VectorVest Views 4/21/06
USING THE RIGHT STOP-PRICES.
When I started buying stocks about 45 years ago, I used a very simple approach to managing my portfolio. There were a couple of reasons for this. One reason was I really didn't know anything about managing a stock portfolio, and the second reason was that I didn't have the tools to do anything more than use a transaction log and a profit and loss table. But it really didn't matter. I wasn't buying that many stocks anyway. Brokerage fees were so high that I was very deliberate about what I bought, and then I was literally forced into holding my stocks for the long-term because of the high transaction costs. More often than not, this practice caused me to hang on to losers too long and it cost me money I shouldn't have lost. Then I got into the bad habit of selling my winners to make up for the losers. All in all, it was a mess.
Finally I decided not to let brokerage fees dictate how I managed my portfolio, nor should I allow tax considerations to dominate my decisions. I had to let the stocks tell me what to do. So I began to use a 10% stop-loss price as a signal to sell and to take profits whenever I thought it was appropriate. This worked a lot better for me. I was also comforted to know that if I had at least ten, dollar-weighted positions in my portfolio and used a 10% stop-loss, I would lose, theoretically, no more than one percent of my portfolio's value on any one position. It wasn't the total solution to managing my portfolio, but it was a major step in the right direction.
Although VectorVest OnLine's Portfolio Manager defaults to ten, dollar-weighted positions, it allows you to have up to 100 positions in your portfolio if you wish. If you want to retain the principle of a one percent loss per position, however, you need to adjust the stop-loss percentage. For example, you should use a 5% stop-loss with a five stock portfolio and a 20% stop-loss with a 20 stock portfolio. Generally speaking, risk decreases as the number of positions increases. But there are no free lunches in the stock market. Performance usually goes down as the number of positions exceeds seven. Most money managers, I'm told, wouldn't dream of having fewer than 50 positions in their portfolios. This practice adheres to the rule that you never want to expose more than two percent of your money to any single trade.
In addition to Stop-Prices, Portfolio Manager also allows one to use a variety of other exit strategies. Since the "Rec = S" selection is hard to beat, I always use it first in my back-testing research. If the results are promising, I'll try to get better results with other exit strategies. Various combinations of position sizes, stop-gain and stop-loss percentages often do the trick.
I must confess that I'm still trying to create a practical system of managing top VST stocks that will out-perform the simple approach of rebalancing. You may recall from my previous essays that the less you manage top-ranked VST stocks, the better they perform. No, I haven't cheated and looked at the strategies that have been submitted for "The Chairman's Challenge," a competition introduced on March 24, 2006, but I'm tempted
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FATALLY FLAWED.
VectorVest Views 9/7/07
When I designed VectorVest almost thirty years ago, I believed that investors should buy good stocks and hold them as long as possible. So I created an exit criteria which weighed heavily on fundamentals so that high RV, high RS stocks would hardly ever get a sell signal. In other words, high RV, high RS stocks such as KO, MCD and MO would be sold only upon deterioration of their fundamentals.
That approach was naive. I knew that individual investors like me heard business news reports only after the stock's price had gone up or down big time. So I had to leave the ivory tower and base my exit criteria on Price. With a Price based Stop, I could decide ahead of time when to close my positions and be proactive instead of reactive. That's one of the things I like most about trading stocks: I have considerable input in controlling my potential losses.
OK, so how would I do that? I could use a simple 10% stop loss and have done so for a number of years. But, I thought, every stock is different and should be handled accordingly. So I finally decided to use a 13-week, non-linear, moving average of closing Price, adjusted for RV and RS. In this way, I would be in sync with the quarterly earnings reporting cycle and I could still tune the Stop-Price to favor stocks with good fundamentals. Even with this inspired design concept, a lot of our subscribers question the usefulness of VectorVest's Stop-Prices. I'm not going to debate the subject now, but I only ask that you read my essays of January 17, 2003 and April 21, 2006.
Truth be known, VectorVest's Stop-Prices are best suited for investors who are interested in holding stocks for the longer-term. They were not designed for active traders who should be using tighter stops. For example, we use 5% stops in managing our Model Portfolio. Regardless of how you select your exit prices, it's essential that you always have an exit Price in mind. In fact, you should know your exit Price even before you buy a stock. Without such a discipline, your trading process will be Fatally Flawed.
P.S. I consider any newsletter, service or stock guru who makes stock recommendations without corresponding exit strategies to also be Fatally Flawed.