Portfolio Management And Allocating For Risk

Panuwat Dangsungnoen

To date, I person written galore articles connected Seeking Alpha. All of these articles person been astir individual stocks/investment opportunities, pinch a mates of summary articles discussing my favourite banal picks for nan upcoming year. Based connected questions and feedback I have received from these articles, I deliberation it is important to besides constitute immoderate articles to thief amended investors connected various finance philosophies and approaches that person helped maine successfully negociate my ain portfolio for galore years.

Not only should readers see that I americium not an finance advisor, but they should besides statement that I americium continuing to learn. As I study adjuvant ideas, I effort to walk them on to use others. So, what I stock present successful this article is wrong that spirit. I americium passing on immoderate adjuvant ideas and approaches that person benefitted me.

The Biggest Mistake - Failing to Protect Money

By acold nan biggest correction I made early connected pinch my investing was allocating my portfolio based upon a stock's imaginable upside. I retrieve galore occasions wherever I heard personification opine astir a company's imaginable and was convinced by their arguments and my ain later owed diligence that nan banal could really beryllium sore. Unfortunately, I really had immoderate early occurrence taking this approach, pinch my investments multiplying. So, my investments doubled aliases tripled successful comparatively short order. Why, you mightiness ask, did I opportunity "unfortunately" if my investments were multi-baggers?

Well, it's because this early occurrence entrenched my bad habit. And so, erstwhile I made bully returns connected comparatively small money, it was mostly luck. Meaning that I past had much money to suffer from my mediocre consequence management/allocation decisions! Moreover, this group successful mobility nan thought that if I could conscionable find 1 aliases 2 much investments, I could make each of nan money I mislaid correct back. In trying this approach, I wasted respective years I could person been investing much wisely.

What was my superior mistake? I was investing and allocating pinch only nan upside successful mind. Sure, theoretically I knew immoderate of my investments could beryllium large losers, but I ne'er really put that thought into practice. I dream by sharing this article pinch Seeking Alpha readers, I tin thief others protect their portfolios from nan aforesaid mistakes I made.

Risk vs. Reward

Almost immoderate banal aliases finance pinch perchance precocious reward besides has a correspondingly precocious risk. As nan saying goes, "The higher nan risk, nan higher nan reward." The inverse besides tends to beryllium true: nan little nan risk, nan little nan reward. This move is what leads galore investors to simply parkland their money successful exchange-traded costs ("ETFs"). These costs simply travel immoderate type of banal index. For example, to travel nan S&P 500, an investor tin simply put successful SPY. This is overmuch little risky than investing successful individual stocks, but besides intends you person nary chance of a "high reward" (as defined by "beating nan market"); that's because SPY is "the market." Yet astir apt everyone reference this article is reference it - and different Seeking Alpha articles - because they purpose to "beat nan market." Therefore, we are consenting to return much risk, seeking that other reward.

What I americium sharing present is nan astir important instruction I person learned: to make much money, you must forestall yourself from losing money. And nan only measurement to do that is to allocate your portfolio based connected consequence assessment. Let maine supply immoderate examples of why this is truthful important. Note that successful each Scenario below, I statesman pinch a $100 investment.

• Scenario A: The institution struggles and nan marketplace drops. I suffer 20% connected my first investment. The banal is now worthy $80. In bid to break even, I must now find a return of 25% ($20 to get backmost to $100, divided by $80 near aft nan first loss).
• Scenario B: The institution makes immoderate mistakes positive nan marketplace drops. I suffer 35% connected my first investment. The banal is now worthy $65. In bid to break even, I must now find a return of 54% ($35 to get backmost to $100, divided by $60 near aft nan first loss).
• Scenario C: The institution makes immoderate immense mistakes and I suffer 50% connected my first investment. The banal is now worthy $50. In bid to break even, I must now find a return of 100% ($50 to get backmost to $100, divided by $50 near aft nan first loss).

What you spot from these scenarios is that nan much you lose, nan bigger nan spread successful really overmuch you must gain backmost conscionable to get to breakeven. At 20%, nan spread (delta) betwixt what you mislaid and what you request to gain backmost is only 5 percent points. When you get to a 35% loss, nan delta is 19 percent points. When you get clear down to a 50% loss, nan spread to breakeven is simply a afloat 50 percent points! So, not only are you losing much connected nan measurement down, but it takes overmuch bigger gains connected nan measurement backmost up.

I dream these examples show you much concretely why nan first norm successful my portfolio is to protect my money. And nan only measurement to protect my money is to measure and allocate for risk. Below, I will talk some really I measure and allocate for risk.

How I Choose Stocks

While location is nary one-size-fits-all approach, I personally look for a definite norm of thumb. Namely, I only put successful an individual banal if I judge location is simply a 3:1 ratio of my assessed reward versus my assessed risk. I cannot accent this adjacent constituent enough: this norm of thumb intends I do not put successful 98-99% of opportunities pinch which I americium presented! Furthermore, arsenic much accusation is learned, arsenic a company's communicative changes, aliases arsenic nan company's valuation changes, I proceed to measure this ratio and allocate appropriately. I will return to this successful much item successful a conception below.

In nan meantime, we should admit location are a batch of "good stories" retired there. Outside of fraudsters, nary 1 starts a institution to bargain our money aliases because they deliberation they will fail. They commencement companies and negociate them because they judge they tin make money - and tons of it. But that does not mean we request to put successful each of them. We tin beryllium selective pinch our money, and our ain appraisal of a company's consequence mightiness beryllium rather different than that of management, aliases moreover of different investors.

Further, we mightiness take different reasons not to invest, including, but not constricted to:

• Having nary liking successful nan company/industry
• Having nary expertise to decently measure nan company
• Finding better-perceived opportunities and/or little consequence successful different investments
• A "gut feeling" location is much consequence than we tin presently perceive/assess
• Simply not being inspired by a circumstantial institution astatine a circumstantial time

All of nan supra reasons are reasons I person chosen to debar definite investments. Some of these missed opportunities would person ended up returning immense profits - and I was wholly comfortable missing retired connected that because of 1 aliases much of nan reasons I stated. Remember, my extremity is not to make each bully finance possible. My goal, first and foremost, is to debar losing money. Second, my extremity is to minimize really overmuch I suffer erstwhile my finance goes incorrect (again, much connected that successful a conception below). This, successful turn, allows maine to make much money erstwhile an finance goes well.

With that successful mind, and looking up towards portfolio construction/allocation, let's get backmost to my norm of thumb: I want to spot 3 times upside ("reward") for each one-time downside ("risk"). So, if I judge a banal could conceivably spell down 10% if I americium wrong, I want to concurrently judge nan banal could return 30% complete that aforesaid timeframe if I americium right. If I deliberation nan banal has 25% downside, I want to spot astatine slightest 75% upside. And, if I deliberation nan banal could spell to zero (100% downside), past I amended spot astatine slightest 300% upside.

Again, this is not a difficult rule, but a wide norm of thumb I usage erstwhile assessing an investment. But this is conscionable nan opening of constructing my portfolio of investments. Why? Because of nan scenarios I gave you astatine nan opening of nan article. If, indeed, 1 of my investments loses 100%, past I must dress up via monolithic returns connected my different investments, each things being equal. But each things are not equal! Thus, we should talk allocating our money betwixt aggregate investments.

Portfolio Allocation Percentages

I dream I person established that my number 1 norm is to debar losing money, and intimately down that, knowing that we sometimes do suffer money connected an investment, is to minimize really overmuch we suffer erstwhile a nonaccomplishment occurs. With these principles successful mind, we tin talk really I past allocate individual stocks wrong my full portfolio. Before getting into circumstantial specifications connected individual stocks, I want to punctual readers of a truth truthful galore investors look to forget: cash is simply a position.

As stated above, I walk connected nan immense mostly of finance opportunities presented to me. And I only consider investing if I measure 3 times nan upside compared to nan downside. That intends I often person rate disposable erstwhile an finance meets my criteria. When I do not person rate available, it usually intends it is invested successful a liquid banal pinch comparatively debased assessed risk, allowing maine to entree it astatine immoderate infinitesimal for a amended opportunity. In immoderate case, location is thing incorrect pinch having rate connected manus to deploy for bully opportunities. There is nary norm that each of your rate must beryllium invested astatine each times!

To further protect my assets, I person a wide norm of thumb to allocate nary much than 10% of my portfolio to 1 stock. While I sometimes break this rule, I do truthful only aft observant study and consideration, and mostly only for a comparatively short magnitude of time. And I surely only do that if I americium highly comfortable pinch nan level of risk. Occasionally, though, I find stocks that are beaten down wholly independently of nan company's basal performance. This tin hap owed to a institution moving done a bad banal marketplace situation (I person seen plentifulness of opportunities complete nan past year!), aliases moreover company-specific issues specified arsenic moving done derivatives connected a equilibrium sheet. In this second case, we should beryllium definite nan institution is successful a fundamentally amended position than erstwhile those derivatives were necessary, of course.

Below are immoderate guidelines I usage for allocating a designated percent of my portfolio to an individual stock.

• 8-10%: Overweight Position. I judge nan institution has a important upside, pinch nan downside limited. While these whitethorn beryllium "multi-baggers," this imaginable will only beryllium recognized complete nan people of 3-5 years (if it is simply a shorter timeframe, past location is almost surely much risk). At nan clip of my first investment, location is virtually nary perceived chance this institution will beryllium retired of business successful nan adjacent 5-10 years.
• 4-7%: Core Position. I judge nan institution has a important upside, but nan downside is besides much probable and much terrible than an Overweight Position. Still, I judge nan institution will almost surely beryllium successful business for nan adjacent 5-10 years.
• 1-3%: Speculative Position: While I judge nan banal could supply a immense upside, I besides admit nan banal could beryllium trim successful half aliases much successful nan adjacent term. Further, I americium not needfully convinced nan institution will beryllium successful business successful 10 years; and if it is, I mightiness still position them arsenic being speculative. However, I besides person immoderate beardown reasons to judge they could succeed.

As you tin spot from nan above, these allocation levels are based connected trying to debar losing money, and erstwhile losses do happen, they are minimized. However, I should statement that I not only initially allocate my portfolio based connected these guidelines, but conscionable arsenic importantly, I continuously manage my portfolio pinch these successful mind.

Managing nan Portfolio Allocation

When I determine to put successful a stock, I person assessed some nan consequence and nan reward and person deemed it a worthy finance by my judgement and standards. But statement that I person deemed it a worthy finance based connected its valuation astatine that circumstantial constituent successful time. In different words, a company's valuation is an highly important facet of making an investment. I americium not investing successful companies successful nan absurd but astatine a circumstantial price/valuation. Naturally, then, erstwhile that valuation changes, I request to re-assess my investment. Let's usage an example.

I person studied Company A and I judge they are a coagulated company. Further, I believe, based connected their business prospects, that they will beryllium worthy $250M, if successful, successful nan adjacent 3 years. However, if they are not successful, I judge they mightiness only beryllium worthy $100M. They are presently weighted astatine $135M. This is simply a cleanable finance for my portfolio: it provides a imaginable 85% return pinch only 26% downside. Therefore, I initiate it successful my portfolio arsenic a Core Position astatine 5% of my portfolio.

Like astir stocks, Company A's shares are traded connected a nationalist exchange, meaning its valuation tin alteration by nan 2nd during marketplace hours. Therefore, it is important for maine to way Company A and to negociate its size successful my portfolio. Why? Because arsenic agelong arsenic its business prospects stay nan same, and I still deliberation it should beryllium weighted astatine $250M successful a mates of years, Company A becomes much "risky" arsenic its value increases. In fact, astatine $200M, Company A is rather risky by my definition. It provides only 25% upside pinch 50% downside-the nonstop other of what I look for successful an investment.

Now, successful nan existent world, arsenic Company A approaches a $200M valuation, it is rather apt nan downside will not stay astatine $100M. This is because Company A has astir apt executed connected its business scheme arsenic I expected, and truthful their downside whitethorn beryllium a overmuch higher valuation than erstwhile I initially invested. At nan aforesaid time, nan upside whitethorn now beryllium higher also. That's why it is important for america to continuously measure our investments.

Sometimes, however, publically traded companies are volatile, pinch valuations changing rapidly. In these scenarios, it is moreover much important to negociate Company A arsenic portion of my portfolio. How do I do that? It's really rather simple. If Company A's banal appreciates truthful that it becomes 6% of my portfolio (as compared to nan first finance arsenic a 5% portfolio position), I will waste capable shares to rebalance Company A arsenic a 5% position successful my portfolio. On nan different hand, if Company A's banal depreciates, truthful that it is now only 4% of my portfolio, I will bargain capable shares to rebalance Company A arsenic a 5% position successful my portfolio. Watching these types of movements connected a play - if not regular - ground allows maine to "buy low, waste high" passim nan clip I ain Company A shares.

Of course, passim this full process, I americium monitoring Company A to spot if it is worthy of a larger percent position aliases if I should statesman trimming it to a smaller percent of my portfolio. Perhaps Company A makes immoderate bully deals pinch different institution and its consequence is now little pinch much upside. I whitethorn past determine Company A is worthy of a 10% position successful my portfolio. Alternatively, possibly those deals autumn through, and I determine Company A is nary longer worthy nan risk, and I nary longer support Company A shares arsenic portion of my portfolio.

One of nan Biggest Risks

I judge 1 of nan biggest risks we investors tin make is falling successful emotion pinch a institution aliases its stock. As investors - and this is astir particularly existent of unit investors - we person overmuch much elasticity than institution management. Sure, we whitethorn not get sweetheart insider deals, but what we do person that insiders do not is elasticity - truthful we should usage that to our advantage! Look astatine what I said supra astir trimming from aliases adding to a position. An insider cannot perchance beryllium that flexible. They whitethorn cognize nan company's banal is comparatively overvalued astatine a fixed constituent successful time, but trading a important information of their shares could origin nan banal to crater aliases could put them nether terrible unit from different insiders and investors.

It is important for america to abstracted our emotions from investing. Investors often go emotionally attached to stocks that person performed good for them, aliases pinch guidance teams who person been bully to them, aliases pinch products they prefer. I tin deliberation of aggregate examples. Tesla (TSLA) is simply a banal that emotionally attracts galore investors. The banal made a batch of group money, and immoderate investors resonate pinch TSLA's mission. Some of these investors made a batch of money connected insubstantial but are now "in nan red" because they ne'er sold immoderate shares arsenic nan value - and frankincense consequence - increased.

Among immoderate investors, I person taken power successful nan past for souring connected a name, aliases for exiting my position while others were still euphoric, simply because nan valuation had risen to a level wherever my assessed consequence acold exceeded my appraisal of reward. I cannot deliberation of 1 illustration wherever I regretted that determination later. In each but 1 of these cases, nan banal yet dropped beneath wherever I sold. In nan other case, I still had nary regret because - arsenic noted supra - I do not consciousness nan request to make money connected each imaginable stock. I walk connected 98-99% of opportunities because I americium avoiding risk!

Conclusion

I dream this article helps different investors debar nan biggest correction I made earlier successful my investing life: allocating my portfolio based upon reward alternatively of risk. As I tried to show successful this article, I judge investors should alternatively make and allocate investments chiefly connected nan ground of risk. This attack leads maine to avoiding investments successful astir 99% of opportunities presented to me. I thin to only put successful a institution if I judge its shares connection a 3:1 ratio of reward to risk. Furthermore, I usage strict guidelines to find nan percent of my portfolio I allocate to immoderate individual stock. I usage those guidelines to perpetually measure nan risk/reward ratio, and will often bargain much shares erstwhile a banal dips while trading if nan shares statesman to climb. Finally, I stressed nan value of removing emotion and bias from investing. Becoming attached to a banal is often a measurement to break my cardinal norm of protecting my money. I tin emotion aliases dislike almost immoderate stock. I tin moreover emotion a banal astatine 1 constituent successful clip and dislike it astatine different - it each depends connected nan value (and frankincense nan perceived risk).

I collaborate pinch different "Breakout Investors" astatine app.breakoutinvestors.com arsenic we effort to beryllium up of nan curve, looking for opportunities wherever nan marketplace has not yet figured retired aliases appreciated a company's basal business aliases upcoming catalysts. I person an accounting grade from Creighton University and a Masters successful Philanthropy and Nonprofit Development from nan University of Northern Iowa. I put for status and arsenic a hobby. I chiefly prosecute successful basal study and look for ample discrepancies successful what I judge a institution is worthy and their existent stock price.