[Exploring the Universe section of Market Shadows Newsletter, Vanity of Vanities (11/5)]
Courtesy of Dr. Paul Price
Most people are rather haphazard in their stock-buying approach. They get ideas from various sources and then simply buy 100 shares of whatever sounds promising. This can leave them poorly diversified, with very unbalanced positions when measured by dollar values.
After thirty four years of putting together portfolios, I’d like to share my common-sense way of starting an equity account.
In the late 1970’s a full service commission was about $90 – $100, and discount brokers like Schwab were charging $29.95 a trade. Odd-lot trading added an eight (remember those) to the price of amounts less than 100 shares.
Today you can trade for as little as $1 per 100 – 200 shares at TradeStation or Interactive Brokers. Many other online brokers charge from $3 – $9 per trade regardless of size. Commissions should no longer be an influence in deciding whether to make a trade.
When starting out, one important consideration is the amount of money you have available to work with. If you have just a few thousand dollars, you’d probably be better off in a mutual fund or ETF (exchange traded fund). This article will deal with how best to allocate amounts of $20,000 or more.
I’m going to use a $100,000 model, but the same technique applies with other investment sizes. I think we need at least 10 different stocks spread over varied industry groups to achieve proper diversification.
I typically hold more than 20 issues in any decent sized account. Why so many? So that no one company initially represents more than 5% of my total capital. Being over-invested in one company is very risky. Inevitably, over a lifetime of stock-buying, we all have occasional individual stocks blowup on us. Count on it.
I got blindsided earlier this year with Knight Capital Group (KCG) when that crazy software algorithm almost bankrupted the company. What looked like a solid, low P/E stock tanked 70% in a day! In a 5-stock portfolio, that would have been catastrophic. As part of a well-rounded account, it was a survivable loss.
My biggest mistakes over the decades have been due to putting too much of my total net worth into stocks I absolutely loved. Those over-weighted positions rarely did well (until right after I reduced my holdings or completely sold out).
Murphy ’s Law: Outsized positions will underperform.
Corollary: Whatever you just nibble at (dollar-wise), will double first.
My rule has evolved into using equal dollar purchases when setting up new portfolios. That means mentally dividing my starting dollars by twenty to get an upper limit for each purchase. With a $100K bankroll, that translates into a $5,000 maximum allocation in any one name.
Now, it’s time to prepare a wish list of companies we’d like to own. Last week’s issue of Market Shadows, Value in the eye of the storm, provided a list of stocks that I thought were worth buying at their then-current prices.
Here’s the list of stocks with their prices as of last week, and their closing prices on Friday, Nov. 2:
Ticker Prices 10/26 Prices 11/2
ABM $18.87 $19.71
ANF $30.37 $32.78
APD $77.57 $78.15
BHI $43.22 $41.59
CAT $84.20 $85.79
CLMS $10.87 $10.93
CMI $93.84 $100.03
COH $55.89 $56.97
DLB $30.83 $34.10
ESRX $62.24 $62.02
HSII $12.02 $12.21
IBKR $14.00 $14.34
ICE $130.44 $129.83
JCI $25.86 $26.25
KELYA $13.13 $13.70
KFY $13.48 $13.75
LH $85.04 $85.27
MOS $53.00 $52.19
POT $40.11 $40.30
RDS.a $67.80 $69.46
SPLS $11.44 $11.47
WAG $35.27 $34.89
XYL $23.59 $25.63
Note: I bought more Lab Corp (LH) last week on an intra-week dip. These stocks are currently part of my long term holdings. Future articles will address the specific factors I look for in selecting the best shares for timely investments.
In early March of 2009, I probably would have put my entire $100,000 to work immediately. That period, and perhaps September 2002, offered some of the most compelling bargains I’d ever seen. A market like today’s falls into middle ground valuation-wise. Most shares today are neither dirt cheap nor outrageously expensive.
After determining how much money to invest, and how much of that to commit immediately, I begin to calculate how much capital to allocate to a selected number of stocks. Then I choose which stocks to take positions in. If starting today, I’d commit about 50% – 75% of my allocated capital. In this example, I’ve jave $50,000 – $75,000 to divide between at least 15 to 20 different companies.
Example: Investing 62.5% of the $100,000 virtual portfolio, and selecting 18 stocks:
$62,500 / 18 = $3,472
At the midpoints of our capital allocation and commitment level, and selecting 18 as the number of stocks to apportion our money into, we can put about $3,500 into each position. Think dollars. To decide on the number of shares for each position we need to work backwards from that.
$3,500 = 700 shares of a $5 stock, 350 shares of a $10 stock, 175 shares of a $20 stock, 87 shares of a $40 stock, 58 shares of a $60 stock and 35 shares of a $100 stock. The number of shares could be in the single-digits if we want a high share price stock such as Apple or Google.
The final amounts don’t have to be exactly $3,500, just in the ballpark. Once the portfolio is set, the amounts will fluctuate anyway.
This is the bare bones of the early phase of my investment strategy. In next week’s issue, I’ll continue the process with part two. Be sure to tune in for more exciting details.