What Most Investing Systems Don't Tell You
The Next Coach?
Everyone has an investing system of one kind or another to
guide them through the stock market minefield. I'm not talking
about a black-box mechanical system, but a simple collection of
rules and tools to follow. Even novices have some sort of belief
system that guides them into what stocks to buy, and when to buy
and sell them. Of course, for beginners, the "rules" are often
based on innuendo and falsehoods ... but they make the odds are
better than playing roulette.
Most systems, though, are more advanced than that; they offer
the investor some structure and guidance for much of what he will
see in the market. These systems will usually tell an investor
when it's safe to buy and when it's dangerous (market timing),
highlight the characteristics a stock should have before being
bought (trending up, good sales growth, etc.) and probably
include some guidance on entry and exit points for individual
stocks (buy on earnings gap, sell on break of the 50-day moving
However, one thing that few systems really cover is position
sizing ... how much of a stock to buy, and how to handle that
position (buy more, sell some, etc.) as things progress. But
that's one of the most important things to know! The reason is
rather obvious-if you buy and sell the exact same stocks at the
exact same time as another investor, but vary your position size,
you'll end up with vastly different results.
I could probably write a 10-page article all about different
methods of position sizing; I've studied dozens of methods, tried
out a bunch of them myself and have even written a bit about it
in past Wealth Advisories. But instead of getting too far into
the deep end on the subject, I want to write about one thing that
happens to many investors, and yet, hardly anyone ever
I'm talking about the danger of small positions.
While this position-size discussion applies somewhat to all
investing styles and systems, it's most applicable to growth
stocks. Why? Because growth stock systems are normally more
skewed than other styles (fewer of your winners will account for
much of your gains), which rely on being correct a higher
percentage of the time.
Said another way, with growth stocks, the size of your average
winner is what counts most; with other styles, that statistic is
important, but your winning percentage is just as vital.
Most investors have heard many times about the danger of
positions that are too big; all that yadda yadda about
diversification and "not having too many eggs in one basket" is
really another way of talking about the mishap of positions that
are too big. And it's true; you shouldn't be putting all of the
rent money in one or two low-priced Internet stocks.
But let's be honest-in the current environment, when appetite
for risk is ridiculously low, few investors are tempted to get
too big. What I've seen is just the opposite ... their positions
are too small, which not only costs them profits on the way up,
but leads to other problems as well.
For instance, in the Cabot Market Letter's Model Portfolio we
have 12 "slots," so each new addition is usually 8% to 9% of the
portfolio (speaking in general terms; it can vary more than
that). However, I know from my various dealings with investors
that many don't think that way-instead, they buy a set number of
shares or buy a relatively small dollar amount.
The end result is that many people might have, say, a $100,000
account, but they're only buying $3,000 positions in each stock
... a 3% position. That's too small! Why? There are many
The first and most obvious: If you actually pick a big winner,
owning a 3.0% position isn't going to do you much good. Said
another way-why take the risk in the first place if you're not
going to make any worthwhile money if you're right? Even if the
3.0% position zooms 50%, you've only made 1.5% in your account
... before any taxes or fees!
And the problems with small positions go further than just not
participating on the upside. What I've found is that, if an
investor has a bunch of small positions, he'll end up being
underinvested if the market really gets going on the upside-he
might own seven or eight good stocks but only be 30% invested.
So, after a couple of months of buying 3% positions, what does he
do? He starts buying bigger stakes-after the market and most
stocks have skyrocketed!
In other words, not only does he miss out on much of the
upside, he ends up putting on big positions when risk is elevated
(after a big run) ... getting the short end of two sticks instead
Another big issue is stock selection. If an investor is taking
small positions (and, hence, small risks) on every trade, he's
far more likely to talk himself into buying some
less-than-stellar set-ups or more speculative companies. That
sounds reasonable, but my experience is that investors who do
this simply throw money away in three or four small chunks. You
shouldn't let your position size tempt you into a poor trade.
As I said above, I could write (or talk) about position sizing
for an hour or two; I am convinced that improving their position
sizing can be a big help to a lot of struggling investors. If you
have any questions, I'm happy to lend some guidance-feel free to
email me (firstname.lastname@example.org).
As for the market environment, it's tough out there-most
growth stocks and the major indexes have been
consolidating/correcting for a month now, and with earnings
season just getting started, volatility is sure to remain
That said, I'm not waving the white flag; in fact, by my
measures, the intermediate-term trend is still pointed up and,
despite plenty of pain in recent days, most leading stocks have
thus far found support above or just below their 50-day moving
That doesn't mean the market can't break wide open-anything is
possible. But as I frequently write in
Cabot Market Letter,
it's best not to anticipate what may or may not happen-instead,
just go with what has actually happened. To this point, we've
seen a tedious retreat that hasn't caused a boatload of
breakdowns, and the major (longer-term) trends are still pointed
Thus, I've pruned some exposure during the past couple of
weeks, but I'm also not burying my head in the sand-I'm keeping
up a list of enticing stories and charts for when the selling
squall passes. One name in my Model Portfolio that has held up
Michael Kors (
, a company I feel could be an emerging high-end retail
Instead of going into detail about the company's wares, what
investors need to focus on is its truly remarkable growth across
the board. In the quarter ending in June, Michael Kors' wholesale
revenues boomed 66%, while licensing revenues gained 61%;
combined, those two made up about half of the firm's quarterly
But it's Michael Kors' retail segment that really gets us
excited-revenues there grew 76%, and at the end of the quarter,
Kors had 253 stores compared to 177 one year before. Amazingly,
sales at stores open at least one year grew a ridiculous 38%!
That might be the biggest number we can ever remember ... except
for the current quarter: Kors has already preannounced great
results, with same-store sales up 45%!!
Of course, the company doesn't have anything revolutionary;
this is no cancer cure or new way of doing business. But we see
something akin to
circa 2003 ... a company with an outstanding brand name and
management that is still early in its growth phase.
Technically, KORS just came public late last year, had a huge
run in January, February and March and then based out while the
market corrected. A gap higher on earnings in August led to
another run, but recently KORS has consolidated, partly because
of the market, but also because of a huge 23-million share
offering. Those shares came from early investors who wanted to
cash out-they were not new shares, so there was no dilution, and
not many shares were from management.
The stock has thus far remained above its 50-day line, and it
seems to have digested the offering in fine fashion. Obviously,
if the market tanks, KORS is likely to get hit, but right here, I
think the stock is a decent buy with big upside potential for
when the bulls return.
All the best,
Cabot Market Letter