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Four Legs of Wealth
Research for Online Investors

by John Dalt

You have worked hard to earn your money.  Now it is time to use discipline and a good plan to grow your portfolio of long-term investments.  A four legged stool is sturdy and will resist tipping over causing injury.  We should ask for the same characteristics in our investment discipline.

Investing in stocks is a lot like investing in real estate.  There are rules, if you ignore the rules you pay the price.

On real estate it is location, location, location.

In stocks it is:

  1. Allocation Diversity. 
  2. Trailing Stop Losses. 
  3. Position Sizing. 
  4. Watch Expenses. 

1. Allocation Diversity
Warren Buffet makes a salient point.  You cannot predict where the next boom or bust is going to occur.  Who would have expected the personal computer to change the way we live?  Who knew that tech was going to blow up in 2001?  Who expected oil to go to $147, and then crash to $30 within 8 months?  You get the point, looking back it is easy to see these made sense and should have been predictable.  But they are not, so we need to spread our investments over different sectors of the economy.  This keeps us from losing too much in a crash of an industry like oil or financials in the last few months.  We want to be exposed to as many different sectors as possible.  No one can predict winners and losers with certainty.  Some may make an impressive call, but not consistently.

2. Trailing Stop Losses
When we buy a stock, we expect it to increase in value and pay us handsomely.  We set a trailing stop loss on the stock the day we buy it.  The highest closing price after we buy a stock raises the trailing stop loss.  If the stock ever drops 20% from our purchase price, or subsequent higher closing price, we sell it.  We take our money and profits to invest in another great company.

In the long term portfolio we base trailing stop decisions on the closing price. We don't want to sell on a dip during the day, only to see the stock recover by close above our trailing stop. If the stock price closes below our trailing stop we sell the stock the next day. This can be entered in the computer as a market order if you like. I prefer to enter a limit order at the closing price the previous day. If the market is up (above your limit price) you will get the higher market price. If it is down the order will wait for price recovery during the day and sell at our "limit price." Unless the stock is suffering a serious sell off, it will almost always cover the price of the close on the previous day.  The other problem with entering stops in the computer is floor traders will dip stocks to take them out. When a trailing stop is entered in your computer, the sell order is displayed on floor traders computers. This is part of the game they play,  dipping the price to take the rubes stock at a cheap price.


3. Position Sizing
This goes hand in hand with allocation diversity.  What good would it do to be diversified but the positions were different sizes.  My luck, the biggest position would be in a sector that suffered and my smallest position would be in the very best sector.  It is important to size each of our positions approximately the same size in dollar amounts.  Once a year, generally in December, we "re-balance" our portfolio.  We sell some of the high flyers and add to the sectors that have decreased in value.  Thus we rebalance each of our positions to make each approximately the same size.  We may pay taxes on some of the stocks that we sell at a gain, but a small amount of taxes is better than holding and ending up with a loss.  We recommend that each position be 5% of the total portfolio.  This means you will be fully invested with 20 stocks.

4. Control Expenses
We recommend you use a discount broker, so you transaction cost is low.  You can enter your orders from your home, in the evening, and save a lot of money over "calling in your orders"  We like to buy quality companies that we can hold onto for the long haul.  We want long term holdings, watching our dividends grow.  We don't want to pay the government just because we saw some other company we liked better.  Long term capital gains are better than regular income, but no taxes at all are even better!  You should try to put your high yield investments in a tax sheltered account.

Trailing Stops

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