Testing your own portfolio

Testing your own portfolio
By Daryl Guppy (China Daily)
Updated: 2010-11-15 10:41

Every investor and trader has a collection of stocks in his or her portfolio. Some are short-term trades, others are long-term investments. With investments in particular, it is easy to forget the original reasons for buying the stock. It is tempting to pay less attention to these long-term stocks and pay more attention to new stocks purchased more recently. The result is often a portfolio filled with under-performing stocks, or stocks that are doing serious damage to the overall return from the portfolio.

Every day every trade in my portfolio has to pass four tests. These tests are designed to make sure I remember why each stock was purchased. This daily review reminds me of my objectives and tells me if those objectives continue to be satisfied. When the trade, or investment fails, then it is time to exit the trade and look at other options. Applying the tests takes just a few moments if it is done every day, or at least once a week.

The four tests involve

1. looking at the cash situation, 
2. asking whether the stock is still worth buying, 
3. considering what could go wrong and 
4. analyzing the trading advantage.

The alternative to the current trade is always cash. If this capital allocated to the trade was held in cash, would it deliver a better return? The answer is not as simple as it looks. The return from the trade must be assessed against the interest return on cash over 30 days, 90 days, 120 days or longer. It is also a mistake to assume the price will increase steadily. Unlike a 90-day interest rate deposit, the market price always includes volatility because it is the nature of market activity.

The size of the expected reward is related to the number of days traders expect to wait for the reward. In a slow trend the expected time period for the price rise might be several weeks. In a fast moving rebound stock the expected time period for the anticipated profit might be a few days or a week.

The second question asks if one started today with cash would one buy the same stocks that are currently in one's portfolio? The question is designed to make one actively assess the value of one's stocks. It is easy to ignore stocks in the portfolio that are not performing well. They do not do any damage, but nor do they contribute actively to the portfolio performance. This question helps one take a new look at these lazy stocks.

There are some stocks one would not buy today because they are already too high. This is usually a good observation because it usually means these trades or investments are amongst the most profitable in one's portfolio.

The third question is designed to confront our tendency to fall in love with our stocks. Are you looking for reasons why your trade is good rather than reasons why the trade can go wrong? When we trade we give money to the market to support our opinion about a stock or the market development. It is a temptation to always look for reasons to convince us the trade is a good proposition, even when it is not performing as we expected.

When we first analyzed the trade we made a more objective assessment, looking at how the trade could succeed, and also how it could fail. Once we own the stock, we have an endowment bias. Because we own the stock we think it has more value than the price we paid for it. This bias prevents ongoing objective analysis.

Finally, what is the trading edge, or advantage in this trade? When the trade was started you believed you had an advantage. Perhaps it was superior analysis of a situation that led you to selecting this stock. Perhaps it was a chart pattern that you recognized before many others in the market. Perhaps the trade is a particular type of investment that yields a good dividend and a good capital gain.

Market conditions change, and this can change the conditions and advantages in the trade. The trading edge you had when the trade opened may disappear. You need to be aware of this so you can make a better decision about closing the trade. You will not always have an advantage, but this is not always a problem. It only becomes a problem when you think you have an advantage but the market has actually taken it away from you. This is one of the factors that keeps people in losing trades.

These are four questions essential for everyday portfolio management.

The author is a well-known international financial technical analysis expert.

http://www.chinadaily.com.cn/bizchina/2010-11/15/content_11549949.htm