Position Trading #1: Diversification
Oct 3, 2011 at 9:44 am in Position Trading by
One of my seven pillars of position trading is diversification. Not only is this important for managing risk, so that a single bad apple won’t kill me, but also it is important for maximising profit, in the sense that only by casting out lots of seeds can I discover which ones are worth nurturing.
We Plough the Fields and Scatter
Paraphrasing the traditional song:
We plough the markets and scatter
Our money on promising stocks
And some are fed, some left to rot
By pyramiding and exercising stops
That pretty much sums it up for me, the idea being to establish small exploratory positions in many stocks and then dropping (by stopping out) the ones that perform badly while nurturing (by pyramiding additional funds into) the best prospects.
Since there are no size-independent dealing fees, this approach to taking many small positions works much better in a spread betting account than it would in a traditional brokerage account.
Diversification Over Time
It’s not just about diversifying across stocks. It’s also about diversifying over time, by establishing a position in each stock when it becomes individually attractive rather than trying to build a portfolio all in one go. Over time new stocks will be added to the portfolio as they become attractive, poorly performing stocks will drop out, and positions in the best performing stocks will grow bigger.
Some people say that you can’t time the whole market, and this way you don’t need to.
All Your Eggs in One Basket?
Some people think they’re diversifying by buying into a FTSE 100 or FTSE All-Share tracker fund, but I think they’re wrong. The whole point of diversification is to spread your eggs across many baskets, but to me a FTSE 100 tracker fund is one basket because you have to buy or sell the the hundred constituent stocks all at the same time with no prospect of buying or selling any of the individual stocks when it is prudent to do so.
Whereas some investment gurus say that we should spread our eggs across many baskets, some great investors — including Warren Buffett, as I understand it – advise that it’s better to put all our eggs in one basket… and watch it carefully!
My take on this is that we should put our eggs in many baskets… and watch them all carefully! Watching many baskets can be labour-intensive, which is why I employ and army of guards to keep watch on my baskets when I’m not looking. Those armed guards are my stop orders, and I’ll look at them in the next installment.
For the record: the FTSE-tracking approach might suit wealthy individuals who want to simply park their money in a less volatile (apparently) investment that requires minimum supervision, but it’s not the kind of diversification I’m looking for.
Tony Loton is a private trader, and author of the book ‘Position Trading’ published by LOTONtech.