There are two main approaches to managing a portfolio.
Two main approaches to managing a portfolio.
- The first is passive management where the investor buys and mostly holds their investments. There may be some re-balancing between stocks and bonds or they may sell some stocks or even their entire stock portfolio during bearish market conditions. This approach suits investors who do not want to spend a lot of time managing their portfolio.
- The second is active management where the investor takes on a shorter term view; however their time frame is still considerably longer than most traders. They tend to sell their stocks rather than holding them even during a bull market or they use hedging tactics to manage the market’s volatility. This approach suits investors who want to spend more time managing their portfolio.
Some of the common active management strategies used by investors are discussed as follows:
Sell Overvalued – Buy Undervalued
This is a common strategy with active investors who want to lock in the profit of a strongly performing stock. They then use the proceeds from the sale to purchase another stock which they hope will do the same.
There are many ways to determine if a stock should be sold. Some investors use a market index such as the S&P 500 and look to sell a stock when it outperforms the index by a certain percentage.
Another approach is to sell when its PEG (price earrings growth ratio) exceeds a certain level. The level is arbitrary but a stock is generally considered to be fairly valued when the PEG ratio is around 1 to 2 and to be overvalued at 3 or more.
Using the PEG ratio investors might buy another stock with a PEG under 1. Some investors will buy with PEGs under 2 with the view of selling when the PEG is over 3 or even 4.
Some investors only use fundamental analysis while others prefer to incorporate technical analysis and charting. The advantage of using charts is that the active investor can more readily locate stocks that are increasing in price.
The active investor might check their portfolio monthly or quarterly, they generally do not check it daily.
The basic idea with this strategy is allow the value of a portfolio to increase while the market is bullish, but to stop the value of a portfolio from dropping when market conditions are bearish. In theory this works well, but in practice it’s more difficult to implement.
There are a variety of instruments that can be used for hedging such as futures contracts, index options and short selling ETFs (ExhangeTraded Funds). The main requirement for a suitable hedge is that the value of the instrument increases as the market declines. When the market starts to decline the investor would apply their hedge. As the market drops the investor’s portfolio value drops, but the hedge value increases thus offsetting the portfolio’s losses. When the market turns bullish again the hedge is removed.
While short selling the S&P 500 Futures contract is a popular and efficient hedge, the downside is that it’s a large contract making it way too expensive for a lot of investors. Another popular hedge is an index put Option which the investor buys (no need to short sell). Other popular hedges are Inverse Index ETFs which the investor buys or they can short sell an Index ETF.
Before using a hedge the investor needs to define just what is required for the market to be bearish. The first step is to determine what time frame to use. A popular choice is the intermediate-term trend and a 50-day moving average does a good job of tracking the market for its intermediate-term trends.
The investor now tracks the market and when it has turned bearish the investor applies their hedge. If the market declines the investor’s portfolio declines in value but their hedge increases in value. However should the market continue to increase then the portfolio continues to increase in value, but the hedge now declines in value?
The end result is that when a hedge is applied it essentially stops the portfolio value from declining or increasing. Thus since the investor is looking for their portfolio to increase in value, the hedge is only useful while the market is declining and should be removed when the market advances.
This is a very simple tactic that can be combined with other strategies. The basic idea is to sell the stock if it declines by a certain amount. This technique is very useful for investors who fear bear markets. During bear markets stock prices typically decline and the stock is only held while prices remain above their initial stop.
The initial stop tactic is effective in getting investors out of the market early for any new stocks purchased when market conditions turn bearish.
This tactic works well for investors who want to ride the bull market higher but do not want to hold losing stocks in their portfolio. The tactic works best when investors only buy stock during bull markets and sell their stocks when market conditions turn bearish – otherwise the stock price will likely drop all the way back down to the initial stop level.
There are several methods investors can use to determine the price level the initial stop should be placed at.
A simple method is to use a fixed percentage value. This is arbitrary but using a value from 5% to 10% is fairly common. So for example, if the investor buys a stock at $50 with a 10% stop they would sell the stock if it traded below $45.
Some investors prefer to use chart patterns to determine an appropriate stop level. For example, if a stock pulled back and started to rally the investor might place the initial stop just below the relative low of the rally.
A Trailing Stop is simply an initial stop that is raised as the stock price increases. The investor would sell their stock when it trades below the trailing stop.
When an investor first buys their stock, the first price level the stop is placed at is referred to as the initial stop. As stock prices increase the stop is raised so it trails behind the raising stock price. A trailing stop is only ever raised and never lowered.
The investor can use a variety of techniques to trail the stocks price advance.
The simplest technique to use a fixed percentage of 5% to 10%. This is deducted from the stock price whenever the stock price increases.
Using chart based trailing stop techniques is popular. The investor can use a weekly line chart and place the trailing stop under the relative lows as the stock price increases. Other techniques include using monthly bar charts and using chart indicators.
Chart 1.below shows an example using a weekly line chart with a trailing stop placed under the pullback lows.
Chart 1. Pullback Low Trailing Stop
Chart by stockcharts.com
In the above chart example, using a trailing stop takes the investor out of the stock on the fourth raised stop. This is an example where the trailing stop works well – it locked in a good profit.
There are pros and cons with using a trailing stop. There are times when the trailing stop works well. At other times the trailing stop can stop investors out early and the stock then continues to trade higher (without the investor owing any shares as they where sold at the trailing stop).