Position Sizing and Offensive Selling
After the sharp decline that we've seen recently in the market, it's inevitable that most investors feel blindsided by the market--the speed of the decline, and in particular in leading stocks, can make your head spin.
And the fears fueled by these declines mean many investors who want to invest in potentially big-winning stocks find themselves scared out of most winners. So, today, I want to talk about an investment style that I've been thinking about for a while--I call it the Conservative Aggressive style.
To explain it, let's consider two systems, the first of which gains, say, 18% per year over three years, while the second system has 15% returns over three years. Clearly everyone would want the first system, right? Well, maybe not.
Imagine we dug further and found that the three years of returns for the first system were +11%, -15% and +74%. On the other hand, the year-by-year returns of the second system were +10%, +15% and +20%. From my back-and-forth with thousands of subscribers over the years, I believe that most investors would prefer the results of the second system because of the steadiness and persistent gain in wealth--especially after they've gone through a few jaw-dropping corrections or sour earnings seasons.
In the real world, the more volatile your results, the more faith you're going to need to stick with a system. It's easy to stick with the plan when all your stocks are going up; but it's infinitely more difficult when a falling market and some bad earnings results are gashing your portfolio, especially when the pain continues for many months.
Thus, many investors are searching for a system that (a) invests in cutting-edge leading stocks with dynamic new products or services, and in turn, allows them to hit the occasional home run ... but (b) they don't want to see their portfolio take enormous drawdowns during the occasional sour earnings season.
Can you have both? To some extent, I believe you can. To get there, all you need to consider are two simple portfolio management techniques.
The first is good old-fashioned position sizing. If you want to own the fastest-moving stocks but don't want to live and die with every tick, then buy smaller amounts, dollarwise, of the stock at the outset.
I know that some investors get an ice-cream headache when presented with any math, but calculating a "proper" position size is important. There's nothing wrong with owning a smaller dollar amount of a very volatile stock.
The second method is something few investors do--take partial profits at pre-defined levels. This way, you don't have to take a small initial position ... but you will have to take some profits on the way up (dubbed offensive selling) when things are good.
There are a million ways to do this, none necessarily better than the other. But the point of partial selling isn't really to book a quick profit (that's all about trading, which isn't my thing). Instead, booking a relatively small initial profit changes your mindset, and actually gives you leeway to hold on to your remaining shares through deeper corrections (because you know the overall trade will show a gain).
For example, you might buy a stock at 50, and place a loss limit at 45 (that's 5 points of risk). If the stock rises, say, 7 to 10 points (1.5 to 2 times your initial risk), you might sell a chunk--not more than half your shares, but enough to take a worthwhile profit.
With the rest of your shares, you'd place your new stop-loss (mental or in the market) at breakeven (in this case, 50), so even if you get stopped out, the overall trade was a profitable one. With that in mind, you can then give your remaining shares room to breathe, sitting through earnings reports and some adverse moves, hoping to ride out a big winning stock.
As I wrote a couple of Cabot Wealth Advisories ago, the key in the stock market is really the outliers--your big losers and your big winners. To get the big winners, you must invest in fast-growing leaders ... but you also need a position you can hold on to for months without panicking, because big moves play out over time. The above methods can help you do that.
Next time, I'll write about a strategy for the "Aggressive Aggressive Investor," giving you the viewpoint from the other end of the spectrum.
Back to the current market. We're in a correction, there's no doubt about that--selling began cropping up a couple of weeks ago and really accelerated on Tuesday of this week, when volume exploded and many leaders went over the falls.
That said, I am not overly defensive here ... in fact, I wouldn't say I am defensive at all. I did advise subscribers to raise some cash, mainly by selling a couple of stocks that had broken down.
And that's what I think is your best move--let the stocks you own tell their own stories. If you own some that show abnormal weakness (big-volume breaks off the 50-day line, especially after lagging the market for a few weeks, etc.), then punt them.
But I don't advise wholesale selling at this point because, while the short-term is likely to bring some more pain and choppiness, I do think the odds favor higher prices down the road. Thus, if you have a good-sized winner or own a few resilient stocks, I would advise giving them a chance to breathe here (though taking partial profits is fine).
As for new buying, I'm not eager to do much here; again, I think the short-term could be rocky, and earnings season is just getting going, layering more uncertainty. Still, when putting together my watch list, I'm focusing on names with great growth that are still acting properly.
One of them is LinkedIn (LNKD), the fast-growing professional social networking site that sports a sky-high valuation ... but also has huge sales and earnings growth and even bigger potential down the road. Here's what I wrote about the stock in Cabot Top Ten Trader back on March 26:
"LinkedIn is a leader in the new wave of social media Internet stocks. The company is basically Facebook with a suit and tie--the company's 150 million-plus members use LinkedIn as an online Rolodex, and because of that, it's emerging as one of the best ways for companies to find the talent they're looking for. Thus, the whole job-seeking industry is being turned on its head--instead of companies advertising job openings and individuals having to make the first move, companies can now take the lead, finding the people that could fit best ... even if they're not looking for a new job! LinkedIn's largest and fastest-growing revenue source is from its hiring solutions segment, where companies pay for the tools to successfully mine its database. Advertising and paid subscriptions make up the rest of revenues, and both of those are growing rapidly, too; efforts by the company to make itself something of a professional portal, where relevant business articles and ideas are presented on a user's page, have resulted in vastly increased traffic. Of course, investors are already excited about the concept--LinkedIn has a lofty valuation (about $10 billion, compared to just $522 million in revenue during the past year), but the triple-digit revenue growth and healthy earnings estimates (up 80% this year, and another 73% in 2013) make this one of the top "glamour" stocks in the market. If management continues to make the right moves, this company could go far."
At that time, LNKD was hovering just over 100 per share after a jazzy analyst upgrade on the shares. It then pulled back into the high 90s on very light volume ... impressively light considering the market's wobbles. And then it surged higher today on some positive analyst commentary
However, after a terrific advance in recent months (60 to 106!) this stock has earned a breather and my guess is that shares won't simply explode higher from here. It might even build out a new base. I think LNKD is one to keep on your watch list, though, as the huge-volume accumulation during the stock's January-through-March advance, the quiet retreat in recent weeks and the huge potential for its business all suggest the stock could be a big winner.
If you really want to nibble, try to get shares around 100 or below, but keep a stop around 89 if you do so. For me, I'm content to just watch it for now, giving it room to wear out some weak hands.
All the best,
Editor of Cabot Market Letter