After all, it has been pounded into investor’s heads as a technique to reduce risk by minimizing your exposure to a single investment. And that’s absolutely correct. But there’s a huge problem…
The majority of investors do not fully understand the concept of diversification.
In fact, there are multiple steps involved when ensuring your portfolio is minimized to investment risk.
We personally like to call the concept asset allocation because as we discussed earlier we are buying businesses/assets when we invest. The big misperception in regards to proper asset allocation is “if you invest in numerous stocks, then you are diversified.” Investors believe this will ensure they avoid catastrophic losses should one of their investments go south.
This couldn’t be any further from the truth. And it’s the exact reason why we monitor the TSP performance and report current market conditions to our subscribers.
Conventional Wisdom Isn’t Completely Wrong
Generally speaking, let us assume you have a portfolio comprised only of oil stocks. If the price of oil drops dramatically or another oil spill disaster occurs, chances are share prices of oil stocks will drop significantly as well. You will in turn experience a noticeable drop in the value of your overall portfolio.
This scenario is literally taking place right now, take a look…
Look at the correlation between the price of oil and the price performance of all three oil stocks.
If, however, you counterbalanced your oil industry stocks with a couple of airline stocks, only part of your portfolio would be affected. In fact, there is a good chance the airline stock prices would climb, as airlines largest expense plummeted due to low crude oil prices. Which would lead to more profits for the company and their investors.
At face value the concept of diversification makes absolute sense. Own stocks across the board and amongst different types of industries. So when or if a stock significantly declines, the value of your overall portfolio won’t be severely effected.
But Here’s The Problem With Conventional Wisdom
It goes without saying… you shouldn’t put all your eggs in one basket.
We all know someone or are perhaps guilty ourselves, who invested a sizable amount of money into one stock and sustained a significant loss. The story and background of the stock sounded great, but at the end of the day money talks…
Have you ever heard of 3D Systems?
Once upon a time, 3D printing stocks rode a gigantic hype bubble. The stock rose from $10 to $95 in 2 years. Based on the idea that 3D printing was a revolutionary technology sitting on the cusp of widespread adoption by a range of industries and even consumers. It seemed as if you couldn’t lose money. Unfortunately this Cinderella story ended badly.
That’s close to a 90% loss in your investment if you purchased at the top! This is why it’s imperative you only invest in the best businesses at a discount.
Regardless of your portfolio’s diversification it is inexcusable to sustain a significant loss such as this in your portfolio.
In fact, if you have the proper asset allocation in your stock portfolio you can ensure you never experience a catastrophic loss.
3 Rules Which Eliminate Substantial Loss In Your Portfolio
For simplicity we are going to assume we have a $100,000 portfolio. You can tailor this to your specific situation if need be.
Here are 3 rules that we live by in regards to investing. Two of them are non negotiable and the last one has some wiggle room.
1. Never Place More Than 5% Into One Position, PERIOD. No Excuses!
No matter how much you believe in a particular stock, proper asset allocation will save your investment portfolio. One of the harshest lessons learned in the stock market is big egos eventually get pummeled.
What most investors fail to realize is the market is not rational. The market is not efficient. One of the best quotes we have ever seen comes from John Maynard Keynes…
“The market can stay irrational longer than you can stay solvent.”
Proper asset allocation is the ultimate protection should things go wrong in one investment. Great investors understand all of their stock picks will not be winners. Therefore they protect themselves and their entire portfolio by implementing this method.
2. Adhere To A 25% Trailing Stop Loss on All Positions. No excuses
Understanding this concept is simple, a stop loss order is simply the line in the sand where an investor says, “I want to exit this position.” In regards to a trailing stop, it’s a stop loss order that adjusts to the price fluctuation of the stock. Don’t worry, we will show you examples in a moment.
This rule allows you to do three things as an investor:
- Let profits run without selling your position too soon.
- Cut your losses early to prevent catastrophic loss to your portfolio.
- Takes all the emotion out of investing.
How A Trailing Stop Is Used
To use a trailing stop, you will determine a percentage below your initial entry price you are willing to lose. This could be 10%, 15% or 25% whatever you determine, this will be your “pack up your bags and move on” price point. In other words, if the price falls below this price point it will set off an automatic trigger to sell. However, we all hope that the price of the stock moves upwards and when/if it does your trailing stop moves upwards as well.
Confused? Don’t worry let’s take a look at some examples.
Sally researched Microsoft (MSFT) and concluded the stock was a great business and loved the idea of owning shares for the long term. She worked overtime for 2 months in order to invest the extra money into MSFT. When it was all said in done Sally was able to purchase shares of Microsoft for $26/share.
Not too shabby! She set a predetermined trailing stop of 25% which put her initial stop price at $19.50.
Sally knew no matter what happened she would sell automatically if Microsoft fell below $19.50.
Yes she would lose money and probably some self confidence as well but she would preserve whatever capital she had left in order to invest in another stock position.
Remember, Sally must still monitor this position on a regular basis in order to adjust her trailing stop appropriately.
In November of 2007 there was a spike in Microsoft’s share price all the way up to approximately $32/share.
Sally had been monitoring this move and had to readjust her 25% trailing stop loss. Since the share price was now $32/share her new stop price was $24.
Unfortunately for Sally in July of 2008 the share price of MSFT closed below $24/share which triggered an automatic sell of her entire position. This resulted in a 7.6% loss on her position.
This definitely isn’t what she had hoped for but it is inevitable in investing and will happen more often than you’d like. But let’s take one more look at how Microsoft performed after Sally was stopped out.
Wow! Looks like Sally got out at the right time.
She purchased her shares for $26 and MSFT ended up trading as low as $14 during the financial collapse. That was almost half the value of her initial position.
We understand individuals from the “buy and hold” philosophy will argue if she simply held onto her shares while purchasing more she would be above break even and at a profit.
We certainly understand their logic but we subscribe to the “We can’t tell the future” philosophy.
We would much rather cut our losses and take our preserved capital somewhere else where we can put it use. For example, Sally would have sold for a 7.6% loss but would have had that capital available to invest in large blue chip stocks trading at fire sale prices during the financial collapse.
The number one thing all investors should acknowledge and remember is it’s far easier entering a stock position but much harder to determine when to sell. Trailing stops eliminate this guessing game and ensures you are profitable or at the very least preserve your investing capital.
3. Maintain 25% Of Your Portfolio In Cash.
There’s no right or wrong answer to how much cash an investor should hold as an investment, it is a strategic decision. We base our entire investment strategy around buying great businesses at bargain basement prices. And those two things rarely happen at the same time.
This is why we like to have cash on hand. It allows us to immediately take advantage of these opportunities when they present themselves.
Some investors would argue against such a large allocation in cash. Especially during of a bull market, where equities are increasing steadily. This argument certainly has merit but you have to remember we’re not buying just any stock. We’re focusing on acquiring the best businesses for the cheapest price. And you never know when these companies are going to go on sale.
Chances are you’ve heard of BP. BP delivers energy products and services people around the world need. There’s an extreme likelihood you’ve purchased gas from one of their gas stations in your lifetime.
On April 20, 2010 Deepwater Horizon, an offshore oil-drilling rig, exploded in the middle of the night while working on a well on the sea floor in the Gulf of Mexico. The blast occurred 41 miles from the Louisiana coast.
For nearly three months, oil leaked from the Macondo well at a rate estimated between 1.4 to 2.5 million gallons per day. Repeated attempts to stop the flow failed until mid-July, when a tighter-fitting cap sealed the well head. In all, the well spilled 4.9 million gallons: the biggest offshore oil spill in history.
The market panicked and investors ran for the exits. BP’s stock price fell from $47 to $22 in less than two months. It went without saying the road to recovery for BP wasn’t going to be easy, but a behemoth like that in the oil & gas industry wasn’t going away overnight. This company’s stock became severely undervalued and offered a great opportunity to investors.
As you can see the stock eventually recovered from its decline and offered investors a significant return on their money. These opportunities do not happen often but when they do you need enough cash to take advantage of them.
How The 3 Rules Come Together
A portfolio that utilizes both the tactics of proper asset allocation and trailing stops will have solid defense against stock market volatility. These rules will GUARANTEE you never suffer significant loss to your portfolio. Here is how:
You will have 15 different positions of $5,000 each if you were fully invested.
Since you are adhering to a trailing stop of 25% you cannot lose more than $1,250 on a single position.
Before you invest a penny you know the most you can lose if you are wrong (and it will happen) you will lose 1.25% of your portfolio.
On the highly off chance there is a complete financial disaster and all 15 of your positions were to hit their 25% trailing stops. Then you would lose 18.75% of your portfolio ($1,250 x 15 positions). That is the absolute worst that could happen, not a penny more.
This is how professional asset allocation and safety is implemented in your investment portfolios.