Sprucing Up Your Buy And Hold Portfolio

Includes: AAPL
by: Adam Aloisi

I've been forever miffed by the simplistic Wall Street investment vernacular of 'buy, sell, or hold." For those of us who've been around the block a while, we know that sell-side firms are skewed to a positive bias on security recommendations, and that "hold" is generally a veiled queue for clients to look for a better opportunity. A "buy" rating usually means the obvious, whereas "strong buy" seems to connote some unheralded urgency that "buy" alone cannot communicate. On the rare occasion a "sell" recommendation is slapped on a stock, it is usually a day late and a dollar short, normally issued following an earnings miss or other corporate disappointment, with no preemptive value.

My point is whether we look at securities as a trade or a longer-term investment, nothing is usually as simple (or accurate) as buy, sell, or hold. Investors need to look past the simplistic nomenclature of sell-side firms and add words like "accumulate" and "pare" to personal jargon. In my view, those two actions are what buy-and-hold investors should be doing with their portfolios to improve total return, more so now than ever. Given the rather lackluster performance of major market indices over the past decade, combined with continued market uncertainties, buy and hold, while still a viable strategy, could use a little freshening up. I believe that investors who add a "trading around positions" philosophy to their repertoire will see improved portfolio performance in what I suspect could prove to be another lost decade trading range.

Trading Around A Position: A Practical Example

How does trading around a position work? Let's take a widely held stock like Apple (NASDAQ:AAPL). Assume that on Jan. 1, 2012 you owned 100 shares worth about $40,000 and your total equity portfolio was worth about $500,000. By mid-March shares hit $600 a and your 100 shares suddenly were worth $60,000. Deciding the position was becoming too much of your overall portfolio (>10%), you pare a quarter of your position (25 shares) for $15,000, leaving you with 75 shares worth $45,000.

In May, you take advantage of a market sell off and see shares of Apple trading for around $550, you accumulate 20 for $11,0000, now owning 95 shares worth $52,250. In August you watch the stock spike once again and decide to pare again, selling 30 at a price of $675 ($20,250), leaving you with 65 shares worth about $44,000.

By November the stock sinks back to $600, and you buy, this time 15 shares for $9000, for a $48,000, an 80 share position. And on January 4, 2013, with shares continuing to have fallen, you accumulate 20 more at $525, bringing you back to a 100 share position, and where you started 2012.

Let's look at the comparative results: If you held the stock and did nothing for the past year, your 100 shares are worth $52,500, with a paper gain of $12,500 on the initial $40,000, or 31.25 percent.

In the trading example, you booked a 50% gain on the 25 share sale ($7,500), and a 68.75% gain ($13,921) on the 30 share sale. You lost $500 on the 20 share buy in May and $1125 on the 15 share buy in November, and are flat on the buy you made on Friday. Your net gain (booked and paper) from the position trading is $19796, almost 50%, compared to 31.25% if you had just sat on the stock.

As you can see, with the volatility that Apple exhibited during the year, an investor who took action and traded around their position posted a 20% better harvested/paper gain than the investor who did nothing.

To Trade Or Not To Trade?

A trading strategy, even one as simple and innocuous as this one, may not appeal at all to those who transact outside a qualified account because of the tax ramifications on each sell. It may not make sense for those with lower account balances because of the trading costs. Others may not like it simply because they don't have the time to devote to it. But for many investors who've traditionally held to a more passive strategy, I believe there is value to a more active posture in today's market.

And keep in mind, this is not day trading. The goal here is not to make you an active trader, the goal is to increase trade frequency in order to benefit from security peaks and valleys in a 'trading range' or volatile market. You maintain a core portfolio, but become a bit more active in how you manage your holdings. When you "pare" a security, it might be as little as 5% or as much as 50% of your current position. The amount you decide to pare might be determined by the level of your conviction that the stock is becoming overbought, by the amount you need to sell to bring the position back to a reasonable percent position in your portfolio, or simply by a level that is sensible for your situation.

Following a "pare," you could do any number of things: rotate and "accumulate" another portfolio position you have better long- or short-side or near- or long-term conviction about, open a new position, or simply remain in cash if that is what you deem appropriate. Whatever you decide, it is important to maintain a disciplined approach to the strategy with pre-set parameters you religiously abide by.

Maintaining Discipline

One of the biggest mistakes investors make, in my view, is deftly crafting a diversified portfolio with a baseline strategy, but having no real plan of attack once it is established. Trading around core positions forces you to take a more active role with your portfolio, it helps you understand trading and valuation patterns that can develop both on a macro- and micro-level, and improves return by encouraging you to harvest profits, decrease portfolio concentration, and reallocate to opportunities you have more conviction in from a near, mid-, or long-term perspective.

A disciplined, active approach requires you to make some initial decisions and set some parameters on how you will manage your portfolio. Some parameters you might set include:

  • A percent or nominal limit that any one position can take in your portfolio, which limits accumulation and encourages paring.
  • A percent or nominal value of capital gain that you will harvest in your portfolio in any given year.
  • A limit on the number of trades that you will execute in any given week, month, or year.
  • A minimum or maximum number of positions that you will hold as your "core" at any one time, thereby creating an allocation "comfort zone," encouraging optimal personal diversification.
  • Other portfolio parameters you set on your own.

The Downside

Obviously, no one has perfect timing and the portfolio "tweaking" we do through accumulation and paring is not going to work masterfully. Sometimes you will pare a position and it will continue higher indefinitely, and sometimes you will accumulate and the security will go lower, hopefully not indefinitely. Again, you need to set portfolio parameters and decide how to deal with stocks making strong, persistent moves in either direction.

The example with Apple above is extreme since it deals with a volatile stock that exhibited a strong upwards bias during the year. Most core, large-cap stocks are not going to make 50% moves in one year. With Apple now in a roughly 30% downtrend, it will be interesting to see what 2013 brings.

You may feel like you made a mistake when stocks either continue an upward move after a pare or downward move following accumulation. However, I would argue that if you make rational, thoughtful, conviction-based portfolio moves, you should never look back at them derisively. Though the market may prove you wrong near-term, you did what you thought right with the information you had and the parameters you set.

If you remain disciplined with the way you manage your core portfolio and trade around your positions, optimally selling into strength and buying into weakness, I would argue that your chances for improved total return success versus doing nothing are high.

Disclosure: I am long AAPL. 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.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.