How to Fix This Common Investing Mistake

Sep 03, 2021

It’s sad but true…

Most individual investors chronically underperform the market.

That might not seem like a big deal. After all, making some money is better than making none, right?

But over a lifetime, this can result in leaving hundreds of thousands — even millions — of dollars on the table.

For many folks, that could mean the difference between financial freedom and merely getting by.

Fortunately, here at TradeSmith, we’ve found that poor investment performance is often the result of just a few common problems that are relatively easy to fix.

A Money Talks reader named John brought up one of these problems in a recent email:

On the day I fully retired from my medical practice, I perchance followed a lead which led me to join TradeStops. I’m now a TradeSmith lifetime member.

I had been a [stock market] bear for a number of years, leaving our savings in bank term deposits. I’m now back in the market and pleased with the results so far…

I have also signed up to several expensive newsletters and purchased stocks based on their advice.

My issue is now “my cup runneth over.” I have 60-odd stocks and these newsletters keep recommending more. I’m a little overwhelmed and I wonder how you would suggest I manage from here on.

Thank you for the note, John!

First of all, let me officially welcome you to the TradeSmith family. I’m thrilled to hear our tools have helped give you the confidence to get back into the market safely.

And rest assured, you’re not alone.

Owning too many stocks is one of the most common problems we see among new subscribers. It’s not unusual for folks who subscribe to several newsletters to find themselves holding hundreds of different stocks at a time.

As you mentioned, it can be overwhelming trying to manage so many positions. And more importantly, our research shows portfolios of more than 50 or 60 positions typically produce significantly lower long-term returns than owning a more concentrated portfolio.

We’ve found that holding 15 to 25 stocks is a good starting point for most investors. This number is large enough to be reasonably diversified but small enough to allow you to closely monitor each investment you own. A smaller portfolio can also significantly reduce any potential transaction fees your brokerage may still charge.

Of course, whittling down a large portfolio can be easier said than done. That’s particularly true for many newsletter recommendations with compelling fundamentals.

Fortunately, our TradeSmith tools can be a huge help here. (And of course, because this is Money Talks, I’ll also share some guidelines for folks who aren’t currently TradeSmith subscribers.)

For this exercise, we’ll assume you’ve already reviewed the fundamental case for each investment you own and are still bullish on its prospects. If not, that should be where you start. It makes no sense to continue to own an investment if the fundamental reason you bought it no longer applies.

In addition, before you get started, you should decide how many stocks you’d like to own.

Again, our research shows most folks do best owning 15 to 25 positions to start, only adding new investments after careful research and consideration.

But depending on your situation, you might choose to own more. What’s important is that you choose a number that you can comfortably track and manage.

Once you’ve decided how many positions you’d like to own, the first step is to downsize your portfolio beginning with your “losers.”

Specifically, we recommend selling any stocks trading in the TradeSmith Health Indicator Red Zone that are also trading at a loss since you bought them.

The reason here is simple: These are stocks that are both “unhealthy” in our system and are costing you money.

Unless you have a great reason to hold on, these are great candidates to sell. When (or if) they eventually turn around and trigger a TradeSmith Entry Signal, you could always consider getting back in.

Depending on how many losing positions you’re currently holding, this step alone could get your portfolio down to a reasonable size. But most folks will probably need to do a little more.

The next step is to consider selling any remaining Red Zone investments with positive returns.

Like before, the reason is simple: While these stocks are currently showing a gain, they’ve still not proven themselves to be “healthy” in our system.

Our research shows Red Zone stocks are historically more likely to suffer an unexpected decline than those in the Green or Yellow Zones. And selling these positions now could potentially offset some of the losses you took in the previous step.

Again, depending on how many stocks you own, these two moves could reduce your portfolio to a manageable size. But if you own a huge number of stocks, there’s a good chance you’ll still need to sell some additional positions.

That is where our Pure Quant tool comes in.

If you’re not familiar, Pure Quant is our proprietary portfolio-building software that makes building a well-diversified, risk-balanced portfolio as easy as clicking a few buttons.

But the algorithm or “rules” we developed to run Pure Quant can also be used as an easy, step-by-step guide to downsizing your portfolio further.

You can work your way through these “rules” until you’ve reached your preferred portfolio size.

  • Sell any stocks that are NOT currently in the Health Indicator Green Zone.

    That includes any remaining Red Zone stocks you may still be holding on to, any Yellow Zone stocks, and any “Gray” stocks (meaning they don’t currently have enough trading history to generate a Health Indicator status).

    This step ensures you’re holding only healthy stocks with positive upward momentum.

  • Sell any remaining Green Zone stocks with an average Volatility Quotient (VQ) of more than 40%.

    As regular Money Talks readers may recall, the VQ is our proprietary measure of a particular stock or asset’s current risk. The average VQ is simply that asset’s average risk over the long term.

    Selling stocks with an average VQ of greater than 40% helps ensure you’re not holding any ticking time bombs that could unexpectedly make a big dent in your portfolio.

  • Sell any remaining Green Zone stocks trading at a loss since reentering the Green Zone.

    While these stocks are technically healthy, they’ve not been performing well and are the next logical place to cut.

  • Sort your remaining stocks by the number of days they’ve been in the Green Zone, and remove as many of the older Green Zone stocks as necessary to meet your preferred portfolio size.

    Again, these stocks are still healthy in our system. However, all things being equal, our research suggests newer Green Zone stocks are likely to outperform those that have been in the Green Zone longer.

Once you reach your preferred portfolio size, you can run your portfolio through our Risk Rebalancer tool to equalize the risk in the remaining positions.

That’s all there is to it. (And folks with access to Pure Quant can even use the tool to complete all four steps, plus rebalancing, automatically.)

Of course, if you’re not currently a TradeSmith subscriber, you won’t be able to use our Health Indicator and VQ metrics to help guide your decisions. And unfortunately, there aren’t many great alternatives available for individual investors. (That’s why we created them in the first place!)

But there are still a couple of things you can do to intelligently downsize your portfolio and improve your long-term returns.

Like before, we’ll assume you’ve already reviewed the fundamental case for each investment and still have a solid reason to own it.

The first thing I would recommend is to sell any positions that are trading at a loss since you bought them.

Now, let me be clear. Here at TradeSmith, we’re not against buying stocks that are “on sale.” But value alone is not enough for us.

Cheap stocks can always get cheaper. And trying to “catch a falling knife” — Wall Street speak for buying a stock in a downtrend — is often a recipe for disaster.

That’s not to say that buying and holding value stocks can’t be a profitable investment approach. But most folks simply don’t have the stomach for it. They typically end up “buying and folding” at the absolute worst time.

We prefer to own healthy stocks with positive upside momentum, even if that means waiting for slightly higher prices to do so. And our research shows most folks can earn better returns (with much less stress) through this approach.

Another simple strategy to downsize your portfolio is to sell your riskiest or most volatile stocks.

Again, we’re not against owning speculative stocks at TradeSmith. But they should represent a relatively small part of your overall portfolio. Unfortunately, many folks — particularly new investors — tend to own way too many of these kinds of stocks. Some even have the bulk of their portfolio in them.

Again, if you’re not a TradeSmith subscriber, you won’t have access to our proprietary VQ. But you can still get a general sense of how volatile a stock has been with some publicly available metrics. These include things like historical volatility, beta, 52-week change, etc.

And of course, in some cases, you don’t even need data to know a stock is risky. If your portfolio is loaded with meme stocks and profitless SPACs, you likely have plenty of “low-hanging fruit” to start downsizing.

I hope today’s lesson was helpful. As always, I welcome your feedback at [email protected]. I can’t respond to every email, but I promise to read them all.