Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).
Starting a stock portfolio? If you're anything like I was when I first started picking individual stocks to buy, you're probably intimidated at the prospect of building up a diversified basket of stocks that won't leave you vulnerable during a correction or crash.
If all of your eggs are in one basket—or even too few baskets—you might face some tough choices and end up selling at the worst time in order to meet expenses. On the other hand, if you have too many stocks across all industries, you might as well just buy the market by indexing, as Jack Bogle famously suggested.
Even worse, di-worstification can rear its ugly head and force your returns to match that of the overall market but with a great deal more work (and probably stress) at your end. If you view yourself as a scientist who conducts their experiments in the market, learn what strategy works for you, have the temerity to follow a rule set rigidly, then you can pick your own investments that have the potential to beat the market.
What follows is a simple, three-step strategy that you can follow in order to ensure you have exposure to various parts of the market but not so much exposure that you're better off buying the index.
How to Maintain a Successful Portfolio Using the Baskets Method
- Pick out multiple baskets.
- Pick the three best stocks in each basket.
- Rebalance your portfolio periodically.
Step 1: Pick Out Multiple Baskets
In order to divide your proverbial eggs, you're going to need to determine what sorts of baskets you want to put them in. Because you're not trying to own everything (the point is very much not to own everything, after all), it makes sense to select a few sectors or broad categories of stocks that can ensure you're not overly exposed to an industry headwind.
One good way to understand why this is important is with a thought experiment: suppose you really like technology stocks, and you buy loads of Microsoft for $45 per share and Amazon for $75 per share. Before you get too excited, imagine that it's December 1999. What follows is a lost decade for both companies, where more than 10 years go by before either stock even bounces back to your original investment price. Ouch.
Stock market history is replete with examples just like this, where one sector (a category of businesses that share similar characteristics like tech or industrials) goes bonkers (very often due to the stocks getting too expensive) and crashes or corrects, dropping 10% or more in a few days.
Even worse, a long time can sometimes go by for an entire sector—not just for individual companies—before that sector is back in favor once again. This means having a few different baskets of stocks makes a great deal of sense. How you divide your stocks is up to you; you might consider geographic diversification along with making sure you have several different industries covered (typically, analysts will divide stocks into 11 or so sectors, and you can read about them here).
You might also consider making sure that you have some small, mid, and large-cap companies as well, since company sizes are prone to trends just as sectors and regions of the world are. Finally, you could try to have a few growth stocks along with your value-oriented selections, since value and growth often compete for institutional cash. No matter how you divide the baskets, you should divide them if you're concerned about having too many stocks vulnerable to one type of event.
Step 2: Pick the Three Best Stocks in Each Basket
I have two different portfolios where I'm experimenting with both of the following strategies. Both strategies divide the stocks into 10 sectors, like this:
- Health Care
- Consumer Goods
- Consumer Services
- Real Estate
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Notice that my sectors aren't exactly the sectors Wall Street analysts will use, and they're probably not going to be the same sectors you pick out; this method happens to make the most sense to me for dividing and grouping types of companies together. It's important to be able to understand each sector in your own way so that you can do the next part: picking out three of the best stocks in each.
For Portfolio 1, I'm actively looking for the three best values in each sector right now. The idea is to know enough about each sector and monitor each one well enough to identify the three best bargains at this moment.
For Portfolio 2, the sector setup is the same, but the goal is to identify and own the three best businesses in each. Naturally, Portfolio 2 is going to take a lot longer to fill up, since I'll only buy a stock when I believe it's priced below its intrinsic value, but I also know that nearly everything reverts to the mean at some point, and Mr. Market is likely to bring an opportunity my way in one of my favorite businesses every so often.
For Portfolio 1, the opportunities are always out there, by definition, since the goal is to own the three best values at today's prices no matter what. That brings us to step three: rebalancing.
Step 3: Rebalance Your Portfolio Periodically
There are many different schools of thought on when to sell a stock, including contradictory fundamentals across different theories. I can really only share what works best for me here, and while your ruleset might be very different than mine, the important thing is to have a process in place and stick with it. For my two-portfolio example, we need two different playbooks.
For Portfolio 1—let's call it the Value Portfolio—I'm pretty good at identifying and buying stocks that are on sale, then waiting for them to approach fair value, and selling whenever they get close. As a result of this relative strength, I often try to buy stocks that are selling for at least 20% less than they're worth. This allows me to have a "trader or investor" mentality where I can hold a stock for a long time, or I can sell if it jumps up at a surprisingly quick rate and make a relatively quick profit.
I like to try to sell any time a stock goes up between 30 and 40% in less than a year since I've almost certainly recently identified the stock as a bargain earlier in the same year. In other words, I give up some of the upside in order to take some of what I perceive as risk off the table. "Nobody ever went broke selling at a profit" is a silly truism, but it is said often for a good reason. For an example of a great value portfolio "cigar butt" style of investing, check out what Seth Klarman does.
Unlike the Value Portfolio, Portfolio 2—let's call it the Quality Portfolio—isn't looking to buy the best bargains in the first place but instead seeks to contain the three best businesses in a sector. While this means waiting for sales to happen, it also means following a very different rule set in order to sell.
Just because a Quality Portfolio stock approaches fair value doesn't mean it's time for me to consider selling unless I think that business is no longer one of the three best in the sector. The Quality Portfolio is much more akin to how Buffet invests for Berkshire Hathaway nowadays, eschewing the "cigar butt" approach I use in my Value Portfolio more and more over time.
This is because smaller, more obvious values are much more difficult and rare if you're looking to buy with huge sums of money. In other words, you and I have serious advantages in terms of what we can buy and still move the needle on our portfolios. Value and quality-oriented portfolios can both work well.
It's Up to You
At the end of the day, coming up with a reasonable rule set like the above, while incredibly helpful, is only half of the job. The rest is up to you: can you stay calm when Mr. Market shows up, and when your friends and family members are talking about how crazy things are right now? If you can control your emotions and consistently apply these rules, you can do well. If you can't, it's probably a good idea to use a dollar cost averaging strategy and just buy the market.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2021 Andrew Smith