Let’s Talk Strategy

Once in a while, I like to talk about trading strategy. I’m often surprised to see how many active traders buy and sell stocks with little regard for sound portfolio management strategies.

 It used to be that widows and pension funds held large-cap blue chip stocks. They were deemed safe and a sure bet in the long- term. But, as the last few years have shown, large-cap stocks are not immune to market weakness and can suffer significant losses. All you have to do is take a look at some of the top large-caps on the “Nifty 50”–the 50 largest U.S. stocks based on market-cap. Pharmaceutical giant Merck & Co, Inc. (NYSE/MRK) is down over 60% since January 2001, and chipmaker Intel Corp. (NASDAQ/INTC) is down 40% since November 2000.

 The reality is that there is no such thing as a safe-haven stock. Sectors go through cycles and trends. Adopting a “buy and hold” strategy for large-cap stocks may work in the longer- term, which I define as over 10 years, but if your time horizon is shorter, you need to be proactive in your investment strategy. Passive investing makes little sense and exposes you to unnecessary risk.

 Large-cap stocks are well known because everyone writes about and covers them. Small-cap stocks, on the other hand, require more digging to find, but the end result could be much more favorable. Time has proven this to be true. Small-caps tend to outperform large-caps over time. The inherent risk is higher with small-caps, but the potential returns are also higher.

 The key to successful portfolio management is diversification and active management. Do not assume a stock is immune to risk. Monitoring your portfolio regularly is crucial and prudent.

 Now, since we are on the topic of portfolio management, here is a lesson to learn. I was having dinner with a dentist friend recently in New York City. He said he got crushed on a short sell and lost significant money and, hence, will not be able to trade for some time. I assume he lost 20%, but, to my dismay, he lost a whopping 50% when he finally admitted defeat and short-covered.

 I was lost for words, but I asked him why he did not place a stop-buy on his short. His response was he really believed the stock was overpriced! He may have been right, but you never fight momentum, especially on a short position. This is reflected in the current market, in which momentum stocks like Google Inc. (NASDAQ/GGOG) are killing short sellers.

 When you get lazy or too confident and choose not to set a stop on either a short or a long position, you risk the chance of allowing your emotions to dictate your trading. And therein lies the problem.

 Emotion-based trading is ill-founded and without a base. This is especially true when you short sell in an upward trending market. The stock may be a dog, but buying in a rising market can even make dogs look great. I stress here that you should always have a mechanical system in place for covering.

 All I have to say is, “Don’t trade on emotion!” It could prove expensive and send you to the sidelines, watching lost opportunities slip away.