Sometime this week, a collective groan will be heard throughout the land. The 52% of stock owning American households will open their monthly statements – and they will be none too happy.
Many will wonder how this happened; How did my portfolio lose so much value? It's cold comfort that most of their friends' and neighbors' saw their portfolios plummet also. Nationwide, over 5 trillion dollars – that's trillion with a "T" ($5,000,000,000,000) – simply vanished."
For many investors, the damage did not have to be nearly as bad as it was. If your portfolio is typical of what I have seen lately -- and I have looked at hundreds of portfolios -- it’s riddled with basic money management mistakes. As the markets collapsed, these errors magnified the damage – they made the situation much, much worse than it need have been.
In my office, part of my duties include comparing new portfolios, to my "model" portfolio. This month alone, I must have looked at countless new accounts – many of which were transferred in by Do-It-Yourselfers from on-line brokers – in horrific shape.
It’s dismaying to see the same basic mistakes come up, over and over again.
I have discussed my belief why mid-March to April 15 will mark a bottom in the sell off, (See 10 Reasons to Start Getting Bullish). As this process unfolds, you should be reviewing your portfolios for these very same mistakes.
As we wait for the Fed's magic to take full affect, here's what you can to do to get your portfolio in order:
12 Stocks Max
I've seen too many portfolios with 20, 30 even 50 positions. That’s simply far too many stocks for the average individual investor – or a pro, for that matter – to track.
Ideally, I prefer 12 - 15 stocks in an account.
For every stock I own, I am aware of at least 4 other companies which must be monitored: two competitors, one supplier, and one customer. If I own Intel (INTC), then I also track the news, reporting dates, quarterly filings (10Qs) and conferences of competitors AMD and Motorola, of supplier Applied Materials (AMAT) and customer Dell.
A portfolio with a dozen stocks means I'm watching at least 50 companies.
Can you imagine tracking the 200 or so companies which a 50 stock portfolio demands? (Me neither).
No More Than 25% Margin
In a Bull market, leverage is a mighty powerful drug that multiplies your gains; In a Bear market, its deadly.
An account of $100,000 on full margin, actually rises 50% when the market gains 25%; That same account, after after the past twelve month 60% drop in the Nasdaq, gets totally wiped out -- a 100% loss. (That actually happens after only a 50% loss) And that's not counting margin interest expenses.
Remember, margin costs you about 10% per year. That means you need to see gains well in excess of 10% to come in flat, after expenses, commissions and taxes.
Its strongly advised to reduce your margin debt to no more than 20% of your total equity. Do not let it creep over that amount in the future.
Eliminate the "Story Stocks"
The dot com's with no revenues, the tech stocks without earnings, the companies which you have no clue what they really do: Dump 'em.
You are going to have to sell something to get under 15 stocks (or less than 20% margin). Since you have to sell something, these are the holdings top get rid of.
In addition to being more manageable, it will be good for your head: The psychology of seeing the same losers on your statements month after month affects your objectivity. If you are too emotional, its difficult to make intelligent, rational decisions.
Learn to Use Stop Losses
I'm amazed at how few investors use this simple tool to limit their downside on their holdings.
To oversimplify, stocks only go up down or sideways. In the event of "down," what do you do to protect against the losses we have seen in companies like Cisco, Lucent, PSI Net, and JDS Uniphase?
The simplest stop is a percentage limit: Whenever you buy a stock, put a sell limit at about 15% below your purchase price. For more volatile stocks like Juniper (which I believe is to volatile for individuals to own) use a 20% stop.
There are at least a half dozen valid stop strategies; Depending upon the feedback, I'll consider outlining them in a future article.
Diversify across Sectors
You cannot be reader of thestreet.com or CB Marketwatch without having seen at least a dozen articles on this subject. Yet, I continue to be amazed at portfolios transferring into the office laden with nothing but Nasdaq tech stocks (the exceptions are diversified into Lucent (LU) and Nortel (NT)).
As we have seen, this is a recipe for disaster.
There are at least 8 sectors which should be represented in a well diversified portfolio: Technology and Telecom are but two of those sectors. Here’s brief list of the others: Basic Materials, Capital Goods, Consumer Durables, Consumer Non-durable/Staples, Energy, Finance, Leisure, Medical/Healthcare, Real Estate, Transportation and Utility.
You do not have to buy stocks in any particular sector today – Some of the energy and utilities are pricey now, and much of the Drug sector has been trending downwards.
Building a well crafted, balanced portfolio takes time -- at least a quarter, if not longer.
Deal with Big Losses Head On
I've looked at a number of portfolios with large, underwater positions. The refrain I hear over and over again is "I don't want to take a loss."
This is the Ostrich methodology of portfolio management: Sticking your head in the sand instead of confronting the issue does not make it go away.
Recognize there is no such thing as a paper loss. If you own 10,000 shares of Cisco (CSCO) at 60, and it closes today at $15, you have lost assets totaling $450,000. Period.
The only paper loss you have are the $450,000 dollar bills you no longer possess. That’s the only paper loss you should ever consider.
How serious are professionals about this? My head trader once startled me in a restaurant by pulling out a wad of $10,000 -- in cash. His answer to my incredulous looks? "Its to remid that the letters and num,bers on my screen reflect real money." (Oh, and don't worry about him -- he was an instructor for the U.S. Marines jungle training course -- I think he can take care of himself).
Get in the habit of marking yourself to market, every day. Start fresh the next morning, and consider your portfolio in terms of assets, and not stocks.
Write Covered Calls
Next, consider writing covered calls on your biggest upside-down positions which you refuse to sell. Go out two to three months at a strike price 20% or so above this weeks close. That means that the 10,000 CSCO shares which just transferred into the office ($50 average price), we will look to generate 5 – 8 % per quarter in option premiums. Each time you write these against the 10,000 shares, up to $15,000 or so can be derived in premiums. These 50% losses take about 2-3 years to make up.
Two caveats about writing options – first, you must be prepared to have your stock called away; If you still like the stock, you’re free to buy it back.
Second, if sell the underlying stock without buying back the call you wrote, you will be “naked short” the calls. That has unlimited theoretical risk – stocks can keep going up forever – so be religious about trading the option and underlying stock in tandem.
Many people are best advised to speak to an advisor well versed in option strategies.
Diversify within Sectors
Even after you have diversified across sectors, be aware of your holdings within sectors. Tech stocks are very interelated by product line.
I've seen too many portfolios whose owners think they are diversifying by owning stocks in the hardware, software and semiconductor and manufacturing areas. While Dell (DELL), Microsoft (MSFT), Intel (INTC) and Applied Materials (AMAT) may all be in different sectors, they are inexorably tied to the PC business.
Owning these four stocks together is a futile exercise in diversification. Other examples abound: wireless groups, internet infrastructure, enterprise software, networking.
Your solution is to pick one and only one stock from a whichever group you choose to own.
This means you should not own JDSU, Corning (GLW) and Ciena (CIEN) as a group; Nor should you hold Nortel (NT), Lucent (LU), Juniper (JNPR) and Cisco (CSCO) as they all more or less trade together.
Conclusion: These half a dozen steps should be part of an investment plan. You must either create your own strategy (and develop the discipline to see it through), or find a trusted professional (preferably through a referral) to assist you.
At the time this was written, Ritholtz was long Ambak, Corning, EDS, EMC, Goldman Sachs, Loral, Microsoft, and Micron Technology. As of April 10, JDSU and The Gap were added to the portfolio.
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Copyright © 2001 Barry L. Ritholtz, All Rights Reserved worldwide. May not be copied, stored or redistributed without prior, written permission.
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