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- No new trades.
Strategy Lab is MSN Money's stock-picking challenge. To learn more about the game and the contenders, click here.
"The world is round and the place which may seem like the end may also be only the beginning." -- Ivy Baker Priest
During the previous round of Strategy Lab, my portfolio return fluctuated around the double-digit range and beat all the indexes pretty much from the beginning.
All in all, I am extremely happy not only with how well my strategy performed but also with how enjoyable the experience was.
I can't stress enough how fortunate I feel to have been able to share my investing ideas in the Lab over the past six months. Given the positive feedback from readers, I think I've done reasonably well. I've also enjoyed competing against the Lab's pros, and thus my personal thanks go to all of my colleagues, whose posts I've enjoyed reading.
For my first article in the new round, I want to summarize some of the core principles I've outlined in the various articles throughout this contest. Take them for what they are.
Opinions are suited only for this particular strategy and are not a silver bullet. Successful investing requires flexibility at all times and acceptance that no one is always right.
My general principles
- Markets go up in the long run due to inflation, so being 100% short is reckless.
- Reduced risk and volatility in your portfolio are best achieved through the active short-selling of stocks.
- Timing the market by moving into and out of cash is an inferior strategy because of the "black swan" effect (large one-day gains account for the majority of long-term returns).
- Moving into and out of index exchange-traded funds, however, is a viable alternative.
- Focusing on less admired names increases the probability that a security has not yet been efficiently priced and mitigates the emotional attachment.
- Consistent focus on macroeconomic developments allows for identification of sectors that are more likely to outperform in the short to medium term.
- Owning a less attractive stock in an outperforming sector is preferred to owning an attractive stock in an underperforming sector.
- Earnings of the overall market in the long run should grow at the nominal gross-domestic-product growth rate of roughly 5% to 6%, in addition to a dividend yield of 2% to 3%. Thus passive investors are unlikely to realize a total market return of more than 7% to 9%.
- Accordingly, achieving double-digit returns requires fairly active investment strategy.
Short-selling rules
- Do not short-sell stocks based on pure valuation. Short only when a company has a reasonable chance of going out of business in the next 18 to 24 months.
- Do not short-sell stocks without debt or a significant liquidity problem (consistently negative cash flow combined with a low cash balance).
- Short-sell only stocks that are already in a downtrend and have high short interest.
- Short-sell only stocks with low margins and negative or declining cash flows.
Risk-management principles
- Avoid shorting stocks in biotech or any other sectors heavy in high-end research and development.
- Short positions should be smaller than the average long position.
- Try to eliminate emotions from the selling process. Limit double-digit losing positions to two or three at a time.
- Don't "double down" on more than two or three positions in the portfolio at any specific time.
- Avoid investing more than 40% of your portfolio in a single sector or more than 10% in a single position.
- Avoid initiating a "full" target position in a stock that has been in a "falling knife" pattern for a prolonged period.
- Review positions daily for significant moves, but avoid trading more frequently than once a week.
- Avoid a "sell at the top" strategy. Instead, sell after a normal short-term correction threatens to become a true decline.
- Watch for the important technical support/resistance levels as potential indicators of investor psychology. Though stand-alone technical analysis should not be a part of a core strategy, it's important to pay attention to it because of its potential for moving investors.
- Look for high or increasing short interest in your long positions as an indication that the companies may have fundamental flaws. Evaluate all possible explanations for the short interest. If no reasons are found, limit the number of short positions to five or less.
Stay safe out there. Feel free to e-mail me at skepticalcapitalist@gmail.com, and visit my blog at The Skeptical Capitalist.
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