Less Is More
By Jonathan Hoenig
SmartMoney.com - Tradecraft
Monday January 28
ALTHOUGH MCDONALD'S (NYSE:MCD - news) has since tried everything from cafes to chicken joints, the company's foundations (and real growth) came from Ray Kroc's original, stunningly simple concept: a burger joint that was cheap, efficient, consistent and, most of all, fast.
And while the company already had a solid footing, Apple Computer's (NASDAQ:AAPL - news) real growth came in 1984 with the introduction of the Macintosh. Even though the machine was more expensive and less powerful than its PC rivals, the computer ``for the rest of us'' succeeded because of one solid premise: You could actually understand how to use it.
Today, Ford Motor (NYSE:F - news) is a large car conglomerate of brands encompassing everything from Mazda to Mercury, Lincoln to Land Rover. But Ford became the largest car maker thanks to the Model T, a mass-produced, reliable, cheap auto with no bells, whistles or variations whatsoever. As Henry Ford supposedly said, you could have it any color...so long as it's black.
The point is that each of these magnificent enterprises succeeded by focusing on a relatively narrow goal. Get that right, and everything else usually just falls into place.
The same is true of trading — although traders too often forget the simple dictum to ``keep it simple, stupid!'' As we've often pointed out, the point of trading isn't to make a large number of transactions or even deal in a large variety of securities. What's important isn't simply allocating resources, but allocating them in the best and most efficient fashion.
There are over 13,000 publicly traded securities — and some people trade as if they thought it was their constitutional responsibility to have a position in as many as possible. But just because a stock is in the news or on the move doesn't mean it needs to find a way into your portfolio. There's a long list of companies that I like but don't own, not because I don't think they are bound to rise, but because I have neither the intellectual nor the economic capital to devote to managing the trade. In the words of architect Mies van der Rohe, when it comes to your portfolio, less is often more.
In good times and bad, we live in a world of scarce resources. And that's especially true of your portfolio. Whether you're managing hundreds of millions or just hundreds, there's just so much capital to go around. You can't invest in everything.
To that end, you want to make it a practice to concentrate on your best ideas and top hunches — the risks you feel most confident about. It's that confidence that you'll need when XYZ moves against you, or when the big brokerage houses downgrade the stock, or when supposed experts think you foolish for wanting to buy it in the first place.
And because every last dollar is important, you can't simply put on trades for the sake of a cheap adrenaline fix. There's always something to bet on, but you need to commit solely to those rare and infrequent opportunities (read: risks) that you just have to take for whatever reason. I look at hundreds of trades a week, but when it comes to actually laying money on the line I choose but a handful.
Most people, unfortunately, aren't that selective. Their trading isn't driven by a patient perspective or a contrarian approach, but by a restless desire to be part of the day's news cycle.
Indeed, just take a glace at the Ameritrade Investor Index to observe the ``ripped from the headlines'' list of most online investors' favorite stocks. Think of the index, which reflects the aggregate buying and selling of Ameritrade's (NASDAQ:AMTD - news) customers, as the footprints left by the herd. And the online investor is mostly set on following that herd instead of leading it.
Although there's an undeniable exciting sense of participatory involvement in owning a stock that is, for better or worse, making news, by the time the ``story'' hits the front page of the papers, most of the money has probably already been made.
Worse yet, chasing too many trades quickly dilutes your capital. I want to be diversified, sure, but you can't fire a rifle without any bullets.
Ultimately, a profitable year will come down to just a small handful of highly successful trades. You don't need to invest in every winning idea, but just one or two in order to pull a decent profit. If you minimize the losses and let the winning trades run, your portfolio will benefit from a small smattering of winners, even if the majority of trades goes nowhere at all.
So how many securities should you trade in? And how should you go about choosing the best assortment of ideas to make up your portfolio? I start with establishing a list of a few major themes that I might be interested in playing. It might be general, like bonds or hard assets, or more narrow, such as gold, dot-coms or Amex stocks.
The next step is to determine which specific securities best fit your market expectations. If you were smart enough to figure on a rebound in Microsoft (NASDAQ:MSFT - news) last year, for example, buying the Nasdaq 100 Trust (AMEX:QQQ - news) wouldn't have helped since the index (like many exchange traded funds) is too broadly defined to derive much benefit from a single security. A better approach would have been to buy Microsoft shares directly, or, for a more leveraged approach, call options. Generally speaking, the more specifically you can fit your trading expectations to the securities, the better positioned you will be to benefit from the market moving your way.
Every position has risk. And although traders are perceived as being gun-slinging gamblers, most of them keep a large percentage of their assets in relatively humdrum, income-oriented instruments.
So you should focus on your top ideas and keep the balance of your portfolio in cash on the sidelines, awaiting deployment into a new position or (better yet) being added to an existing one.
Like any dynamic entity, your portfolio's form should follow its function. And because your trading capital is your most valuable resource, you can't afford to spread it around to the detriment of the best possible opportunities. Diversification is important, but you can have too much of a good thing.
You want to own the least amount of positions needed to achieve proper exposure to a particular theme or portfolio goal. A mature trader knows that the best gambles are often the ones you don't take. And only after a long and expensive education did I learn that you don't need to play in every puddle or go on every ride to have a good time at the fair.
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Jonathan Hoenig is portfolio manager with a Chicago-based hedge fund. |
