Being in the right Sectors and Industries at the right time is what every investor shoots for. Conglomerates, Utilities, Aerospace, Finance, etc. Awesome groups lately with some spectacular gains.
But having too much of any one good thing can work against you when those groups inevitably turn around. (Just ask the ‘Tech.’ investors back in 2000. Or even the overweighted Energy guys in ’05.)
Having a diversified portfolio is critical for reducing unsystematic risk (sometimes referred to as unsystemic risk), which is the risk to your portfolio due to one stock (or a group of related stocks).
Systemic risk (also know as market risk), is the risk attributed to the whole of the market itself. Systemic risk can’t really be diversified away.
But unsystematic risk (also known as specific risk), can be lessened with proper diversification and proper stock weighting.
For the sake if this article, let’s say that the right number of stocks to hold in a portfolio is no less than 5 and let’s say no more than 20. (Investors and Money Managers with very large portfolios will usually be forced to hold a much larger number of stocks for many reasons, not the least of which is the sheer amount of money they’re trying to fit into the market. But let’s put that topic beyond the scope of this article.)
So let’s say between 5 and 20 stocks is the right number of stocks to have in a portfolio with 10 being the ideal for many.
This means no one stock will ever account for more than 20% of a portfolio and never any less than 5%, with the goal being approx. 10% for each stock.
Let’s also say for the sake of this article that no one Sector or Industry ever represents more than 20% of your holdings, i.e., 20% of your stocks are Utilities, 20% are Finance, 20% are Aerospace, etc.
Here’s where some people get confused.
If you’ve got a 10 stock portfolio and 2 of your stocks are in oil stocks; that would appear to be fine on the surface. Any more would increase your specific risk (which is the type of risk/volatility people try and avoid).
But if 50% of your money is tied up in those two stocks, with tiny portions allocated elsewhere, you’ve missed the point.
So if 20% of your stocks are allocated to Energy, that means no more than 20% of your funds should be in energy -- no more.
It’s good to get into the habit of making sure your stock buys are equally dollar weighted. Which means, you buy the same dollar amount of shares for every stock.
No, not the same amount of shares, but the same dollar amount of shares.
For instance, back in Oct. of ’05, many oil stocks dropped by -20% and more within just a few weeks.
If you had just 2 oil stocks in a larger 10 stock portfolio, with everything equally dollar weighted, and both of those stocks each went down -20%, it would have represented only a -4% loss for the portfolio as a whole.
For example: on a $20,000 portfolio, each stock would get $2,000 (10%). A -20% drop in each oil stock would be a -$400 loss in ea. (or -$800 total). And -$800 represents only 4% (-4%) of the $20,000 portfolio.
However, what if you had 25% in each of your oil stocks. Now that loss (-$2,000 total), would represent 10% (-10%) of your portfolio.
The scenario of course gets worse and worse the more unbalanced it gets.
Now let’s say some of the other stocks in your portfolio were winners. Just remember, the more you have over-allocated in one stock(s), the more under-allocated you are in another.
If the 2 stocks out of your 10 stocks represented 50% of your portfolio, that means each of the other 8 stocks only represents 6.25% of your portfolio.
So let’s say the 2 oil stocks both lost -20% each for a total loss of -$2,000. But now let’s say 2 other stocks ea. gained 20%. However, since the other stocks had only a 6.25% weighting, the gains are only $250 for each (or $500 total). Your gains haven’t offset your losses, and you’re still down -$1,500 or -7.5% overall.
However, if you were equally weighted, the gains would have completely offset your losses.
If you’re using a proven, profitable trading strategy, you’ll typically be purchasing your stocks in an equal dollar weighted format. And a good strategy will usually have a high win ratio of 60% or 70% or even higher. And if your strategy is typically finding good, solid stocks, you’ll often see those stocks coming from the best Sectors and Industries.
So don’t put the bulk of your money (and never ever all of it) in just one Sector or Industry. Diversify your portfolio over several ‘best’ Sectors and Industries. (And make sure all of your stocks are equally dollar weighted.)
If you want to make sure you’re diversified over enough groups, you can specifically screen for that.
Here’s a screen to start you off. (Incidentally, I ran a series of tests over the last 6 1/4 years (1/2001 thru 3/2007), using a 4 week rebalancing period and starting each run on different start dates so each test would be rebalanced over a different set of four-week periods. This was done to eliminate coincidence and verify robustness.) The average total compounded return (from 1/2001 thru 3/2007) is 518.4% for an average compounded annual growth rate of 33.4%.
I screened for the top 5 Sectors and then picked the top 2 stocks in each one of those Sectors for a total of 10 stocks.
But first, I wanted to qualify the ‘Universe’ with the following parameters;
· Zacks Rank <= 2
(The Zacks Rank (which is considered by many to be the best rating system out there), looks at upward earnings estimates revisions (amongst other things), and will get us into companies whose forecasted earnings are getting stronger.)
· Price >= 5
(All of the stocks have to be trading at a minimum of $5 or higher. Most money managers won’t touch anything under $5.)
· Volume >= 50,000
(The average 20 day share volume has to be at least 50,000 shares traded on a daily basis or more. In short, it has to be tradable.)
· ROE >= Median ROE for the Relevant Sector
(Every Sector has its own ‘high’ or ‘low’ ROE values. A low ROE for one Sector might be very high for another. And since we’re ultimately trying to find the best stocks within the best Sectors; finding stocks that have ROE’s greater than the median ROE for their relevant Sector makes sense.)
· % Change in F(1) Earn. Est. Rev. -- 12 Wks: Top 5 Sectors
(expressed as % Change F(1) Est. – 12 Weeks TopSectM#5)
(I’m looking for the Top 5 Sectors based on the Median F(1) Earnings Estimate Revisions over the last 12 Weeks. Companies with upward earnings estimate revisions have a tendency to see even more upward earnings estimate revisions, and this helps paint a solid picture moving forward.)
Then I look for the top two stocks within each of the 5 best Sectors.
·% Change in F(1) Earn. Est. Rev. -- 12 Wks: Top 2 Stocks in each
(expressed as % Change F(1) Est. – 12 Weeks Top#InSect2)
(Lastly, I’m looking for the Top 2 Stocks in each of the Top 5 Sectors based on the highest F(1) Earnings Estimate Revisions over the last 12 Weeks.)
This leaves me with a nicely diversified 10 stock portfolio every time I run the screen.
Here’s a few of the stocks that made it to this week’s list (for the week of Mon., 6/11/07):
TKLC Tekelec, Inc. (Computer and Technology Sector)
MDR McDermott International (Oils-Energy Sector)
CMI Cummins, Inc. (Auto-Tires-Trucks Sector)
With the Research Wizard you can also determine on your own how you want to rank the Sectors and what the best stocks are. Do you want to rank the Sectors based on their 3 Month % Price Change? -– you can. Maybe on their EPS Growth Rates, or Net Margin Increase, or etc. It’s up to you. And then make sure to backtest it to see how it works.
Sign up now for your 2 week free trial to the Research Wizard and get the rest of the stocks on this list and see what other Sectors came thru this screen. Or build your own screens and then test them. Get started now and start making better decisions today.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.