With all of the noise that's been circulating the market since before the election, it's become harder and harder to invest with a level head. Emotions end up running wild, causing investors to make knee-jerk, unjustified decisions that leave their portfolios worse off than they were in the first place.
The simple fact is that it is impossible, even with the best analysis and insight, to eliminate all risks when it comes to investing. But careful selection and proper diversification allow us to manage that risk and still produce above-average returns over the intermediate and long term. The key is a well-rounded approach, and I don't recommend allocating more than 5% of your total investable dollars to any one position in your portfolio. This helps the losers, which are an inevitable part of investing, sting less.
Say a company you are invested in reports disappointing earnings and quickly leaves you with a 20% loss. With just 5% allocated to that stock, your portfolio takes a very manageable 1% hit for the year that your remaining stocks should easily be able to make up. If the 19 other positions have an average return of 12% and the market gains 10% overall, you'll still outperform with 10.4% profits despite the 20% loser.
Of course, it's still disappointing to be left with some red ink, so when you're holding on to a stock that shows a double-digit loss how do you make a sound judgment based on business sense and not emotion? I like to remember Warren Buffet's excellent dictum: In the short term the market is a popularity machine, and in the long run it's a weighing machine. So I go back and review the long-term earnings power of a company, which is how most stocks are valued. If I see no reason to doubt my original assumptions and conclude that the stock is down either for a reason not clearly defined or because the industry is out of favor, there is no reason to panic. As long as I'm properly diversified I can weather the weakness.
However, if I find that the stock is down for a clear reason (such as an earnings disappointment) my earnings outlook would have to change. Even the slightest downward revision of future expectations can have a meaningful negative impact on value, especially for higher PE growth stocks. So let's say a stock is down 10% following a weaker-than-expected report. My new calculations would likely show that the stock is expensive despite its decline. In this case, it would be important to stick to the knitting and sell, even though it may be painful to take the loss. Remember, staying disciplined with a risk management strategy is imperative to building wealth over the long term.
It all boils down to three key steps to controlling your emotions and making smart decisions when it comes to your portfolio:
Diversify. When a position is not life or death to your portfolio, you are able to evaluate any potential problems more calmly and rationally.
Accept the fact that some price movements are simply short-term randomness. If there are no headlines or unusual trading volume to suggest that a several-day pullback is meaningful, take a deep breath and keep a close eye on your position. Selling may still be warranted, but never pull the trigger as a panicked knee-jerk reaction.
Realize that over time stocks will reflect the present value of their future earnings. If a stock is down sharply, reevaluate its earnings situation. If the new analysis suggests the stock still has more to fall, have the discipline to sell whether or not it's painful – trust me, taking on a larger loss will be even more painful. On the other hand, if the company's earnings potential has not been compromised, don't be afraid to weather the storm and hang on for a rebound over the long term.
Investing should be treated as your business, not your baby. If you let the qualitative and quantitative facts act as your guide, over time you will achieve exceptional results.