The risk of focusing on individual securities at the expense of your portfolio is a simultaneous breakdown of several positions. If you have 25 positions in your portfolio, for example, and the amount at risk for each position is 1 percent, it’s conceivable (and almost anything can happen in financial markets) that all 25 positions will go against you at the same time and cause a major loss of 25 percent of your portfolio.
Don’t believe it can happen? Consider that U.S. equity markets dropped 22.6 percent on October 19, 1987 (during what had been a strong bull market). Few believed a move of that magnitude could happen in a single day. That loss actually exceeded any single-day loss experienced during the Great Depression.
External factors beyond anyone’s control can impact markets day to day. And it’s possible for a company you own shares in to announce a lawsuit or loss of a key customer, which could send the shares tanking in a heartbeat. To combat this risk, monitor the risk not only at the individual stock level, but also at the total portfolio level.
Manage risks: Limit all position losses to 7 percent
The prudent approach to limit the losses from all your positions is to place a ceiling on the amount of capital you risk at any one time. Determine how much to risk on any single position — I recommend between 0.25 percent and 2 percent of total capital. The cumulative total of the amount at risk for each position is considered your total capital at risk.I recommend limiting your total capital at risk to 7 percent. Doing so means that the most you could lose in a single day if everything were to go wrong is 7 percent. Of course, you shouldn’t set stop losses so close to your entry prices that they’re triggered frequently; that may be a sign you aren’t giving your stock room to fluctuate. A 7 percent level should rarely (if ever) be triggered because it would require all position stop losses to be executed on the same day.
The maximum amount you should risk in a single position, in my opinion, is 0.5 percent. This amount allows you to have at least 14 positions (0.5% × 14 = 7%). The larger the amount you risk on a single position, the fewer positions you can hold. And the fewer positions you hold, the higher the risk of your portfolio and the greater chance of a major account value swing that may be difficult to recover from.To help you understand how this 7 percent rule works, consider an example: Trader Bob has constructed a portfolio of seven different positions that’s worth $50,609. Figure 10-2 shows, from left to right, the symbol of each of his positions, the current stock price for each of his positions, his entry price, the number of shares he owns, his stop-loss level (exit level), and his total amount at risk based on the specified exit level.
Information from Trader Bob’s hypothetical portfolio.The total amount of capital that Trader Bob has at risk based on this portfolio is 5.25 percent, found by summing up the Amount at Risk column. So, Trader Bob can risk an additional 1.75 percent of his portfolio on new positions before he hits the 7 percent ceiling that I recommend. That 1.75 percent may be spread across five or more positions.
If you enjoy finding Waldo, you may have noticed that the amount of risk listed for shares of AAPL, or Apple Inc., is 0.00 percent. What gives? As a position moves in your favor, you can adjust the stop-loss price higher or lower, depending on the direction you’re trading. In this case, shares of AAPL were purchased at $140.92 and promptly began rising. After a nice gain, Trader Bob decided to raise his stop-loss level to his entry price level. Doing so meant he could risk more capital in other positions he owns. The assumed worse outcome from his position in AAPL is to break even (barring the stock price gapping down).
The amount at risk can never be a negative value, so don’t use negative risk amounts when you can raise your stop-loss order to a price that locks in a profit. If Trader Bob raises his stop loss to $150 in the future, his amount at risk isn’t –0.5 percent. Raising your stop-loss order ensures your portfolio doesn’t swing trade too aggressively and compensates for the inherent limits of stop-loss orders. After all, you may or may not get executed at your stop-loss price. So if a security gaps down below your stop-loss price, your stop-loss order will be executed at a much lower price than you anticipated.
Diversify your allocations
Another method of limiting losses on a portfolio level is diversification. No doubt you’ve heard the term thrown around on financial news networks. It seems every expert often recommends avoiding “putting your eggs in one basket.” Fortunately for you, this section gives you a bit more to go on than a farm analogy.Diversification is one of the shining gems mined from academia. In a nutshell, investing in more than one company, industry, country, or trading vehicle helps protect you if a problem befalls one or more of those holdings. The aim is to have a portfolio in which some securities’ gains offset other securities’ losses. The best scenario is simply a portfolio with all gainers, but some positions make money while others lose money.
At its simplest level, diversification can be seen as a tool of avoiding the problems of a single company. For example, you may buy shares in General Motors and Ford so that, if Ford takes a tumble, your shares in General Motors can offset your losses.
But what happens if a trade war brings down both General Motors and Ford? In that scenario, owning securities not in the auto business may be prudent. So, you pick up shares of Nike and Amazon. But when the United States goes into recessions, shares of all your U.S.-based companies are likely to fall. That means you may want to be investing in Asia or Europe as well.These examples give you an idea of the benefits of diversification. The simplest form of diversification is investing in several securities, but you also can diversify according to industry exposure, country, and asset class. I cover all three of these options in the following sections.
By number of securities
The most elementary way of diversifying your portfolio is simply to spread your assets across several securities. The more, the better — the thinking goes. But how many securities constitute a diversified portfolio?The benefits of diversification can be realized with 10 to 20 securities, but I should warn you: This number assumes the companies are in different industries and countries. Investing in 10 semiconductor manufacturers doesn’t expose a portfolio to businesses outside of a small niche of the market.
Your trading plan should indicate a target number of positions you trade. The more positions you have, the less time you’ll have to devote to each single one and the more likely your returns will mirror the market. So, keep your number below 20.
Following the position sizing guidelines largely takes care of this first point of diversification by number because the risk guidelines ensure that you have several positions. But if you’re going to brave the market without these guidelines, try to construct a portfolio of at least ten different positions and securities in different industries (see the following section for tips).By industry exposure
According to William J. O’Neil, founder of Investor’s Business Daily, an industry group roughly determines 30 to 40 percent of a security’s return. So being exposed to only one or two industry groups is extremely risky because the returns of your securities will be very similar. Think about it in terms of the auto example from earlier in this chapter: Are the factors affecting General Motors and Ford all that different? Or United Airlines and Delta? Exxon Mobil and Chevron?Figure 10-3 is an outline of the major industry sectors (as defined by the Global Industry Classification Standard, or GICS). Fortunately, the software services you use should break down the industry or economic sector that your securities belong to.
Source: MSCIGICS sector classification.
There’s nothing wrong with concentrating in a few sectors — say four or five. But beware of investing in only one or two sectors because you won’t benefit from the diversification benefits inherent in investing in different parts of the economy.
Be sure to set a minimum number of industry groups that you trade in. I recommend identifying at least three different sectors and trading a minimum of five different industry groups, smaller classification groupings than sectors. For example, healthcare equipment, healthcare providers, and healthcare technology are all industry groups in the healthcare sector so investing across these three industries would not diversify your portfolio outside of the healthcare sector.
By asset class and country
Another way to diversify your portfolio is to invest in different asset classes and countries. The asset classes you trade decrease your overall portfolio risk, so if you’re using this approach, you should shoot to trade two to three different asset classes. Different countries exhibit different risk characteristics; I try to trade equities in at least two to three different countries.Three vehicles for achieving diversification by asset class and countries are exchange-traded funds (ETFs), American Depository Receipts (ADRs), and Real Estate Investment Trusts (REITs).
Exchange-Traded Funds (ETFs)
ETFs have exploded in growth over the last few years with assets topping $4 trillion. ETFs are funds that represent baskets of securities — such as a basket of stocks in the same industry, a basket of commodities (such as energy or agricultural commodities), or a basket of foreign equities (listed in Mexico, Brazil, China, or Turkey, among many others). Trading ETFs helps diversify your portfolio across several securities in one sector or country. For example, you may be right on a substantial move in oil stocks, but you may select the one oil company that’s having problems.Buying an energy ETF (such as the iShares US Energy ETF) allows you to profit from the movement of several energy stocks. Purchasing one ETF is like instant diversification across a style or sector of the market. However, for investors who are socially responsible and care about environment, social, and governance issues, keep in mind that an ETF doesn’t allow you to exclude companies that fail to meet specific socially responsible guidelines. Therefore, you’re best off investing in individual stocks that do meet your guidelines.
Sometimes there’s a bull market in commodities whereas stock markets are lagging. So various asset classes can provide a boost of returns in addition to lower risk. Here are some of the main ETFs that offer you exposure to commodities:
- Precious metals: Gold can be traded via SPDR Gold Shares Gold (symbol: GLD in the United States); silver can be traded via iShares Silver Trust (symbol: SLV). If you’re interested in metals and mining, you can swing trade the SPDR S&P Metals & Mining ETF (symbol: XME).
- Energy: Your options for trading energy ETFs include Energy Select Sector SPDR (symbol: XLE). Or you can trade energy stocks that rise and fall with the price of oil. Energy exploration and production companies especially track changes in crude oil and natural gas prices.
- Agricultural commodities: Many ETFs give you exposure to agricultural commodities such as timber (symbol: WOOD) or fertilizers and agricultural chemicals (symbol: VEGI).
American Depository Receipts (ADRs)
ADRs allow you to take advantage of strength (or weakness) in a company based outside the United States without ever leaving home. Currently, the fastest growing markets are in China, India, and Africa.Mixing international securities into your portfolio offers greater diversification benefits than having only U.S. stocks because international markets may zig when the U.S. market zags. The more technical explanation of the benefit of ADRs is that foreign securities have lower correlation ratios to the U.S. market than domestic securities. Of course, the currency of those foreign markets may also improve (or hurt) your returns.