Welcome to our third and final blog covering Chris Burgess's Beat the Market class. In this class, Chris uses fundamental analysis to pick which companies you should consider trading. In our first blog that you can read here, he covered how to use a macro-economic analysis approach to the stock market to pick out companies. In our second blog, which you can read here, Chris covered how to break down the data you have collated with data-driven, event-driven, and observation-driven idea generation. Finally, in today's blog, we will be covering a deep dive into portfolio management.
At this point through the Beat the Market class, you have done all your analysis and picked a few profitable trades. Now would be an excellent point to bring up two essential concepts that will help you keep the newly generated cash in your jeans: diversification and exposure.
Portfolio diversification is one of the most misunderstood and misapplied concepts in finance. Simply put, diversification is to avoid putting all of your eggs in one basket. However, it's also crucial that you diversify properly and not amateurishly.
For example, if you are all in on Telsa with your entire trading account and suddenly Elon Musk dies in a car accident, you are in serious trouble. But if Telsa is only one of many stocks that you own, it won't be a big hit to your overall wealth because you have other stocks making money. We know that we're not going to get all of our trades right. So, it's essential to have multiple trades going simultaneously to balance out any losers with our winners.
Diversification is all about the Aristotelian Mean, which states, "For every virtue, there exists two vices: one, its lack and the other, it's excess." Therefore, we must aim for that "sweet spot" where we are diversified, yet our trading account is not over-diversified. The problem with most retail traders is they tend to do one or the other extreme: they either only have 1-3 positions in their portfolio, or they have way too many.
Diversification works when you have multiple positions that all have low correlations with each other. When two stocks are correlated, such as GS and JPM, it means they move up and down together. If you have stocks with low correlations and one industry is having trouble, it doesn't affect other stocks in your portfolio.
While many retail traders will only have 1-3 positions in their portfolio, which does not provide enough diversification, many others go the opposite extreme and buy an index fund. They assume that they are well-diversified and safe because the index fund has exposure to all 500 stocks in the S&P 500 index. However, many of the stocks in the S&P 500 are highly correlated with each other. Pick any one stock, and there are indeed 20-50 other stocks that go up and down with it, which ultimately defeats the whole purpose of diversification.
We usually recommend about 8-10 positions that are all lowly or inversely-correlated. Additionally, about half of those positions should be short; thus, if the market crashes or pulls back, your short positions will make money, thereby protecting your capital.
Your trading account should maintain about 8-10 positions with low correlations composed of a mixture of long and short positions for protection. This way, you can limit your risk by imposing exposure limits, both on your individual positions and on your portfolio as a whole. After all, putting cash in your jeans is great but keeping the cash in your jeans and protecting yourself against volatile market shifts is even better.