Beyond Stock Picking - A 3D Framework For Smarter Portfolios

Tue 4:47pm by Edward Croft

20 comments 1441 reads

We’ve all been there. Picked some great stocks with conviction. Run our winners. Been delighted with the gains. Only to see those gains drain away.

It hurts, it’s galling, and you are left wondering where you went wrong.

Worse than that, by the time it happens you may have started counting on those gains as part of your future planning. How are you going to pay for that big ticket item - that home purchase, a child's education, or an early retirement? It’s very real.

In this piece, I’ll introduce the three mistakes we can all make, and the three solutions.

But first, a personal tale…

An early education

For me, my big lesson came in the global financial crisis. I was young enough to be reckless, but old enough to have known better.

I had a silly amount of my capital riding on two big picks. Both were AIM listed stocks. One was called Renesola (SOLA) - a solar energy company that was absolutely smashing it on sales growth. The other was RC Group (RCG) - a biometrics company. I’m sure some of you remember these stocks.

I’d bought really well. And I’d bought more as they rose. At their peak, I had 50% of my portfolio in RCG, and probably 30% in SOLA. They really were motoring - they had both already tripled. I couldn’t have been more confident.

It was 2007… what could possibly have gone wrong?

The mistakes we all make

There’s an eye-opening academic research paper by Barber and Odean titled “The Behaviour of Individual Investors”. When I first read it I was gobsmacked. It was a mirror of every mistake I’d ever made, and hugely influential in shaping my future mindset.

I’ve thought long and hard about their findings, and grouped them into three themes:

1. We suffer “perverse stock selection”

That quoted phrase is their words. We often pick risky stocks for the wrong reasons.

We often talk about the perils of story stocks at Stockopedia. Stories are how the human mind makes sense of the world, but projecting a hollywood ending onto a share is not rational.

Whether we’re chasing headlines, themes we know a lot about or jumping on a bandwagon so not to miss out. We seem to have a “taste for stocks with lottery-like payoffs”.

But lottery tickets have negative returns!

2. We underdiversify

We buy a…

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potoroo

Wed 9:51am

Wed 9:59am

Reference to the number of shares in a portfolio: Ed suggests a minimum of 14 and NAPS has 20 - to cover the sectors. Is there a rule to calculate a maximum number to avoid turning the portfolio into a mini tracker fund and inevitably unable to outperform the market?

FREng

Wed 10:03am

Thanks, ED. It's extremely helful to be reminded of the things I consistrntly do wrong!

I looked for a "like" button at the end of the article, as a way of showing apprecieation.

JSchoffer

Wed 11:44am

Thanks Ed very informative.

"Don’t hang onto your losers - have a bias to selling them (using a stop loss, or after a fixed time), or average down (but only if you have genuine insight - which you probably don’t).
This part in particular resonates well with me, my success rate at averaging down just wasn't worth the hassle. I've found it much more successful and stressfree to mercilessly cut losers at 15-20% down and not look back.

Revs8

Wed 11:46am

A very good reminder and I do struggle to stick to my rules.

Where is the like button?

jjis

Wed 12:14pm

Lots of research suggest 15 to 20 fives most of the risk reduction from diversification benefits. See the link below for an example of this research. The summary of which was

"All in all, these results demonstrate that effective diversification
depends on portfolio style. For large-cap portfolios, there’s little to
be gained by diversifying beyond 15 stock or so. For small-cap
portfolios, peak diversification is achieved with around 26 stocks. The
same applies for non-dividend portfolios, while growth and value
portfolios need a roughly equal number of stocks to optimally reduce
volatility."

Peak Diversification Paper.

Hope this helps.

Dicky Mint

Wed 12:52pm

Great Article.

In my SIPP I have 16 holdings - when I set it up (June 2023) they all had an equal value but over time this has changed significantly. My focus was solid income with growth potential and accordingly the yield of the portfolio at purchase was 7.4% but as the share prices have increased this has reduced slightly and is currently running at 6.3%, still acceptable. In approaching two years my return is 32.6% with all dividends reinvested.

I use a buy and hold approach following the general principles of the High Yield Portfolio (HYP) strategy.

I feel they are quite well diversified, the 16 stocks cover 12 Industry Groups) but there is definitely room for adding something else and diversifying further:

Food & Tobacco
Residential & Commercial REIT
Oil & Gas
Collective Investments (Investment Trusts)
Metals & Mining
Investment Banking and Banking Services
Specialty Retailers
Insurance
Banking Services
Electrical Utilities & IPPs
Homebuilding & Construction Supplies
Containers & Packaging

I look forward to your webinars, they are always very informative

Mark Carter

Wed 3:38pm

RCG. That rings a bell. Wasn't it a Chinese scam? Plenty of cash (allegedly), which turned out not to be the case.

Towards the end they came up with the idea of putting RFID tags on rocks, of all things.

Edward Croft

Wed 3:57pm

Well - RCG did have real products.

I do remember how hyped everyone got about the potential "oh my god there will be RFID chips in every supermarket warehouse in the world - think of the total addressable market!"

I bought their biometric fingerprint id security device for my laptop - I may have had it shipped over from Hong Kong. It worked for a while. Then it locked me out of my computer forever. I should have realised that was the sell signal!

TheHitman

Wed 4:52pm

I have the opposite experience, arbitrary stop losses didn't work for me - especially when market falls were down to Mr. Market rather than any profit warning / company performance. Most of time, the share price rose, or there was a takeover, etc.

I have since implemented averaging down where Mr. Market gives me the opportunity and it's working quite well.

Wed 5:00pm

I had to set the stop losses far enough away for this reason. Glad you've found a system which works for you! Hopefully we can both profit nicely

Harry Hindsight

Wed 8:05pm

The future rhymes with history past.

Wed 8:08pm

Look one day Boohoo (LON:DEBS) will become a market leader and kick Frasers (LON:FRAS) in the underpants :)

An advantage of losers is you can offset them against capital gains - when/if they turn up.

AliasBruce

Thu 5:58am

Great article I recognise some of my own flaws in this, which will hopefully help to refine my approach. Really interesting to reference the academic research paper (which I now have to read), is there a resource that gathers academic research regarding investing?

Gnome2

Thu 6:51am

Oh yes, RCG. What a story stock that one was. You could make a Netflix series out of that stock alone! You're right Ed, they did have a real product. It was an RFID-secured jewelry box, if I remember correctly. It was that sudden realization that finally convinced me to bail out. An expensive mistake, but one of the cheapest lessons I ever learned.

Thanks for a great article.

SCI20

Thu 7:47am

From the excellent book by Morgan Housel, Same as Ever: “The irony of good times is they breed complacency and skepticism of warnings. “ This is true for economies, the markets and life in general.

Brilliant Leader

Thu 9:02am

Another excellent, thought provoking article Ed and I look forward to the webinars (although personally speaking, winter webinars are preferable to summer ones!).

I wanted to pick up on this point, “the consistent application of the NAPS rules has outperformed every UK equity fund over a decade”. A while ago you mentioned the possibility of launching an ETF focused on the NAPs principles. Has this fallen by the wayside or is it still in the works? In asking this, I appreciate the regulatory hurdles might be insurmountable but nonetheless, I thought I’d ask.

Cheers
Simon

GloucesterBob

Thu 10:52am

Excellent article and have just gone through my whole portfolio and added sell rules to the spreadsheet. Fairly simple really.

Anything found in my NAPS like screen, hold until either 20% drop from their highest point, or the STOCKRANK drops below 80.
Anything found but not via NAPS. 20% drop from the highest point, or 10% drop if they have made more than 30%

The one scenario I am failing to cover is.

Not a NAPS stock but pays a divi above 10%. Do I hold regardless, or sell and then look to buy back in purely for the dividend.

Any thoughts appreciated.

john2

Thu 11:43am

I have held Legal & General (LON:LGEN) for 10 years. The share price is currently almost the same as what I paid 10 years ago, and has gone both up and down by 20% or so. However it has consistently paid a high dividend - currently 8.86%. As a pensioner, I find the steady income very useful, and look for share price appreciation elsewhere.

Silver Moon

Thu 1:07pm

The value of the Pound is a real problem there, inflation robs the dividend on such a time scale. As a pensioner I might be happy to be collecting support regularly and not worry too much about the capital. Living is for now.

Beyond stock picking - a 3D framework for smarter portfolios

An early education

The mistakes we all make

1. We suffer “perverse stock selection”

2. We underdiversify

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About the Author

Edward Croft

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