If you know the markets and know yourself, you need not fear the result of a hundred battles. —Yvan Byeajee, professional trader
We live in the age of trading aphorisms: 'Be disciplined.' 'Be patient.' 'Never add to a loser.' Twitter in particular is awash with them, as they fit the format — trading excellence reduced to 140 characters. I had to cull my Twitter stream, as I was inundated with Jesse Livermore quotes and 'Top 10 rules' with no relevance to my own style of trading. And don't get me started on those inspirational passages superimposed over pictures of sun setting over a beach.
Actually, many of these quotes contain some very good information, especially for the developing trader. But we are simply overloaded by information. Much of the advice is at the point of cliché. We read the text and have heard it many times before, but do we really stop to think what it means? Does it makes sense to you and your process?
One commonly accepted wisdom is that you must diversify your portfolio. Stock pickers should never have all their eggs in one basket so must spread the risk. Nobody would argue with this, but does it mean we should buy ten stocks instead of just one or two? What are the alternatives?
A selection of stocks
A well-balanced, diversified portfolio should contain more than just stocks. Fixed income, ETFs, and currencies can all play a part, and there are some very good articles about portfolio allocation on Seeking Alpha.
I want to focus on how diversified stocks in a portfolio perform compared to a benchmark.
The selection of stocks I will use is based on Robert Mattei's 2015 article, 'Performance Of The 25 Most Followed Stocks on Seeking Alpha'. The portfolio exemplifies the 'average Joe' holding all of Seeking Alpha's 10 most-followed stocks:
I use the top 10, as I'd guess 10 is a more typical number of holdings than 25. It does a decent job at diversifying: the big tech names are all there, along with an energy-focused conglomerate (NYSE:GE), financials (Bank of America and Citigroup), a telecom (AT&T) and auto-industry leader Ford Motor.
I often find the comments section following each article as informative as the article itself.
One of the comments at the end of Robert Mattei's article was: 'I own about 25 stocks. Not one above 10% of the portfolio.'
To which the reply was, 'You may just as well buy a S&P ETF and go fishing. Why bother owning individual stocks?'
This may be a good point; why bother with all the research, the sweating through earnings, the buying, selling and commissions if an ETF can replicate the same performance?
Lets check if it does:
Source: Tradewithbeta software.
Returns from a portfolio constructed with the 10 stocks above is practically indistinguishable from an equal holding of the PowerShare QQQ Trust ETF (QQQ). An 80-day holding period of the 10 stocks long v QQQ short, each with approximately $100K value, gives a $51 profit.
Even over a longer term 200-day holding period, the correlation is high:
Source: Tradewithbeta software.
Please note: The data on both the charts above is around 2 weeks old. This does not detract from the correlation or affect the ideas in this article.
Clearly, the extra time and effort of picking 10 stocks is not worth it. You only need one or two bad performers to drag down your whole portfolio. And no matter how much you research and analyze, you never know which stocks they will be.
I wrote recently about AAPL and AMZN and how they rarely perform well at the same time. One of them is always dragging its feet. If you can spot this type of behavior, and use the cyclical rotations between sectors, your stock positions can be selected in a way that considerably beats the QQQ. However, this requires a lot of analysis and skill, and the risk is you actually start to underperform.
There is a lot of advice for traders on the internet. These wise words are usually just accepted as the truth and never really tested. Diversifying your stocks is undoubtedly a good idea, but the specifics need to be carefully considered. Perhaps the advice should be re-written: buy the QQQ and go fishing.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.