JUST LIKE THE
animal for which it's named, a real bull market will do its darndest to shake anybody off its back. And although the corner of Wall and Broad isn't a stop on the rodeo circuit just yet, the concept ofbull riding
is the same nevertheless: Get on and hang on for as long as possible. But as every cowboy can attest, investors should be prepared for the inevitable fall as well. Lord knows we'll all get bucked off eventually.
So whether it's hard assets or international stocks, I start with the mentality that in my portfolio, nothing is too sacred to sell. Some people fall in love with favorite holdings, but for me stocks are just pieces of paper. When a bull kicks me off its back, my focus isn't to avoid a fall but a broken neck. And regardless of whether I'm selling at a profit or a loss, the challenge is to do it in the most strategic way the market will allow.
As even a novice investor will attest, buying a stock is easy; it's selling that's undoubtedly the much harder trade. As regular readers know, I've long advocated the use of stop-loss orders, set below the current market price, as the best method for getting out. Investors use a percentage decline or place the stops below a particular level of support. Of course, these techniques work only if investors are disciplined enough to follow them. Sell-stops are an effective way of preserving a position while at the same time reducing risk. I don't sell for the heck of it, but place my stops and let the market "take me out."
Just because investors can> get out of a position, however, doesn't mean they necessarily want to. It's a lot easier to stay in the trade if they have hedged some risk by holding cash.
As I wrote a few weeks back, too often holding cash tends to be an all-or-nothing affair. But when putting money to work, I've found some luck in pairing an aggressive trade with an equally sized cash allocation. Not only am I more comfortable in setting slightly wider (and less likely to be hit) stop orders, but regardless of how the trade works out I'm left in a relatively strong position. If the market rallies, then I've got ammo to expand my commitment to the trade. If it falls, then I'll cut my risk profile even further by sequestering the cash in a CD or short-term bond.
As I always like to point out, trading is first and foremost an exercise in observation. And on those all-too-frequent occasions when I get stopped out of a stock, employing some basic group analysis can help determine whether a major trend has changed or merely paused along the way.
Like flocks of birds or schools of fish, stocks tend to move in concert with their sector or industry group. So upon getting stopped out of a position, I'll take a detailed look at the companies within the group to which the stock belongs. If my holding was the only name to drop, that tells me the trend is likely still intact, making me more prone to either re-enter the trade or find a stronger name in the group to tax-swap into. If other stocks in the group have fallen along with my holding, then it puts me on notice that the larger trend has likely changed.
Finally, to avoid getting bucked off a stock or at least to soften the blow I try and diversify by size, style and, most important, time. As I wrote two years back, too often people treat investing like getting a flu shot: solely an annual affair. But the market is always changing, and at any given point there are literally dozens of cycles either just getting started or beginning to sputter out.
So when running a portfolio, the idea is always to own something that's getting ready to bloom. And the best way to accomplish that is by diversifying investments over time, not simply dropping a lump sum into the market at any one moment. Although there are no hard and fast rules, generally, I wouldn't want to invest more than 20% of assets in any given month.
Investors who allocate funds over a longer period are more likely to participate in a number of different trends, each at various points in a market cycle. The net result for their portfolios: a smoother ride. While one position is correcting, another is going through the roof. And because there's less volatility to the overall bottom line, investors are able to hold on to positions that would otherwise kick them off.
The best trading ideas mean little to those who can't stay on for the ride. By hedging with cash, analyzing group movement and diversifying over time, investors are able to better wrangle a market doing its best to throw them to the ground. As usual, good technique won't keep them from losing money, but it will soften the blow when they do. And because the name of the game is staying in the game, that's usually enough to tip the odds.
Jonathan Hoenig is managing member at Capitalistpig Asset Management, a Chicago-based hedge fund.>