It seems to me that the only way the best portfolio of stocks to own after a correction can be the same as before the correction is if stock prices don’t matter. This is absurd. Yet, many people “stay the course” which means they don’t change a thing whenever stock prices come down significantly. It isn’t crazy to make adjustments to your portfolio after a correction. In fact, I think it is a rational response.
This is a good time to evaluate your stocks because it is likely that you will rank them differently after this recent correction so that some trades might be in order. Here’s what I am coaching my managers and new clients to do.
Step 1: Start A Spreadsheet
In column A, list the stocks you own. In column B enter the percentage of your portfolio each stock represents.
Sort the spreadsheet by column B in descending order so your largest holding is at the top of the list. Label column C “Confidence”.
Step 2: First Pass, Stock Evaluation
Starting with the stock at the top of the list, ask yourself:
What is the company doing that can materially increase the stock price over the next three years?
Why three years? Because that is the shortest time horizon over which individual investors might have an advantage over Wall Street.
We all compete in a market where Wall Street analysts get information sooner than we do. If you try to compete with them over a day, a week, a month or a quarter, the odds are stacked against you.
However, almost all Wall Street analysts have never worked outside of the financial industry. They don’t know what it takes to satisfy customers in any other industry. If you have management experience in any other industry, that knowledge could give you an advantage.
But, lets be frank here, there is almost nothing a company can do in less than three years that will materially increase its stock price. If you are not willing to give a company’s management three years to execute their plan, don’t invest in the stock.
For the first pass, consider only what you already know about each stock. Enter a zero in column C next to any stock that you honestly don’t know what they are doing that could drive the stock significantly higher over 3 years.
Step 3: First Cut Analysis
Sort the list by column C so that all of the stocks you rated zero are together at the bottom of the list.
Add up the percentages in column B for all the stocks that rated zero in column C. This is the percentage of your portfolio that you have no confidence will deliver a significant return over the next three years.
If the total invested in the zeros is less than 10% of your portfolio, congratulations! You’ve done better than 90% of the people I’ve gone through this exercise with when they open an account with us.
Nevertheless, it is still a good idea to sell the zeros and invest the proceeds into stocks in which you have more confidence while the correction has made them cheap.
If the percentage is greater than 10%, you’ve got some big changes to consider. It’s still a good idea to sell the zeros and invest the proceeds in higher confidence stocks.
However, I find that when people have to make decisions affecting more than 10% of their portfolio they want more certainty that they are making the right decisions than is possible to have about stocks.
The best solution I’ve found is to make a bunch of smaller decisions. For example, if you have 20% of your portfolio in zero confidence stocks, sell them 1% at a time. It may take 20 orders to complete the trade, but that is better than doing nothing while waiting for news that increases your certainty enough to pull the trigger all at once.
A Real Example
Here’s a conversation I recently had with new client I took through this process.
Ken Kam: What percentage of your portfolio is invested in the stocks you rated zero?
New Client: 60%.
Kam: Which stocks did you rate zero?
Client: Network Appliance, Starbucks and Applied Materials. I bought them all in 2000 and I’ve made good money on them.
Kam: The question now is do you have any reason to hold them over the next three years?
If there isn’t anything management is doing that has the potential to deliver a material gain in three years, you ought to sell it.
Before you decide to keep any of these stocks, you need to research them enough to have a reason to hold them. However, even if you decide to keep them, reduce your position to 5% each so your returns are not overly dependent on them.
This should free up at least 45% of your portfolio to invest either in other stocks you have more confidence in, or in one of my manager’s portfolios. The choice depends on how much of your portfolio you want to manage yourself.
Client: I’m not ready to sell 45% of my holding all at once. What should I do?
Kam: I’d rather see you take lots of small steps in the right direction rather than stay where you are waiting for something to happen that makes the decision easier.
I suggest you place limit orders to sell 1% of your portfolio’s worth of each of the three stocks. For the first tranche, set the limit price close to the market price so you’ll get an execution the next time a big order comes in for the stock.
Client: That feels a lot more comfortable than selling it all at once. What should I do with the cash when these first orders are executed?
Kam: If you want to use one of our managers, I’ll help you choose one that has a different investment style so you can diversify into areas that you may not feel you have the expertise to invest in yourself.
My Take: Corrections are to be expected. When they occur, it is silly to think that nothing needs to be changed. There is a rational way to respond to a correction.
If you put together a spreadsheet as described above, send me a message to let me know what you thought of the process.
This article is part of a series I write for those who want to get their portfolios back on track. To be notified when the next installment is published, click here.
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