Managing Your Portfolio
Overview
You’ve analyzed the market to identify its current trend. You’ve generated a watch list using the Market Smith Screener and Reports functions. You’ve analyzed each stock on a fundamental and technical basis to identify the best possible times to buy. Now, we will discuss techniques to manage your portfolio to lock in gains and avoid severe losses.
Portfolio Structure
It’s important to remember that your objective in the market isn’t just to be right, it’s to make big money when you are. Two portfolio management techniques that may help you achieve that goal are concentrating your purchases and using proper follow-up buys. We discuss these techniques below.
Concentrated Portfolios
When it comes to the stock market, sometimes it’s better to put your eggs in a few baskets and watch those baskets very closely. If you own too many stocks, you’re unlikely to know any of them very well. As a result, if the market turns, you’ll probably react slowly to the changing conditions.
Consider putting a strict limit on the number of stocks in your portfolio. Then enforce this limit by refusing to add a new stock until you’ve sold one you already own. If, for example, you’ve decided to own no more than 10 stocks, sell the least attractive of the 10 before making a new buy. If you’re a growth investor, your least attractive stock is usually the one that’s performed the worst since you bought it.
That being said, some diversification is warranted. For example, it’s best not to put more than 35% to 40% of your portfolio in any single stock. As far as allocation to one industry group or sector, 25% to 30% might be a reasonable limit for a new investor. As you gain more experience, you can go above this limit. But you must be fast on your feet, always executing strict sell disciplines to protect yourself. You can track other leadings stocks in each stock’s industry group by using the Industry Group Related Information Panels within MarketSmith.
It’s a good idea to set up a portfolio in MarketSmith with the names you currently own. For our purposes, we’ll call this list “My Holdings.” Check this My Holdings list daily and pay attention to things like Relative Strength and the price-volume action on the chart. This will key you in to which stocks are showing strength.
Force Feed Your Winners
Of every 10 stocks you buy, only one or two are likely to be truly outstanding performers. Your goal is to allocate the most capital to your best stocks. Say the market has just entered a new rally and you buy five or six stocks. As the rally continues, some of those stocks will show more strength than others. You might consider selling the stocks that are down the most or up the least, and reallocating the resulting capital to your strongest holdings.
Follow-Up Buys
When you buy a new stock, think about not committing your entire position in one decision. Instead, commit little by little as you confirm your stock is showing strength by advancing ahead. Say your full position for a stock would be $10,000. For your first position, you could contribute $5000 at the start and then, if the stock continues to advance, add additional, smaller amounts until you’ve reached your full position.
We call this technique pyramiding or averaging up, because after a larger initial purchase, you make smaller ones as the stock advances. It’s important that you buy fewer shares with your second and third purchases to avoid running up your average cost. Also, avoid buying more than 5% above the pivot point.
Profit and Loss Plan
In the Analyzing Stocks section, we discussed the best time to buy a stock. Once you’ve purchased a stock, it’s important that you have a plan to lock in gains and avoid large losses.
Cutting Losses
If you employ the buying strategy discussed earlier and recommend by our founder William J. O’Neil, we recommend implementing a rule to cut all losses on an individual stock at a maximum of 7% or 8% of the initial purchase price to manage risk. No one is right every time they buy a stock. This is your insurance policy to prevent severe losses that will be difficult to come back from. In many cases, you may be able to get out of a poorly performing stock even before it reaches this threshold. If the stock rebounds and breaks out again, you can always buy it back.
It’s important to remember that this rule pertains to your initial purchase price. Once you are up on a stock, you can give it more room for normal fluctuations. The difference is if you are down on your initial purchase, you’re probably starting off wrong. The stock is not acting the way it should after a breakout. If you are already up on a stock, the stock has acted correctly and you have a profit, so you can afford to give the stock some room and not get shaken out by a normal correction.
Timing your buys correctly is an important part of this concept. If you buy fundamentally strong stocks emerging from sound bases in uptrending markets, they won’t often correct more than 8% from your initial purchase price. But if you make a mistake, this rule is there to protect you from severe losses.
Create a portfolio in MarketSmith with just your holdings and check this list daily. You may also want to use the Notes & Discussion Panel within MarketSmith to mark the point on the chart where you will be prepared to cut your loss.
Taking Profits
The best time to sell a stock is when it’s on the way up, while it’s still advancing and looking strong to everyone else. If you wait for a stock’s exact top, you’ll likely be late. You can very easily be caught in the 20% to 40% market corrections that can hit market leaders.
In our extensive studies of the charts of former market leaders, we discovered that successful stocks tend to move up 20% to 25% after breaking out. Then they decline, build new bases, and sometimes continue to advance. If you’re buying breakouts, consider taking many of your profits when you’re up 20% to 25% in a stock. If the stock is forming another base, you can then wait to see if it emerges and offers another opportunity to buy.
There’s a key exception to this. We identified that if in a bull market, one of your stocks surges 20% or more on good volume in just one, two or three weeks from its initial breakout, you could have a big winner on your hands. Set these types of stocks aside and hold them at least eight weeks. At the end of the eight weeks, review the situation and decide if the stock should be held for an even bigger gain.
Again, you may find it useful to use the Markups and Notes & Discussion features of MarketSmith to mark a target zone of when you will first consider taking profits on a stock.
Sell Signals
If you are holding a stock beyond its initial 20% to 25% move because you believe it has the potential to be a big winner, you will need to stay conscious of a few other sell signals. The overarching concept to remember is that while you should buy stocks based on a combination of fundamental and technicals, you should sell based solely on technicals. By technicals, we refer to price and volume movements in a stock best tracked with stock charts.
When stocks top, the fundamentals will often still look great. If you wait for the bad news to come out, you will be too late. Institutional investors spend their massive resources and industry contacts looking for any signs that a company’s earnings growth is slowing. Therefore, as an individual investor, you would likely be among the last to hear about a fundamental change. The big advantage you possess, however, is size. An individual investor can usually exit a position rather quickly and not affect the stock’s price. On the other hand, large institutional investors, with the huge number of shares they hold, cannot begin exiting a position without leaving tracks and the process can take weeks to unfold. If you learn to interpret sell signals correctly, you can recognize when demand for a stock’s shares wanes.
Climax Top
Many leading stocks end their runs in what we call a climax top. A climax top is when a stock suddenly advances at a much faster rate for one or two weeks after an increase over many months. On a MarketSmith Chart, you can spot this because the spread from the absolute low to the absolute high of the week will be wider than any price spread in any week up to that point. Volume will often be heavy at this point and the ultimate top sometimes occurs on the heaviest volume day since the beginning of the stock’s advance. At this time, when seemingly everybody is buying the stock and it looks like it might double again, the bubble will burst. Everyone who wants to buy the stock has, and the only direction for the stock to go is down.
Another sign of a climax top is what we call an exhaustion gap. This is a case in which, after months of advancing, a stock makes a large gap up. For example, it might close one day at $60 and open the next morning at $65. This climatic action is a sign that the top could be only a day or two away. You can spot an exhaustion gap on a MarketSmith Daily Chart by looking for white space between the high of the previous day and the open of the next day.
PE Expansion
Another method to help identify where a leading stock might top is measuring its PE expansion. In our studies of the best performing stocks of all time, we found that the PE of a top-performing growth stock will expand more than 100 percent from where it was when the stock began its move.
For example, say a stock’s PE ratio was 40x when it first broke out. If the stock is now trading at more than 80x earnings, it could be a sign that a top could be near. In every cycle we have studied, there have been great growth stocks that the institutions go after en masse, eventually pushing their PE ratios to heights that can’t be justified. In the market, the names change but the patterns repeat over and over again.
PE is tracked on the Data Boxes on both MarketSmith Daily and Weekly Charts. A historical range is also given for each quarter on the bottom of a MarketSmith Daily chart. After every purchase you make, it’s a good idea to print and save copies of the Daily and Weekly MarketSmith charts at that point in time. This will help you track what the stock’s fundamental and technical characteristics were at the time and can also be a great tool to study your trades at a later time.
Channel Lines
Channel lines can also help you spot the end of a stock’s long run. On a Daily or Weekly Chart, use the line pen to draw an upward-trending straight line connecting three major lows along the absolute bottom of a stock’s temporary pullbacks in price. Then draw a second line connecting three major highs along the top. Put some time in between each point (a few months), so that you‘re plotting the major trend. If a stock goes through an upper channel line, this is a sign you are near a top.
Base Count
Another technique to track when a leading stock’s move may be ending is by keeping track of the number of bases it forms. Properly formed first and second stage bases have a high probability of success. But stocks forming third or fourth stage bases may be nearing the top. Stocks breaking out of fourth stage bases are highly prone to failure because, at this point, most of the people who want to buy the stock have already done so. If you own a stock breaking out of a fourth stage base, you may want to think about selling it.
Relative Strength Line
The relative strength line available on MarketSmith charts can also provide signs that a stock’s run may be over. This line measures the stock’s relative performance vs. the S&P 500. If a stock breakouts at or near a new high, the relative strength line should break out at the same time or shortly after. If it doesn’t, it’s a sign that the stock has lost its leadership position and you should consider selling
Industry Group Analysis
Keep an eye on the other leading stocks within the industry group of each stock you purchase. If these other stocks make tops, it’s a sign that your stock could be near a top as well. You can easily track the other constituents of an industry group by going to the Industry & Sector section of the Market Smith Related Information panel.
Further Study
You can learn more about sell rules in William J. O’Neil’s books How to Make Money in Stocks and The Successful Investor. You may also want to take a look at the investment education resources of Investors.com.
Common Portfolio Management Mistakes
Forgetting about Sold Stocks
There may be times when you think you have spotted a stock with strong fundamental and technical characteristics, but the stock doesn’t act right after its breakout, and so you are forced to sell. Don’t completely forget about that stock. There’s a chance you were just early in your timing or the general market conditions weren’t right. Keep the stock on your radar. If the stock breaks out again from a proper base, don’t be afraid to buy it back.
Not Wanting to Take a Loss
Many investors will refuse to sell a stock that is down because that would mean “admitting” they were wrong in the first place. If you’re down on a stock, you already have a loss. Holding on doesn’t change anything. We recommend cutting losses at 7% to 8% below your purchase price. In many cases, your capital will serve you better allocated to another stock with a stronger likelihood to advance.
Ignoring Sell Signals
Selling right is as important as buying right. It’s easy to get attached to a stock that has advanced a lot from your purchase price. You might really like the company story and the fundamentals may still look fabulous. If you ignore signs that a stock is topping, however, you may watch your hard earned gains evaporate. Remove emotion from the equation. Employ a rule-based system to help spot when a stock is topping.
You’ve analyzed the market to identify its current trend. You’ve generated a watch list using the Market Smith Screener and Reports functions. You’ve analyzed each stock on a fundamental and technical basis to identify the best possible times to buy. Now, we will discuss techniques to manage your portfolio to lock in gains and avoid severe losses.
Portfolio Structure
It’s important to remember that your objective in the market isn’t just to be right, it’s to make big money when you are. Two portfolio management techniques that may help you achieve that goal are concentrating your purchases and using proper follow-up buys. We discuss these techniques below.
Concentrated Portfolios
When it comes to the stock market, sometimes it’s better to put your eggs in a few baskets and watch those baskets very closely. If you own too many stocks, you’re unlikely to know any of them very well. As a result, if the market turns, you’ll probably react slowly to the changing conditions.
Consider putting a strict limit on the number of stocks in your portfolio. Then enforce this limit by refusing to add a new stock until you’ve sold one you already own. If, for example, you’ve decided to own no more than 10 stocks, sell the least attractive of the 10 before making a new buy. If you’re a growth investor, your least attractive stock is usually the one that’s performed the worst since you bought it.
That being said, some diversification is warranted. For example, it’s best not to put more than 35% to 40% of your portfolio in any single stock. As far as allocation to one industry group or sector, 25% to 30% might be a reasonable limit for a new investor. As you gain more experience, you can go above this limit. But you must be fast on your feet, always executing strict sell disciplines to protect yourself. You can track other leadings stocks in each stock’s industry group by using the Industry Group Related Information Panels within MarketSmith.
It’s a good idea to set up a portfolio in MarketSmith with the names you currently own. For our purposes, we’ll call this list “My Holdings.” Check this My Holdings list daily and pay attention to things like Relative Strength and the price-volume action on the chart. This will key you in to which stocks are showing strength.
Force Feed Your Winners
Of every 10 stocks you buy, only one or two are likely to be truly outstanding performers. Your goal is to allocate the most capital to your best stocks. Say the market has just entered a new rally and you buy five or six stocks. As the rally continues, some of those stocks will show more strength than others. You might consider selling the stocks that are down the most or up the least, and reallocating the resulting capital to your strongest holdings.
Follow-Up Buys
When you buy a new stock, think about not committing your entire position in one decision. Instead, commit little by little as you confirm your stock is showing strength by advancing ahead. Say your full position for a stock would be $10,000. For your first position, you could contribute $5000 at the start and then, if the stock continues to advance, add additional, smaller amounts until you’ve reached your full position.
We call this technique pyramiding or averaging up, because after a larger initial purchase, you make smaller ones as the stock advances. It’s important that you buy fewer shares with your second and third purchases to avoid running up your average cost. Also, avoid buying more than 5% above the pivot point.
Profit and Loss Plan
In the Analyzing Stocks section, we discussed the best time to buy a stock. Once you’ve purchased a stock, it’s important that you have a plan to lock in gains and avoid large losses.
Cutting Losses
If you employ the buying strategy discussed earlier and recommend by our founder William J. O’Neil, we recommend implementing a rule to cut all losses on an individual stock at a maximum of 7% or 8% of the initial purchase price to manage risk. No one is right every time they buy a stock. This is your insurance policy to prevent severe losses that will be difficult to come back from. In many cases, you may be able to get out of a poorly performing stock even before it reaches this threshold. If the stock rebounds and breaks out again, you can always buy it back.
It’s important to remember that this rule pertains to your initial purchase price. Once you are up on a stock, you can give it more room for normal fluctuations. The difference is if you are down on your initial purchase, you’re probably starting off wrong. The stock is not acting the way it should after a breakout. If you are already up on a stock, the stock has acted correctly and you have a profit, so you can afford to give the stock some room and not get shaken out by a normal correction.
Timing your buys correctly is an important part of this concept. If you buy fundamentally strong stocks emerging from sound bases in uptrending markets, they won’t often correct more than 8% from your initial purchase price. But if you make a mistake, this rule is there to protect you from severe losses.
Create a portfolio in MarketSmith with just your holdings and check this list daily. You may also want to use the Notes & Discussion Panel within MarketSmith to mark the point on the chart where you will be prepared to cut your loss.
Taking Profits
The best time to sell a stock is when it’s on the way up, while it’s still advancing and looking strong to everyone else. If you wait for a stock’s exact top, you’ll likely be late. You can very easily be caught in the 20% to 40% market corrections that can hit market leaders.
In our extensive studies of the charts of former market leaders, we discovered that successful stocks tend to move up 20% to 25% after breaking out. Then they decline, build new bases, and sometimes continue to advance. If you’re buying breakouts, consider taking many of your profits when you’re up 20% to 25% in a stock. If the stock is forming another base, you can then wait to see if it emerges and offers another opportunity to buy.
There’s a key exception to this. We identified that if in a bull market, one of your stocks surges 20% or more on good volume in just one, two or three weeks from its initial breakout, you could have a big winner on your hands. Set these types of stocks aside and hold them at least eight weeks. At the end of the eight weeks, review the situation and decide if the stock should be held for an even bigger gain.
Again, you may find it useful to use the Markups and Notes & Discussion features of MarketSmith to mark a target zone of when you will first consider taking profits on a stock.
Sell Signals
If you are holding a stock beyond its initial 20% to 25% move because you believe it has the potential to be a big winner, you will need to stay conscious of a few other sell signals. The overarching concept to remember is that while you should buy stocks based on a combination of fundamental and technicals, you should sell based solely on technicals. By technicals, we refer to price and volume movements in a stock best tracked with stock charts.
When stocks top, the fundamentals will often still look great. If you wait for the bad news to come out, you will be too late. Institutional investors spend their massive resources and industry contacts looking for any signs that a company’s earnings growth is slowing. Therefore, as an individual investor, you would likely be among the last to hear about a fundamental change. The big advantage you possess, however, is size. An individual investor can usually exit a position rather quickly and not affect the stock’s price. On the other hand, large institutional investors, with the huge number of shares they hold, cannot begin exiting a position without leaving tracks and the process can take weeks to unfold. If you learn to interpret sell signals correctly, you can recognize when demand for a stock’s shares wanes.
Climax Top
Many leading stocks end their runs in what we call a climax top. A climax top is when a stock suddenly advances at a much faster rate for one or two weeks after an increase over many months. On a MarketSmith Chart, you can spot this because the spread from the absolute low to the absolute high of the week will be wider than any price spread in any week up to that point. Volume will often be heavy at this point and the ultimate top sometimes occurs on the heaviest volume day since the beginning of the stock’s advance. At this time, when seemingly everybody is buying the stock and it looks like it might double again, the bubble will burst. Everyone who wants to buy the stock has, and the only direction for the stock to go is down.
Another sign of a climax top is what we call an exhaustion gap. This is a case in which, after months of advancing, a stock makes a large gap up. For example, it might close one day at $60 and open the next morning at $65. This climatic action is a sign that the top could be only a day or two away. You can spot an exhaustion gap on a MarketSmith Daily Chart by looking for white space between the high of the previous day and the open of the next day.
PE Expansion
Another method to help identify where a leading stock might top is measuring its PE expansion. In our studies of the best performing stocks of all time, we found that the PE of a top-performing growth stock will expand more than 100 percent from where it was when the stock began its move.
For example, say a stock’s PE ratio was 40x when it first broke out. If the stock is now trading at more than 80x earnings, it could be a sign that a top could be near. In every cycle we have studied, there have been great growth stocks that the institutions go after en masse, eventually pushing their PE ratios to heights that can’t be justified. In the market, the names change but the patterns repeat over and over again.
PE is tracked on the Data Boxes on both MarketSmith Daily and Weekly Charts. A historical range is also given for each quarter on the bottom of a MarketSmith Daily chart. After every purchase you make, it’s a good idea to print and save copies of the Daily and Weekly MarketSmith charts at that point in time. This will help you track what the stock’s fundamental and technical characteristics were at the time and can also be a great tool to study your trades at a later time.
Channel Lines
Channel lines can also help you spot the end of a stock’s long run. On a Daily or Weekly Chart, use the line pen to draw an upward-trending straight line connecting three major lows along the absolute bottom of a stock’s temporary pullbacks in price. Then draw a second line connecting three major highs along the top. Put some time in between each point (a few months), so that you‘re plotting the major trend. If a stock goes through an upper channel line, this is a sign you are near a top.
Base Count
Another technique to track when a leading stock’s move may be ending is by keeping track of the number of bases it forms. Properly formed first and second stage bases have a high probability of success. But stocks forming third or fourth stage bases may be nearing the top. Stocks breaking out of fourth stage bases are highly prone to failure because, at this point, most of the people who want to buy the stock have already done so. If you own a stock breaking out of a fourth stage base, you may want to think about selling it.
Relative Strength Line
The relative strength line available on MarketSmith charts can also provide signs that a stock’s run may be over. This line measures the stock’s relative performance vs. the S&P 500. If a stock breakouts at or near a new high, the relative strength line should break out at the same time or shortly after. If it doesn’t, it’s a sign that the stock has lost its leadership position and you should consider selling
Industry Group Analysis
Keep an eye on the other leading stocks within the industry group of each stock you purchase. If these other stocks make tops, it’s a sign that your stock could be near a top as well. You can easily track the other constituents of an industry group by going to the Industry & Sector section of the Market Smith Related Information panel.
Further Study
You can learn more about sell rules in William J. O’Neil’s books How to Make Money in Stocks and The Successful Investor. You may also want to take a look at the investment education resources of Investors.com.
Common Portfolio Management Mistakes
Forgetting about Sold Stocks
There may be times when you think you have spotted a stock with strong fundamental and technical characteristics, but the stock doesn’t act right after its breakout, and so you are forced to sell. Don’t completely forget about that stock. There’s a chance you were just early in your timing or the general market conditions weren’t right. Keep the stock on your radar. If the stock breaks out again from a proper base, don’t be afraid to buy it back.
Not Wanting to Take a Loss
Many investors will refuse to sell a stock that is down because that would mean “admitting” they were wrong in the first place. If you’re down on a stock, you already have a loss. Holding on doesn’t change anything. We recommend cutting losses at 7% to 8% below your purchase price. In many cases, your capital will serve you better allocated to another stock with a stronger likelihood to advance.
Ignoring Sell Signals
Selling right is as important as buying right. It’s easy to get attached to a stock that has advanced a lot from your purchase price. You might really like the company story and the fundamentals may still look fabulous. If you ignore signs that a stock is topping, however, you may watch your hard earned gains evaporate. Remove emotion from the equation. Employ a rule-based system to help spot when a stock is topping.
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