like every other perishable thing, operates on a distinct and established cycle. Each one is a living entity with an identity all its own.
Life springs up in the strangest of places, and a trading idea is no different. It might come from a fully formed and well-researched hypothesis...or on a completely impulsive whim. A trade can be inspired by a personal experience or an emotionless stock screen. It might add to your portfolio's volatility, or reduce it.
Remember, though, that an oak tree drops thousands of acorns, but only a tiny fraction will ever sprout. And so it goes with building a portfolio. Because nobody can be right all the time, you must scatter your seed far and wide. So find a standard trading unit somewhere between 2% and 5% of your portfolio, and stick with it. Get used to putting on trades that grow into> oak trees, not starting with oaks that may shrivel back into acorns.
When a trade is young...and foundering...and looking for direction...there's not much we can do for it. And just as every toddler could one day grow up to be president, so does every trade carry the possibility of being the next big thing.
Of course, most won't be. In fact, the overwhelming majority of my trades go nowhere special at all. Having losing trades does not by definition make you a bad trader. And if you can't learn to accept this simple fact of life, then buy an actively managed mutual fund and call it a day.
For those few bets that do pay off, you'll inevitably find that a small trade quickly grows into a substantial position. Think of it as your position entering adolescence: Whether you're adding to the trade or just patiently watching it grow, a winning trade will often have astonishing growth spurts in short periods of time.
As a position grows, it will by definition become a larger part of your portfolio. And although you might be salivating at the thought of a lay-up profit in such short order, resist the temptation to make the cash register ring as soon as a stock surges. Just as good parents recognize that a teenager needs more autonomy and responsibility, you can only profit on a stock's longer-term trend if you don't stand in its way.
Eventually, of course, that teenager grows up, his eyesight deteriorates, his pate goes bald and his waistline expands. And there comes a time when trades, too, begin to feel their age. Nevermind the long haul. The truth is that a stock's main period of significant, rapid price appreciation is often confined to a relatively short span of time. Motorola and Dell Computer are two prime examples of stocks that grew up in the 1990s and should probably have long since been retired from your portfolio. Even Warren Buffett, who's known for never selling a stock, recently put his Citigroup stake out to pasture.
Within your portfolio, you know a position has matured once a decline or stagnation in its price begins to have a meaningfully detrimental impact on your overall bottom line. But just because a stock isn't as spry as it once was doesn't mean it's time to put it on an ice floe and push it out to sea. When one of my positions begins to falter, I set a schedule of sell stop orders that will reduce my exposure should the stock continue to fall. So if my 500-share position of XYZ falls from 60 to 50, I might set orders to sell 100 shares of stock every two points down. The weaker the stock becomes, the less my portfolio is exposed. I protect my upside, but also my profit.
Your profit is your oxygen. There's nothing more important than ensuring a smooth, steady supply. So on those fortunate occasions where you're able to make some money, you must be very particular about how those proceeds are spent. How you reinvest your capital is almost as important as how you deploy it in the first place.
As we've discussed before, a percentage of any score must immediately be segregated to cover the unavoidable tax bite that goes along with any capital gain. I'm also of the school that says some of your profits should be spent. Making money isn't easy, and buying even a small something for yourself is the best way to remind us of what makes money worth working for.
The remainder should be reinvested into your most promising new ideas but not the way most people do it.
Fresh on the heels of a speculative win, they'll usually plunge straight into another stock pick. Indeed, on the heels of a big score, most people find it quite tempting to "switch" that is, to immediately plow the entire proceeds of one winning trade into the next hopeful contestant. So if they sell $10,000 worth of Wal-Mart Stores, many people simply buy $10,000 of Gap or Sun Microsystems or whatever their fancy happens to be at the moment.
But just as an oak tree scatters many acorns, a winning trade should serve to fund any number of new promising ideas. New positions should start with your standard trading size. Assuming the 3% portfolio allocation to each new trade, selling a 12% position should yield at least four new trades. Over time, you'll find that, on average, one will be a stinker and two might go nowhere at all. The fourth will be another oak tree, yielding another harvest of acorns, ready to be planted in whatever you consider to be the most fertile soil at that time.
Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund.>