More Investing Basics

Portfolio Management

Asset Class – A group of securities that have similar financial characteristics and behave similarly in the marketplace. The three main asset classes are equities (stocks), fixed-income (bonds) and cash. Other asset classes of note include real estate, commodities, precious metals, and collectibles. Asset classes reflect different potential for risk and return, and typically perform differently from one another in different market conditions.


Closed-End Fund – a CEF can be thought of like a mutual fund in that each one holds a basket of securities and thereby is “self-diversified” within the bounds of its stated sector, class, industry, or other purpose. It is actively managed by an investment team or professional. The difference between a closed-end fund and a mutual fund (which is an open-end fund) is that a CEF initially raises a prescribed amount of capital by issuing a fixed number of shares. These shares are then purchased by investors just like shares of stock. (Mutual funds do not have a fixed number of shares, and raise their capital as they sell more shares. They also do not trade like stock, but work on a different trading system.) Closed-end Funds allow investors an easy way to own a broad basket of securities in a single transaction, and offer the convenience of a stock with the diversification of a mutual fund. The stock prices of a closed-end fund fluctuate according to supply-and-demand market forces, and by the changing values of the securities within the fund. Because of their price structure, CEFs can be purchased and sold at a discount or a premium.


ETF – this type of security is called an Exchange Traded Fund, and works similarly to a CEF, but sports some differences in its makeup. It more closely resembles a mutual fund by its financial characteristics, but, like a CEF, is easier to buy and sell than a mutual fund. An ETF may track an index, an industry, or a basket of assets, but trades like a stock on an exchange. Unlike mutual funds, ETFs experience price changes throughout the day, and can be bought and sold during the day just like common stocks. Exchange Traded Funds allow investors an easy way to own a broad basket of securities in a single transaction, and offer the convenience of a stock with the diversification of a mutual fund. Because of their price structure, ETFs can be purchased and sold at a discount or a premium.


Moving Average – an easy way to track trends in the markets or in a single security. A moving average takes the daily prices for a specified period (i.e. 200 days, 50 days, 10 days) and averages them, creating a new line on the price chart. This smoothes out the price fluctuations to form a line that denotes whether or not the movement is in an uptrend (above the moving average) or in a downtrend (below the moving average). It is a “moving” average because the time period moves, for instance, the previous 50 days’ average today will differ from the previous 50 days tomorrow. A Simple Moving Average (SMA) is calculated by adding the closing prices of a security for a number of time periods and then dividing by the number of time periods. A moving average lags the market because it uses data from prior time periods. . An Exponential Moving Average (EMA) gives greater weight to more recent data as a way to reduce the lag. The shorter the time span, the more sensitive a moving average will be to price fluctuations. The longer the time span, the less sensitive, and consequently, the smoother the moving average will be.


Trailing Stop – probably the best exit strategy for stock positions. Sticking to a trailing stop takes the emotion out of your trades, keeping you from selling too soon…or too late. A good percentage to use is 25% for your trailing stop. This means you don’t want to lose any more than 25% of your investment. If you know your stock is volatile, keep your position size small and use a wider stop to allow for the volatility. If you’re looking for shorter term gains on a stock that’s trending upward, or if you have a large position size, you can use a tighter stop, say 10% or 15%.

Heres’ how it works: Let’s say you buy 10 shares of stock for $10 a share. Your investment is $100. You calculate your maximum loss at 25% of your entry price of $10, which is $2.50. For the 10 shares you own, this would equal a $25 loss. This is the maximum amount you’re willing to lose on this investment. In our example, you don’t want your share price to go below $7.50 (because $10 – $2.50 = $7.50). This is your trailing stop. If the share price drops to $7.50, you sell your investment, having only lost $25.

However, let’s say the share price climbs up to $12.00. Because your stop is meant to “trail” the share price, you recalculate your stop by multiplying the new price by 25%. $12x25% = $3, so $12 - $3 = $9. Your new trailing stop is $9. If the share price were to drop to $9, then you sell, having only lost 10% of your original investment of $100. When it hits $15 a share, your trailing stop moves up to $11.25 ($15 – 15(25%) = 11.50, because 25% of 15 = $3.75). Now, even if you hit your stop, you come out of the overall trade with a gain, because it would be worth $112.50 at your exit point.

The magic of using trailing stops is that they allow you to let your winners ride by keeping you from getting nervous/greedy and selling too soon. They also give you a definitive exit point so you don’t suffer any potentially catastrophic losses. Also built-in to trailing stops as a strategy is the ability to allow for price fluctuations that will occur. No need to get unnerved by a bad week or month, just follow your trailing stops. When you do get stopped out of a trade, whether with a gain or a loss, it’s time to move on and redeploy that money in a fresh new trade.


Position Sizing – this is an important aspect of your portfolio management because it keeps you from losing too much on a security that turns out to be a bad one. It can literally be the difference between success and failure as a long-term investor. As a general rule, you should not have more than about 4% of your investment portfolio committed to one security. This is so that, if you lose 25% on a stock that fell after you purchased it, you would only lose 1% of your whole portfolio on that one bad trade (25% of 4% is 1%). Losing 1% isn’t too hard to stomach, is it? But if you had committed, say, 50% to that same stock, thinking it was “a sure thing”, your loss would have been 12.5% of your whole portfolio, for which you would be kicking yourself! And the loss could even be much greater if you didn’t follow a trailing stop! Position sizing keeps you from ruining your portfolio through only a couple of securities that unexpectedly go south. They allow you to sleep at night, knowing no single stock will wipe out all your hard work.

Keep in mind that mutual funds, or other baskets of securities, hold set position sizes of a wide array of securities within them, thereby diluting the risk. As such, depending on the diversification within the fund, you can hold a larger position size and still sleep at night. It is still necessary to “not put all your eggs in one basket”, as they say, so a variety of funds is still necessary for long-term success.


Rebalancing – when you have set particular percentages for your portfolio allocations and your positions, these percentages will eventually become out of whack. Some securities and asset classes will do very well and your positions will swell. Others will stagnate or decline, and these positions may contract or just stay the same. While you may be tempted to let your winners continue their run, it is inevitable that the markets will change, and your winners will begin to decline and your slow-movers will begin to grow. Rebalancing, usually done once a year, allows you to skim some gains from your winners (selling high) and beef up your smaller position sizes (buying low) in preparation for a change in market conditions. This is done by selling shares from your positions that have grown above your set position-sizes to bring them back to your predetermined percentages. Then you purchase shares in your securities that have slipped below your desired position size, bringing those positions back up to their predetermined percentages. This way you take advantage of bull markets in whatever sector or asset class they may happen to be.



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