Pin the Tail on the Monkey – Musings on Portfolio Management – Part 2 of 2

 

What ways can we ‘Manage’ a Trade to make such a difference?
As per much of the text in Part 1, I am of the conclusion that how I manage a Trade has a huge impact on my Returns and might explain how I got higher Returns than my friend last year who has an extremely similar Portfolio. Here is a quick list of the factors that I think make a real difference:

  • Add to Winners and starve Losers – this can be refined by the use of Stoplosses where you ditch a Trade if the Share Price falls a certain % from your Entry Price Level or maybe if a certain Technical Chart-based Support Level is breached. I do not use Stoplosses except on a rare exceptional basis. I put a lot of effort over 2015 to Add to my Winners – this was a very successful strategy for me. The precise meaning of ‘Run your Winners’ came up on a tweet the other day – it is easy and glib to say it, but what does it actually mean? I thought about this and I think it is best to have some Rules that make you Add to your Winners. For example, you could have a Rule where you buy an Initial Chunk of Stock and if it rises 5%, then you Buy some more – that is a simple mechanical Rule, a bit like a Stoploss but working the other way. In practice, I tend to Buy a Stock and then follow the Candlesticks and the Technical Elements like RSI, MACD, Bollinger Bands, etc. and if it perhaps starts to do well and then has a Pullback, I will reassess the Fundamentals and if they still look good, then I will buy more.
  • Run Momentum – this is linked to the above; it is critical to Run Winners and take advantage of the Momentum ‘Free Lunch‘. I think this can be helped by having clear Targets which you regularly review and reset – I have included a Link to some Blogs about this at the end of this scribble. However, something I have felt in 2016 is that except for certain Stocks in the Natural Resources sectors and Megacap Defensive Stocks (Tobacco, Utilities), Momentum has not really been such a reliable concept this year – at least, not in terms of Upside Momentum, but plenty of things seem to have Downside Momentum !!
  • Use of Technical Analysis concepts to help with Entries and Exits – this Charting ‘seaweed, pig’s entrails, tea leaves’ stuff is very subjective and probabilistic and will fail a lot – but if you get the hang of it then the times when it does help seem to win out. Combining simple Technical Analysis techniques with Fundamental Analysis I think can create an ‘Edge’ (there is a link to a previous Blog about ‘Edge‘ at the bottom of this effort).
  • Diversification – it is unclear to me what the optimum number of Holdings is but I suspect that the bare minimum should be about 18 to get Diversification benefits – again it is a ‘Free Lunch’ and well worth scoffing while it’s hot.
  • Hedging out Downside Risk – oh god, don’t get me started on that poxy subject again – if you want to know about it then look at the Links at the bottom of this Blog.
  • Rules around the size of each Position – perhaps a ‘Starter’ size of 2% of Portfolio and a Maximum size of 8% or something – when a Position grows over 8%, you chop it. Minimum Trade size of 1% perhaps (depends on Portfolio size in monetary terms and the Number of Stocks you want to hold). Obviously these Rules about Position Sizes can help dictate a ‘TopChopping’ (TopSlicing) strategy – if the Position gets over the Size in your Rules, then you hack away at it.
  • Spread Stocks across Sectors and perhaps have a Maximum of 2 or 3 Stocks in each Sector.
  • Keep Costs low – this is a really easy one – just paying £15 a Trade rather than £10 a Trade can have huge Cost Implications when compounded over many Trades over many Years.
  • Don’t Overtrade – not sure how you limit this – it is perhaps an aspiration/guideline/principle rather than something you can easily set Rules around. Maybe if you regularly do more than 5 Trades a Week you are Overtrading (this really is for a Long Term Investor, rather than someone with a ‘Trading’ approach). I must say I am constantly surprised by how little I trade, especially this year. I note that loads of People on Twitter are constantly trading away – it will be interesting to see over time how the Results we all achieve differ.

If you scoot across to my ‘M3 Manifesto’ webpage then you will see a lot of stuff like the above which I use to make up my ‘Rules’.

Something I wish to add here is that although I have suggested that the above ways of managing a particular Trade might explain the differences in performance between my Portfolio and those of People I know with similar Portfolios, another very simple explanation might arise from the Power of Compounding over very small differences. What I mean by this is that say for instance I buy a Share for 500p but my mate buys it at 505p and then when we come to sell it, I sell for 600p but my mate sells at 594p – I won’t show you the boring maths but even on this simple trade, I would be 2.4% better off than my friend. Compound this over many trades and it would make a lot of sense that our Overall Portfolio Performance for the Year would vary quite a bit. Of course, in reality, there will be many occasions when she gets a better Price to buy or sell than I do – which sort of explains why the overall Performances don’t vary massively.

What are the key Psychology Factors?
Allied to the kind of Rules that I have laid out above, there are some helpful Psychology aspects that I think can have a huge impact on whether or not a Trade is successful:

  • Always be calm, rational, robotic – Emotion is a bad thing and it needs to be wiped out. Don’t get all excited when you make a Profit – and don’t get all depressed and suicidal when a Trade goes horribly wrong and you get a Profit Warning – it happens, use your calm, rational, Brain to think about solutions and how you will move forwards.
  • Don’t panic, don’t rush – there is never a need to panic or rush into a Trade – I can almost guarantee 100% that if you are rushing to do a Trade then you are probably about to screw up badly. Obviously I am talking here in the context of a Long Term Investor and Short Term Traders cannot delay taking Trades or closing Positions – but even for them it is clear that highly emotionally charged and stressful Trading is probably not going to help returns.
  • Make Trading Decisions outside of Market Hours – this is something I am a firm believer in and it is very unusual for me to make a Decision to Buy or Sell something while the Markets are open and trading. I find that during Market Hours my emotions are too easily impacted by what is happening around me and I need to calm down and keep away. Far better I find to make cold, rational, Decisions when the Markets are closed and I have End of Day Charting Information (particularly around Candlestick Patterns) to base my thinking upon.
  • Try to make as much as possible of your Investing Approach to be sort of Mechanical – have Rules and make it your psychological task to follow them to the letter. Only change the Rules if you find that time and time again they are not working and make sure you probably analyse the situation so that you are 100% sure the Rule is wrong and it is not your application of it (most times it will be your inability to follow Rules when the pressure is on that is causing the poor Outcomes).
  • Focus – this is easy for me as I am a Full Time Investor and do not have distractions like a Career and Kids and stuff – but it is important to understand your time limitations and to adapt your Investing Style to suit the time you have available and therefore the Focus you can apply to the task. Having said that, I am finding the Summer Sun and the lure of the PUB quite distracting forces this year !!

An Unusual Hypothesis
All the stuff I have scribbled above leads me to a bit of a thought experiment that could actually be tested if people could be bothered (I can’t, but no doubt others have tried similar experiments in the past). If I am right that Stock Selection is of such low importance with regard to whether or not a Trade is successful and that how we manage a Trade matters more, then if we chose a basket of Stocks at random (‘Monkey with a Pin’) then in theory we could make money.

Simplistically, we could choose maybe 18 Stocks from the London Stockmarket and then use a pre-defined set of Rules, similar to mine listed above, to go about managing these 18 Stocks. This might or might not work, and I suspect that if we open it up to all Stocks available in London, then we would end up picking many of the utter cr*p AIM trash that lurks around in the WheelieBin – and if we get a couple of our Random Stocks going to zero then it is likely that the Experiment would fail.

To improve the chances of success, it would probably make sense to do some initial screening of the Universe of Stocks and try to remove the stinky Junk that could cause problems – maybe parameters like the following would help:

  • No Foreign listed Stocks.
  • Market Cap above £50m.
  • P/E Ratios between 8 to 14 (obviously this stuff is subjective and could be tweaked).
  • Net Debt no more than 2 times Profit after Tax.
  • No Loss making Stocks.

If you pop over to my ‘WheelieBin’ webpage then you will see a huge list there of these kind of Risk Factors that could be incorporated to whittle down the Universe of possible Stocks to include – but obviously if your parameters are too strict then the Universe will be a bit meaningless. You might find that you could even just say your Universe is the FTSE350 and pick 18 Stocks randomly from that.

All you then need is one Monkey and one Pin. Easy. Especially if you live near a Zoo.

Following the selection of the 18 Random ‘Monkey’ Stocks, you would then manage the Portfolio according to the Rules – for instance, if a Stock moved up 5% you might have a Rule that says you need to buy more – so you would add to the Position etc. As part of the approach you would need ‘Selling Rules’ as well, and once a Rule is triggered to Sell a particular Stock, you would need to borrow the Monkey from Whipsnade Zoo again and get him (or her) to pick your next Stock to buy.

I won’t go into detail here about how you tell the gender of a Monkey……

If you were to undertake such an Experiment, and of course you need to have appropriate Trading Rules and the Psychological temperament to apply them with the necessary discipline, I would bet that even with a Random selection of Stocks from the Universe of ‘Quality’ Stocks you would produce good Returns. Of course, if I am right, then to a large extent we are all wasting our time doing all this in-depth Research and Fundamental Analysis on Stocks……..

A Contradiction
I haven’t really thought this Section of text through, but I just wanted to lob something in so that Readers are aware of it and can perhaps do their own thinking around the Contradiction I think exists.

The sort of background theme of this Blog Series is about how maybe we are fooling ourselves trying to Pick Stocks and that perhaps it is much more important to focus on how we Manage those Stocks in our Portfolios (obviously assuming we are not buying Cr*p which will almost guarantee we will lose money however well we attempt to Manage the Portfolio). Not only does this idea help to explain why my Portfolio Performance differs so much to that of my Friend with a similar Portfolio, but it also helps explain why so many People on Twitter with entirely difference Baskets of Stocks get such similar overall Results.

However, it strikes me that the Stockopedia system that uses things like ‘StockRanks’ to create Portfolios of Stocks that might perform well sort of contradicts the idea that Stock Picking is a waste of time. I am not a Stockopedia User myself, although I am very impressed by it and from what I have seen about Model Portfolios and stuff, it is clear that it does seem to work.

Obviously if this Stockopedia Stock Picking approach is then combined with the kind of Portfolio Management ‘tricks’ I have mentioned, then a highly superior Performance might be possible to attain.

Hopefully that makes the point I wanted to put over.

Cheers, WD.

Article written by @wheeliedealer

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