How to protect your portfolio from yourself
Seeking Alpha (seekingalpha.com), a well-respected publisher of finance-related content, recently published an enlightening article titled “4 Simple Rules To Protect Your Portfolio From Yourself.” It’s a long article, full of sound advice based on historical analysis and advice from many stock market experts, such as Ray Dalio, Warren Buffett and Charlie Munger, among others.
I list the author’s rules below, with my own commentary.
Rule 1: “Invest a fixed amount in any given month.”
The reason for this rule is quite simple: You will never be able to time the market reliably. Even the most successful investors don’t pretend they can predict when the markets will hit their peaks or hit the bottom.
In the long run, stocks will appreciate in value along with the growth in the economy, and if you are out of the market long enough, you are guaranteed to lose the opportunity to increase the value of your portfolio.
As the author of the article points out, the best and worst days in the market happen close together. If you avoid the worst days, you will also miss the best ones.
One way to take advantage of the long-term trends in the market is to consistently invest. The author recommends this method: Determine at the beginning of each year how much you will invest and divide that amount by 12. That’s your monthly investment budget.
The value of this approach is discipline. It forces you to invest even when you are fearful of a market fall. It also prevents you from investing too much when you may be over-optimistic. Investing gradually forces you to take advantage of the growth in stock value over time.
Overall, by investing a fixed amount each month, you are, as the author says, both “forcing” and “easing” your way into investing, taking advantage of long-term trends, without having to guess right about market increases and decreases.
Rule 2: “Define your maximum allocation to a stock.”
One of the bedrock rules of investing is diversification: not exposing yourself to undue risk by owning a disproportionate amount of a given stock or industry group.
But how do you judge the proper allocation, especially if you are holding “winners” you are loathe to sell?
The author recommends this be done from a cost-basis perspective. For example, If you invested $25,000 in an individual stock, your cost basis remains $25,000 even if, say, the market value has increased to $100,000.
You may decide, as the author recommends, to cap your exposure at anywhere from 5% (the equivalent of holding at least 20 companies) to 10% (the equivalent of at least 10 companies) — again, on the basis of cost basis, not current market value. [Ed. Note: That is, don’t let what you invested in any one company’s stock represent more than 5% (or 10%) of your total expenditures on stock.]
If you focus on risk allocation from a cost basis rather than current value, it will encourage you to add to your winners and prevent you from adding too much to your losers.
Rule 3: “Don’t add to your losers.”
The best way to avoid having a significant loser in your portfolio is to never average down. It’s normal to have some losers in your portfolio. But you must avoid the urge to “double down.” It rarely succeeds.
Rule 4: “Don’t sell your winners.”
If Rule 3 is difficult for some, Rule 4 is easy to follow. It merely requires you to leave your winners alone — for as long as possible. The author quotes the legendary investor Charlie Munger: “The first rule of compounding: Never interrupt it unnecessarily.”
As Warren Buffett once remarked, “Our favorite holding period is forever.” His philosophy, which is hard to argue with, is that fear and greed lead investors to sell and buy at the wrong time.
If you find a good company, unless it suffers a drastic change that threatens its ability to compound earnings, you should hold it as long as possible.
Although the article focused on individual stocks, I believe the recommendations are applicable to specific sectors also.
Elliot Raphaelson welcomes your questions and comments at firstname.lastname@example.org.
© 2021 Elliot Raphaelson. Distributed by Tribune Content Agency, LLC.