Finished The Yearly Rebalancing of My Portfolio

Today I finished rebalancing my portfolio, as required by the Stock Trading Riches system. This involved buying or selling each stock that was under or over my constant value target by at least 10% - so that each stock position was now at the constant value.

This year, I did it in two parts: sales last Friday and the buys today. This was because I now keep the majority of the cash portion of my portfolio invested in a no-load short-term bond fund.

After selling the gainers, I then calculated how much more money I would need to complete the buys, and then placed a sell order for the mutual fund on Friday. Today, the mutual fund sale proceeds were in my account, and I used them to complete the buys.

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The Importance of Stock Market Capitalization For Building A Diversified Portfolio

Stocks can be separated into 4 groups, according to their market capitalization:

1. micro caps - below $300 million

2. small caps - between $300 million and $1 billion

3. mid caps - between $1 billion and $5 billion

4. large caps - over $5 billion

I talk in more detail about market cap analysis in my book Stock Trading Riches because it's important for investors to allocate their portfolios among all market caps to provide diversification, avoid cyclical returns, and take advantage of "regression to the mean" (e.g. one market cap segment outperforms another, but then they converge).
Market cap is calculated by multiplying the number of shares outstanding by the share price. For example, if stock ABC issued 6 million shares, and the price of each share is $6, then ABC has a market capitalization of $36 million.

In general, micro caps are new companies that are just hitting their stride. Small caps tend to have their infrastructure in place and are in growth mode. Mid caps are big regional or national companies. Large caps tend to be established multinational corporations.

Stocks within each market cap share important characteristics in the areas such as growth rate, risk, dividends, visibility, and international exposure.

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Successful Traders and Investors Keep Their Emotions in Check

To succeed while trading the stock market, you need to be able to control your emotions. You can't become angry or fearful when you are on a losing streak. Alternatively, you can't become euphoric or greedy when you are winning.

Individual stocks, the stock market itself, and trading systems all run on cycles. They will enter money-making modes some of the time and then, without warning, switch.

The only thing we can predict 100% is that, whatever the current state of the market, it will eventually switch, and then eventually return.

If you jump out of the market when it is down, there is a good chance that you will miss the rebound. Similarly, if the market has been strong for a long time, and has reached fantastic heights, you can't become greedy and buy a lot, because the market may fall.

To keep myself from trading impulsively on emotion (and losing), I developed a simple trading plan that lightens my positions as they reach high levels, and starts scaling in as my positions go down.

As a result, I built up my positions at good prices, and scale out as the market goes higher.

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Stock Trading is Like Football - They Both Require Patience

When I was younger, and played the early versions of electronic football, I almost always went on fourth down - even from my own side of the field. I wanted to score quickly and often, and rack up points. What usually happened, however, was that I was stopped and ended up losing the game because the opponent always had better field position.

Now, being older and wiser, I always root for the Bears (my hometown team from Chicago) to play safe and conservatively. I would never think about going on fourth down unless it was late in the game and my team was behind. Also, when my team is looking at long 3rd downs (such as 3rd and 15), I don't automatically expect them to try a long pass. I'm ok with them gaining a little yardage, punting it away, and waiting until the next possession.

Similarly, you have to be patent when stock trading. When I was younger, I wanted to see success right away. I ended up losing a lot because I day traded and used futures, options, and margin trading to leverage my way to success.

My profits went up (and my stress down) when I stopped trying to make quick profits. Instead, like football, I started playing safely and conservatively.

Since day trading left me stressed with no edge, I switched to long term trading, which I found suited my personality much better. I also stopped using margin, futures, and options because they masked my edge. They left me dependent on short term luck to avoid margin calls.

I realized that one of the reasons I was impatient to day trade and make profits was that I didn't trust longer term trading systems. So, I took a few years off trading and did nothing but system design and testing until I proved to myself that my long term trading system had an edge.

I designed the system to suit my personality and needs. I then became passionate and excited about trading my system and knew that I would make money over the long term - even if I could not see profits in the short term.

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Successful Investing is Not Just About Good Stock Picking - You Also Need to Buy Low and Sell High

If you want your portfolio to beat the market over time (generating a better return with less risk), then picking good stocks is just part of the answer. In fact, you don't need to hit home runs by picking the next potential Microsoft or Apple.

You need a trading system that buys low and sells high (Looking for chart patterns is not a way to do it).

Here are 3 reliable ways:

1. Identify a stock that is about to undergo a dramatic shift. This goes beyond studying fundamental data to find good companies. You are also trying to time big moves up or down. This is the hard way to trade because, not only do you need to study the facts, but you have to figure out how the market will respond - not an easy task.

2. Evaluate the stock like a business. You calculate the intrinsic per share value of the company, and compare it to the stock price. Buy when a good company is under valued and sell when the company is overvalued. This is the system that Warren Buffett uses. It requires you to possess a high degree of financial and business knowledge. You also must spend a lot of time doing research. Unless you have an MBA and/or a background as an analyst, it is hard to really get a good edge.

3. Have an automated formula that scales in and out of stocks. This is the method that I use for trading, and I believe it is superior because anyone can use it. You don't need a lot of financial knowledge and time spent in research - only the discipline to stick with the plan.

With this method, you always have a base position in a good company, and increase or decrease the size of your position, depending on the change in the current stock price. Because you are not making a few large trades, errors caused by buying too high or selling too low are self corrected over time.

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The Scaling Flaw That Affects Trading from Chart Patterns

Many traders use charts of past prices to trade stocks. They feel that, if the chart makes certain patterns, it can predict what the stock is likely to do in the near future.

One of the problems with chart reading is that pattern recognition is fairly subjective (the human brain likes to organize random data into pictures). One trader may see a pattern where another one doesn't. This makes charting-based trading systems hard to test.

However, studies that have been done using objective definitions of patterns consistently detect no trading advantage. They show that trading on chart patterns are equivalent to buying randomly.

I think that another flaw of chart based systems, which nobody really talks about, is scaling. Chart scaling, in my opinion, is the reason that patterns looks so seductive and accurate in hindsight.

Traders develop patterns by studying charts of big moves that have already occurred. They frequently "see" consolidations and patterns before the big moves.

For example, one pattern is called sideways consolidation - where the market trades almost horizontally in a narrow range. Then, prices eventually "breakout" and make a big up or down move.

The problem is that, after a market's range has expanded, the scaling of the chart changes as well. This scale change smooths out the movements that occurred prior to the big move, and creates the sideways consolidation. Prior to the big move, traders would not have seen the sideways consolidation, because the chart scale would have been different.

Let's assume that the market moved in a range between 10 and 20 for 6 months. The chart would be scaled from 10 to 20, and the chart will show lots of peaks and valleys. After the market moves to 85, the chart now reflects a range from 10 to 85. This compresses the peaks and valleys between 10 and 20. The result is that the 6 months before the move looks like a sideways consolidation pattern.

Unfortunately, you can't trade on patterns that occur after the move.

This is why my trading system does not use charts - only prices. Numbers are objective, and not open to interpretation. I only use charts to find prices for stocks I want to back test using my spreadsheet.

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