No way do I compare with the great investor and finance teacher Benjamin Graham, but I like to think we have one important thing in common: As he did before 1929, despite years of investing, I took on too much risk in the last bull market that ended in March and April 2000.
Graham was almost completely wiped out. He had to sell his abode and move his family. Only a relative's help kept his business from bankruptcy. He spent the rest of his life refining, practicing, and teaching a value investing strategy, most famously published in Security Analysis (classic 1940 edition, with changes from the 1934 edition, available now). Some of his Columbia students -- Warren Buffett received an A+ in his class -- profited from his learning.
I wasn't wiped out like Graham, but I didn't enjoy the significant pain. The main thing keeping me afloat was the discipline to keep investing every month, in large part in an S&P 500 index fund. (Remember, adding money doesn't increase your return -- that's cheating. You need to calculate your returns using Internal Rate of Return -- the XIRR function for you Excel wizards -- which accounts for new money added.). And like Graham, all along I seriously reevaluated how I invest, and used learning to change badly performing investments for better ones.
Not too much risk, but unknown risk
In the reevaluation process, I didn't run away from risk just because a stampeding bull market led to a growling bear. Far from it. Rather, it slowly dawned that the fatal flaw was underestimating the risks taken. Too large a percentage of my portfolio presented business and valuation risks ranging from aggressive, screaming, eye-popping, and beyond to something like what Keanu Reeves experiences when he first leaves The Matrix. (Holy tightrope, Batman!) Except I believed the range was low to high. If I had better understood the risks, I would have accepted fewer of them and with more care.
After several years of work, I outlined my goals and strategy in four columns. Following these guidelines has markedly improved my returns vs. the market in the last two years. You can find the columns listed as "Author's Favorites" on my author page, shared in the Motley Fool spirit of learning together. I hope they can help you in your own risk management.
The top goal -- still ongoing -- was to master financial statements. In addition to my generous fellow analysts at TMF and the community on our discussion boards, these four masterpieces proved invaluable:
- Thornton O'glove, Quality of Earnings
- Howard Schilit, Financial Shenanigans (new edition in hardcover; former in paper)
- Kathryn Staley, The Art of Short Selling (expensive, but worth it)
- Mulford & Comiskey, The Financial Numbers Game
Today, I'm happy to add to this list Hewitt Heiserman's Earnings That Count, forthcoming from McGraw-Hill. Heiserman graciously provided me an advance copy of the manuscript. In it, he clearly explains how to use financial statements and basic arithmetic to obtain a better earnings number from both conservative and aggressive perspectives. If you find companies that perform strongly on each, you've got a great growth stock, and the opposite provides a strong sell sign.
Without gimmicks, Earnings That Count requires only that you warm the chair. Any of us can. Remember Richard Nixon? No genius, he finished first in his class in law school in large part for the study time that reportedly earned him the nickname Iron Butt.
Financial statement education is never finished, but you have to get started. (One place is our How-To Guide to cracking the financial statement code.)
The more I learned about financials, the more I learned about the real risks of owning part of this or that business. Along came a stock portfolio allocation that felt right.
I'm not talking asset allocation -- a specific investment strategy where you choose assets such as stocks, bonds, and real estate that don't behave in the same way, so you can achieve more predictable returns with less risk. If that sounds like something for you, you're in luck, because we're offering an online seminar right now to help you use it: Perfect Your Portfolio: Asset Allocation for Long-Term Wealth. Click on the link for information and to register.
Rather, I mean allocation within an all-stock portfolio. A way to try to outperform the broad-market averages, while at the same time keeping risk vs. return at my comfort level.
The allocation I set for myself to start covered three categories:
- 40%-50% high-yield stocks; large-capitalization dominant companies; S&P 500 or other low-expense, broad-market stock index fund; cash waiting to be invested. Example: Altria
- 30% value investments, usually small-cap stocks. Buy at discount to low-range estimate of intrinsic value and consider selling at a high-end estimate. Example: Quality Systems
(NASDAQ:QSII); Sportsman's Guide (NASDAQ:SGDE)
- 20%-30% informed speculations. Rule Breakers, shorts, options. Example: XM Satellite Radio
(NASDAQ:XMSR), a Rule Breaker.
You will find this allocation and the stocks I chose listed on my profile. (Every TMF employee publicly discloses all stock holdings directly or beneficially owned.) There are currently 18, because I usually start buying a stock with 5% of my current portfolio value, moving to 10% as a full position. A number of these holdings are ones I've owned for years and survived the reevaluation. I'd prefer to have a smaller, more focused portfolio of, say, six to 12 stocks. That will come as the winners and losers sort themselves out over the years.
Some of the 10% positions will appreciate and take on a larger share of the portfolio, but I won't buy and sell to maintain the percentages for the categories. As long as a business performs well and its valuation still offers potential returns reasonable for the risk, I'll let winning stocks take on ever larger shares of the portfolio.
It will be great to be like a friend of The Motley Fool, who e-mailed that he has 50% of his portfolio in Abbott Laboratories
Your allocation will vary
You almost certainly can't learn your own allocation from someone else. For all sorts of reasons, you may be best off with 100% in a low-expense index mutual fund that mimics a broad-market average, like the S&P 500 or Wilshire 5000. Or perhaps at a certain stage, only dividend-paying stocks make sense for you.
If you are an index-only investor who is starting to learn about individual stocks, you might adopt Matt Richey's (TMF Matt) "index plus a few" strategy. If you are knowledgeable about certain industries, you might choose to allocate a greater percentage there.
And you can have a long, happy investing life without owning any stock in my third, high-risk category.
Know thy risk
The key is that no matter your risk tolerance, know your allocation. Know the risks you have accepted. Don't be like many of us who chose between aggressive and screaming risks for too many stocks in the raging bull market.
Can you right now write or type out your stock holdings and classify them according to risk? Before you start, follow the old saw: If worrying about the market is keeping you up at night or distracting you from your work and relationships, you hold too many risky stocks or have not adopted a strategy that allows to keep emotion out of investing. Each is a sign that you may need to reevaluate your portfolio.
You vs. the herd
In Don't Avoid Stocks, I discussed the definable self-destructive behavior of the individual investor to pile in at times of maximum enthusiasm and pile out at times of maximum fear. This is guaranteed to deplete your capital, even without a crash or three-year bear market. But even those who stay invested forget that the key to surviving even the longest bear market is periodic or Drip investing (argued in Party Like It's 1929.). Stay disciplined, don't lose your nerve.
My parting shot is that this is no argument for a mindless buy-and-hold strategy. It's about devoting effort, taking time, and finding a way through whatever the market brings you. For many of us, that's growth at a reasonable price. For the next three weeks, I'll take each of these three categories and look at how growth at a reasonable price applies to each and what risks and potential returns each category presents. I'll detail representative buys and sells I've made and why, as well as other candidates "on deck."
You don't have to show up at any special time, because everything I write is available archived (regular short Takes, longer analysis on Tuesdays). That's true for all of my wonderful Foolish colleagues, too. Find any of our archives via the Fool.com home page drop-down menu, or any column by clicking at the top next to the writer's spiffy picture.
Have a most Foolish week!
Tom Jacobs (TMF Tom9) asks who needs alarm clocks when you have cats or dogs. He owns shares of all companies mentioned here except Abbott Labs. All of his holdings are listed in his profile . Motley Fool writers are investors writing for investors .