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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:
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Allocation Diversity.
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Trailing Stop Losses.
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Position Sizing.
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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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