Wow, what an opening week for the stock market. Shares have suffered their worst opening week in many years. The first week of 2016 has resulted in many stock market investors questioning their methods and tactics as the overall market has been smacked down due to a variety of international pressures.
First there is the trouble in China with the Central Bank making bold moves to help support the economy. Next, the always volatile North Korean government has returned to its old tricks of making threats. The stock market hates uncertainty and the current conditions possess huge amounts of uncertainty.
While no one knows for certain what the future holds, we firmly believe that the current bout of craziness will be short lived and the market will soon revert to its normal ways.
With this said, smart investors buy when there is blood in the streets and the public is afraid. It is a time-tested method proven since the days of Baron Rothchild.
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However, what many investors don’t talk about is the key to surviving and thriving during volatile times is to have a properly designed stock market portfolio.
The bottom line to remember is that stocks have an inherent upward drift. This means that despite the sell-offs, the stock market naturally trends higher over time. The key to capturing this upward drift is diversification in your long term portfolio.
The old wisdom of “Don’t put all your eggs in one basket” makes great sense when building a portfolio. This is due to the fact that when some of your stocks are suffering, others will be performing as expected. This diversification enables you to maintain the course of holding stocks and even adding to positions since the losers are offset by the winners. Having a diversified core position will take advantage of the upward drift over the long term without forcing you to liquidate due to the guaranteed periods of selling.
There is no need to build your core positions with mutual funds. Although this is a common method among investors. Mutual funds have multiple drawbacks due to high fees and tax implications. A much smarter way to easily diversify is by ETF’s. ETF’s are flexible, liquid, and provide investors with easy diversification.
In fact, ETF’s like the S&P 500 SPDR (NYSE:SPY) is diversified across the entire broad market. Other ETF’s provide diversification into the Dow Jones Industrial Average like the SPDR DJ Trust ETF (NYSE:DIA) and others provide diversification into global markets and even commodities.
While ETF’s make sense for the core of your stock market portfolio, many investors prefer to build their own portfolio core.
This core should consist of an even weighting of value and growth stocks. I think an ideal core for launching a diversified U.S. stock market portfolio would consist of 5 value stocks and 5 stocks in the growth camp. The number of shares is dictated by the amount you can dedicate to the market with 50% of your allocated capital.
The next part of this article will explain how to handle the other 50%
As far as picking the exact stocks, I like to adhere to Peter Lynch’s maxim of investing into what you know for the first 10 stocks in the core portfolio.
The Nitty Gritty
Now that we understand the importance of building a diversified core position, what is the next step?
There are numerous methods of managing an investment portfolio. Many investors simply buy and hold their entire portfolio. Other investors become strictly active traders, trading rapidly in and out of positions attempting to catch the inevitable ebb and flow of the marketplace.
There are positives and negatives to these two primary investment ideas. The buy and hold crowd will pay far less commission, allow the inherent upward drift of the stock market to work in their favor and have the ability to dollar cost average into the position by investing the same amount over and over regardless of the price of the underlying stock/ETF.
However, the unavoidable large down moves are psychologically difficult to withstand while being stuck in the position. The active trading crowd can profit from the up and down, has the ability to sit out market corrections, and has the satisfaction of being actively involved with a hands-on investment. However, the risk will ramp higher, commissions can be substantial and active trading takes time that may not be available for the individual.
What’s the solution? It is a combination of the two ideas. A method created by institutions known as “trading around a core position” combines the best of both ideas into a highly effective trading/investing strategy. Here are the basic steps to implement, starting with an assumption of starting with $20,000.00 to invest.
- Split Your Capital into Two Groups
Instead of applying your entire portfolio in one or the other strategy, you will place 50% into the core diversified position as discussed above. This position can be built on market reflecting ETF’s or your own stock picks. It really depends on your personal thoughts as an investor as to what makes most sense to you.
- Build The Core Position
50% will be considered your “core” position. This position will be your long term hold. It should be diversified so it takes advantage of one of the only certainties of the stock market known as long term upward drift. Once you have your core position built, using dollar cost averaging to increase it makes solid sense over the long term. It is critical to note that there will be periods of drawdowns in your core position. Dollar-cost averaging allows you to actively take advantage of the drawdowns within the long-term core positions.
The drawdown periods can also be effectively used to further the diversification of the core portfolio. Use your judgment when it comes to what to diversify into. Just remember to keep an equal balance between value and growth names. Using the dividend reinvestment strategy within the core position also makes powerful sense.
- Place the other 50% in an active trading account
Now the fun part! This 50% is used to trade the stocks that are on the move. One can go both long or short capturing profits regardless of the direction. There are variations on this same theme utilizing options or futures contracts depending on your skill level, interests and the market environment. Active trading with 50% of your portfolio value makes solid sense. Investors can use screeners and other ways to locate stocks that are on the move or about to make a move. While active trading is not for everyone, it can be a way to supercharge your portfolio growth while awaiting for the core positions to slowly build wealth.
Remember, the above way to design your stock market portfolio is simply a basic guideline. The idea of trading around a core portfolio makes sense but the basic idea can be tweaked in numerous ways. The 50/50 split is simply a starting point. Some investors ramp up the core position to 80 or even 90% plus of the total portfolio value. It is truly a personal decision and there is no one way to divide the capital between active trading and core position holding.