just asking to get stopped out, most likely at a significant loss. There’s a difference between risk and recklessness; the point of trading is to grow big positions, not start out with them.
Conversely, many people spoil their stock picks by betting too small. In determining position size, most people’s first step is to characterize potential holdings. They invest a small amount of money in a “risky” stock, and considerably more in one they deem “safe.” Although this seems like a smart idea, it’s actually a recipe for disaster. Inevitably what ends up happening is the seemingly safe names underperform, and although the “risky” picks might go up, the return doesn’t make much difference to the investor because he has taken such a comparatively small position size.
The key is consistency. I can’t stress enough the importance of consistent position sizing. It’s one of the most overlooked components of successful portfolio management. My advice: Pick a standard trading unit, somewhere between 2% and 5% of your overall portfolio, and stick with it. This ensures that your positions are appropriate to your overall account, as well as to the sizes of your other positions.
Another quick way to spoil a stock pick is, ironically, to have too many other stock picks. We live in a world of scarce resources, and when it comes to investing capital, there’s just so much to go around. Although at any given moment there’s a list of 20 different companies I’d love to buy, I can’t afford to go after anything other than my top few ideas.
For example, as I’ve mentioned in recent weeks, I’ve been buying Latin American stocks for a while. And although reinsurance, railroads and satellite companies have also caught my eye, I’ve had to restrain myself to only a few introductory positions in these very promising sectors. The fact is that, right now, I’m “dating” Latin America, and until that relationship breaks up, well, I’m spoken for. While it doesn’t restrict me from watching other sectors, I’m careful not to spread my investment capital too thin.
As we pointed out last year, you need only a handful of good ideas a year to produce an excellent return. While many people still insist the point of trading is to make a large number of transactions, the truth is that less is often more.
Here’s a typical scenario. An investor does the requisite research and decides to buy XYZ. A few days into the trade, he gets bored. Maybe the stock is up, maybe it’s down regardless, it’s not providing the high return he’d hoped for. So although the trade is only a few days old and might even be going his way, he finds another promising idea and starts from scratch. Like Pavlov’s dog, he’s always salivating for another snack. Even if the actual stock picks are golden, the investor will never know about it because he’s trading simply to trade, rather than to make money.
The solution for you, of course, is to refine your efforts to a short list of ideas — and go for them. Depending on your account size, you might have up to six trading themes at once. Smaller portfolios, such as those under $30,000, should have considerably less. While I’ve always got a watch list of potential investments on deck, I’m not too quick to dump a winning trade just because another attractive opportunity comes down the pike. Real moves take time.
The whole point of investing, after all, is to pick winners. But no matter how good your stock picks are, bad technique will render them impotent from the start. Trading the wrong position size and vacillating between too many ideas are easy ways to eliminate the potential of an otherwise promising stock purchase.
– Originally on May 05, 2003 by Jonathan Hoenig
