Three Stock Gumshoe Resolutions

Some weekend preaching from your blatherer-in-chief

By Travis Johnson, Stock Gumshoe, March 17, 2018

Every year we resolve to do better, right? That’s the human condition — we are frail, weak, and conflicted… we are busy, irritable, and unfocused… and we want to do better.

It’s no different for your friends here at Stock Gumshoe… so today, as we recover from the Ides of March, I offer up some New Year’s Resolutions for us (you can say we’re late… I say we’re contrarian)… and it’s the third month, so we’ll go with three resolutions.

We would not, of course, deign to tell you what your priorities should be, thinking for yourself is the core of Gumshoe-ishness, but here are three things that I think can help us all.

First: Help each other.

That’s the way to make the world a better place, as we all know. Nothing makes you feel as good as helping someone else… in the context of our little community here at Stock Gumshoe, I’d say that takes the form of answering questions, providing honest opinions, and being kind.

Some material ways you can do that? If you’ve got a couple minutes as you wait for the next great investing idea to fire across your synapses, click on the “Reader Started Discussions” link under Discussions up top… you’ll see that there are filters on the left side to help ID the discussions that are recently active, but if you want to step up and be extra-helpful to a fellow investor click on that “no answers” box. Some questions or discussion starters never get any useful answers or participation, but a few good comments can turn a confused investor into someone with the tools to learn a little bit more. You can help.

Or share your opinions about the newsletters you’ve subscribed to — newsletters can provide a great education or some useful trading ideas, they can help you think in a new way about an investment, or they can be an expensive waste of time… share your experience and let people know what you think about the newsletters you’ve subscribed to by giving them your “star” ratings and posting comments about your experiences on our newsletter ranking pages.

Second: Help yourself… by being honest with yourself.

It’s really hard to write about your own portfolio honestly. You research, think about, sometimes obsess over the individual stocks or investments you make, and they begin to feel like your friends and family… you love them, warts and all, so it’s hard to see the ugliness or imagine the dark side.

Either that, or you find yourself flinging money at one “hot” idea after another, sometimes enjoying a bump up in the stock price and sometimes embarrassed to find that you bought something you didn’t understand.

One way to work on that is to talk to other people about the investments you make. That means you have to go “on the record” and bare your investing soul a little bit. That’s what I do in writing about my Real Money Portfolio for the Irregulars, and I’ve been doing something similar, in a variety of formats, for more than 15 years. It really helps.

I get the silly urges in my head, too, and sometimes I even act on them, but knowing that I’m going to write about these investments helps me to think carefully about buys and sells beforehand and realize that whether or not I’m wrong, I need to have a rational thought process that I’m not embarrassed by. And I need to keep the stupid stuff small.

I’m embarrassed by the results from time to time, of course… but because I have to justify my ideas in writing, I have to think about them more, and that helps me to avoid some of the dumber “hot” ideas that tempt for a few moments at a time, and it keeps my sillier speculations small.

You can do that here at Stock Gumshoe, if you like — our “start a discussion” feature is designed to help folks ask questions or post ideas, but you can also submit article-length musings or analysis of stocks or assessments of your own portfolio if you like… and if you stick with it, you might even develop a following — as hendrixnuzzles has, for example, with his threads about mining stocks and Clean TeQ that have attracted quite a few participants who chip in their own ideas and analysis, several readers contribute avidly to those threads now, but they are sustained by his regular posting about his own analysis and his own portfolio.

You do have to be a member of the Stock Gumshoe Irregulars to start your own discussion threads or submit your own longer commentary… but you can jump into the threads or articles submitted by others and add a comment of your own even if you’re a free member. Start talking… we don’t tolerate personal attacks or cruelty here, and you’ll probably have to bring your “A” game and stick with it if you want to build a following, but thoughtfulness is always welcome… and it will probably do your portfolio some good.

And third, Know Yourself and Know Your Portfolio.

We could also call this know your allocations. Many of us start out with a bit of “play money” that we use to dabble in individual stocks or trade options or look for the next great gold mine or cryptocurrency, but over time that can change as we get excited about a stock or a sector, particularly if things seem to be going really well in a bull market. Have you slowly built up a pretty big investment portfolio? If so, what is it exposed to? What are the largest risks to your portfolio? Did you start with a nicely diversified portfolio, but drift into a 50% allocation to FANG stocks or biotech or junior miners over time?

If you don’t know the answer to that, you’re not ready for the next market crash or bear market.

I’ll just include one quick plug here: The most valuable tool I use for portfolio monitoring is Personal Capital, which is a Stock Gumshoe advertiser that also offers some great free tools that I use every day. I use their free tools to look at the allocations in my portfolio on a regular basis, across a dozen bank and brokerage and mutual fund accounts — including both the active and passive parts of my portfolio. You can set up your own Personal Capital account here, free — and in full disclosure, if you do so, Stock Gumshoe might receive a finders fee. I think it’s only open to users in the United States, and there are similar services out there — but this is the one I like.

You probably won’t avoid a crash even if your portfolio is genuinely diversified, of course, people almost never sell at the top (and if they do, they are likely to be too pleased with themselves to buy at the bottom), but you’ll know whether particular events are likely to destroy your portfolio or simply be a headwind for a little while, and you’ll have thought through a few risks that you need to be wary of. It’s hard to think rationally in a week when the market falls by 5-10% or more, as some of you no doubt noticed at the end of January, so any thinking you can do about “what if” scenarios beforehand might be helpful.

The hidden concentration risks that creep into portfolios during bull markets can perhaps be best understood by looking at a couple past market collapses — the dot com crash and the financial crisis, both of which are probably well within your memory (the average newsletter subscriber is a 60-year-old guy with an above-average income, so forgive me if I assume too much).

If you were invested in the broad market in 2000, you took an ugly hit — if you effectively had a diversified portfolio that mimicked the S&P 500, the most widely-used index of large US stocks, you saw your portfolio lose about 40% in value over the next couple years as the dot-com bubble popped. That was painful.

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But if you had gotten caught up in the mania, and were convinced that riding those growing tech stocks was the only way to get rich, you would have been in far worse shape — the Nasdaq index, which back then was almost exclusively a tech stock index dominated by Cisco and Microsoft and the other emerging mega tech stocks, fell 80% in that same time frame… and unlike the broader market, it didn’t bounce back. The S&P was back in positive territory by 2006, so it took some waiting and a sustained three-year climb from the 2002-2003 lows before investors were made whole again, but patience and ‘buy and hold’ worked to restore those portfolios, eventually. That’s mostly because the broad market wasn’t just sustained by one valuation theory or one sector move, so there was some real earnings power in there to hold up the averages once the froth of the tech mania was dispersed into the atmosphere. There were new stories to find and new growth to discover and dividend payments and everything else to find in the broader markets, because you were fishing in a quiet part of the ocean that had been ignored for a while, not in a pond full of crashed and burning jet-skis that had just been doused with acid rain.

This is the chart of what the market looked like — comparing the S&P 500 (the SPY ETF, in this case) to the Nasdaq Index (the QQQ ETF), from March of 2000 through October of 2006:

Now, it so happened that one of the stories that emerged from those mid-2000s was the rise of real estate and the “rock-solid” bet that was real estate — houses felt like something real and solid that you could count on after the ephemeral surge of the dot-coms. And maybe you noticed that value investors were extolling the virtues of big banks in 2004, or that homebuilders and condo developers couldn’t build fast enough in 2005, and you got sucked into another story.

This chart is a little misleading, since the homebuilders never really got as “bubbly” in shooting higher as the Nasdaq stocks did around 2000, but it shows, again, the importance of asset allocation — certainly homebuilders and big banks were doing well and were widely-admired stories in 2005 and 2006 until the wheels started to come off. Homebuilders fell apart first, then the banks, and that brought the whole market down… but, as happens time and time again, the broader market and the diversified S&P 500 did not fall nearly as far, and bounced back much faster. If you were widely diversified and sat tight, your portfolio probably recovered from the 2008-2009 crash by, oh, sometime in 2012… but if you had gone overweight in the big banks because they were rallying strongly, and kept that overweight exposure, you would have still been deeply in the red five years later:

And, in fact, it wasn’t until last year that the financial sector finally clawed back from all those losses (homebuilders got back in the green in 2015, the banks in 2017). That’s a lot of time to spend getting back to even.

Closer to home, how about those of us who have often fallen under the sway of gold stocks, anticipating that precious metals will protect us from calamity? In modern times, at least so far, they don’t particularly show any signs of protecting or safeguarding your assets as well as diversified portfolios of debt or equities.

Remember 2009? We were all in the midst of the financial crisis, we thought the ATMs might stop working at any minute, there would be blood in the streets, stocks were crashing across all sectors, calamity was upon us and even the sage words of Warren Buffett didn’t convince many people to start buying stocks during the 2008/9 collapse.

Gold would save us, though, that was for sure… and it was rising precipitously, getting above $1,000 an ounce for the first time ever and helping a new generation of gold bugs to emerge from the earth like the 17-year cicada (OK, in this case it was the 31-year cicada… but you get the idea).

That worked really well, the big gold miners (that’s the GDX ETF) were up close to 100% within two years, and gold itself more than doubled shortly thereafter… but then it collapsed again, with some paroxysms of movement thanks to the Euro crisis and some other global events, and those who committed large sums to mining stocks in 2009 may have still not yet recovered (though the metal itself did stabilize).

What does that mean? It means that nothing protects you completely from a downfall — but everything does a better job of protecting you than something does.

So make sure that you’re not betting most of your portfolio on one idea (gold will go up, banks are the best investments, technology is the only way to grow, I only want growth stocks, I only want dividend stocks, I’m putting it all in bitcoin because cryptos are obviously the future… etc., etc.)

Even if you have 30 or 100 stocks in your portfolio, if most of them are connected to one idea that you have in your head about the “inevitable” future trend of some currency or market or technology… then they can all go wrong at once.

That’s easier said than done, because a lot of this comes through subconsciously. I’m attracted to insurance stocks, for example, because of the incredible success I’ve had with Berkshire Hathaway and Markel, and I hate to sell those value-compounding machines (even when, in the case of Markel, the valuation has gotten a bit crazy), so I’ve ended up with a substantial overweight in the insurance sector in my portfolio.

Likewise, the incredible growth of the biggest technology stocks has led all of us — even those of us who are just buying index funds — to be very heavily invested in the market’s most popular stocks… we are all living in a market where the FAAG stocks (Facebook, Apple, Amazon, and Alphabet/Google… I left out the N for Netflix because it’s so much smaller) are more than 10% of the whole S&P 500 by themselves and are favorites of most individual investors, and those companies face real risks in valuation sentiment and concentration risk within their businesses (Apple’s stock is driven by the cycles of its one core product, Facebook and Google are overwhelmingly advertising-driven businesses, Amazon is dependent on an investor “story” that lets them get away with being much more long-term focused than most public companies, etc.)… and, of course, all of them are also very much subject to regulatory risk because of their massive size and their ability to reach into every aspect of our lives (and, in some cases, into our very thoughts).

We’re all taking risks, that’s not a surprise, but it’s important to try to know the risks you’re taking… and know what would happen to your portfolio if whatever scenario you consider unimaginable comes to pass — because you’re probably wrong, it’s probably not really unimaginable.

Gold could fall to $500 an ounce… would that make it impossible for you to retire? Price controls could destroy the profitability of the pharmaceutical industry… would that mean your kids can’t go to college? Interest rates could fall to zero again or, on the flip side, we could have 15% inflation again in the US… would that mean you have to stop traveling? Amazon and Google could be chopped down by regulators just as Microsoft was before them… you can surely make your own list of possible risks. These are not likely scenarios, perhaps, but they’re far from impossible… and I can imagine scenarios where two or three of those things happen in just the space of a few months. And that’s without the really scary black swans like war and plague.

One of the easiest ways to think about risk is by looking at the top of your portfolio — what’s something that could really crush the share price of your favorite stock or your biggest holding? If that happened, would that same “catalyst” also impact any of the other stocks in your portfolio? I

Or alternatively, has your portfolio mostly moved in unison in rising over the past year or two? Do you feel like you’re the king of the world, and all of your top stock holdings have clobbered the overall market? If they’re all going up together, can you imagine a scenario in which they would all fall together?

If you can’t imagine that, try harder. Stocks go down a lot faster than they go up.

Do you have several early stage companies, tech stocks or biotechs or junior miners, for example, that you can tell will need to raise a lot of capital to continue exploration or R&D or product development over the next few years? Do a lot of your stocks rely on a high level of debt that they recycle year after year to fund their growth, without ever paying down principal (like many REITs or MLPs?) Remember what happened to every company that had to roll over debt or raise money in 2009? What if the interest costs for those companies double in the next three years?

So diversification isn’t just “owning a lot of different stocks.”

And along with real diversification across sectors and influences, it’s wise to think ahead about having a real strategy for what to do when things get ugly.

I categorize holdings in my mind, particularly these days, as to whether they’re “hold tight” stocks or are just stocks that I’m riding because they’re rising. Berkshire Hathaway is a “hold tight” stock, I’m almost certainly not going to sell it if it drops by 25% on some bad news because I know the real value of its holdings will likely endure. I’m more likely to buy more.

But when CoreSite (COR) fell below its normal trading range, for example I sold about 2/3 of my position. It was overvalued and running low on growth potential… but I didn’t reduce that position until it hit my trigger point on the downside, because it can certainly keep growing a bit more slowly for years if the market keeps growing and they keep boosting the dividend. Now that position is no longer a huge one in my portfolio — it was well over 5% of my holdings at the peak last Fall, now a lot of that has been converted to cash and it’s about 1.5% of my portfolio — that’s risk reduction.

In more momentum-driven names, the situation is clearer still. If NVIDIA (NVDA) hits its stop loss, or Ligand Pharmaceuticals (LGND) or Five Below (FIVE) hits a stop loss, I’ll probably sell. Those are stocks with exceptional recent earnings growth, whose valuations are based on continuing or accelerating future growth multiplied by investor sentiment, and that means there’s no nearby “support” from something real and reliable in their balance sheets or income statements. They’re in totally different industries, but are priced for high expectations, so with just a bit of market-wide sentiment shift they could easily fall 30% and still be priced at a premium to the market, and if the market itself is also falling and overall valuation sentiment is dropping for everything, a much more severe drop is eminently possible even if those companies don’t do anything wrong or miss their next quarterly earnings estimate. All it takes is a drop in optimism about the future to really destroy the share price of a growth or momentum stock, so taking cues from stop loss triggers is one way to make sure you’re ready to react to that kind of sentiment shift.

So to a great degree, this is about knowing your stocks — knowing their business model, knowing what they’re likely to focus on over the next few years, knowing what risks might lurk in their balance sheets, or whether they need to raise money, or whether they are reliant on the economy of a single country, or a certain kind of product that seems like it’s on top of the world but will, someday, be toppled or face pricing pressures.

But more importantly, it’s about knowing yourself — have you picked all stocks that are similar, that tend to move at the same time? What’s your emotional reaction to a 10% drop in one of those stocks? What will you do if your whole portfolio drops by 20% in a given month?

I can’t answer that, and I don’t know what will happen to every stock in my portfolio in every eventuality, either, of course… but I try to think about that, and I try to be ready with a plan in case the digested food waste hits the air circulation device.

For me, that plan is being diversified, including, in a point I make regularly, diversifying some of my portfolio away from myself (mostly into mutual funds, both passive and active) so that my portfolio is not completely reliant on my personal decisionmaking on a day-to-day basis, and keeping a relatively large cash balance in my portfolios, adding more cash as I can, so that I can hope to be greedy when others are fearful.

I don’t know if it will work, and maybe I’ll be too fearful to make the best move when that time comes, but at least I can prepare and try to envision that future… that, at least, gives me a chance of success. I hope your chances are better than mine, and I’d love to hear what you’re thinking about your portfolio… have a great weekend!