Portfolios of Professional Traders
We must free ourselves of the hope that the sea will ever rest. We must learn to sail in high winds.
—Aristotle Onassis (1906–1975)
Shipping magnate
Strategy to Professional Status: Part I
Aim
To establish your Various Portfolios Before you start to Trade
Three Specific Portfolios
The preceding figure sets the scene for building a set of portfolios that should replace any speculation, specific shares influencing the overall portfolio, and more importantly, enables emotion to be largely removed from the equation.
Portfolio 1: Foundation of Wealth
Nearly all novice traders who come to me to join my share mentoring program want to make instant wealth. This is not a very solid foundation to build your long-term wealth. In the same breath, many say that they want to learn to trade because “I believe I can change careers and retire on more wealth than my current pension.”
Then they say that they do not want to save for their retirement—or, stated differently, they have no “trading pension plan.”
How can you build wealth and financial independence without first having sound foundational principles to build upon? I have found that many people simply have not thought about their trading plans in a logical or thoroughly enough manner. In fact, many novices start on the premise that they do not need a trading plan.
To protect your profits and maximize wealth, you need to have a plan and a strategy. Without a logical or disciplined approach, novice traders are destined to experience elation and panic all the time. This is the cycle that has to be broken if you want to build a foundation of wealth for your future.
The irony is that even skilled traders think that all gains are theirs to spend; what about costs of trading, living expenses, or retirement funds? The answer is that such traders and investors start to lose their future earning power and end up with no long-term wealth. As such, certainly, there is no foundation on which to build even more wealth.
Bottom line is that you need:
• To have a long-term portfolio to earn dividends as a retirement income.
• You need to have a salary while you build that long-term wealth. This is achieved by developing day trading strategies.
• In addition, you need a trading strategy to protect your long-term wealth, by taking advantage of short-term market anomalies.
Take the following true example:
Ken Smith came to me some seven years ago. His contention was that he could successfully trade the single-stock futures with a few well-placed technical indicators.
His aim: To turn his $2 million into $20 million within three years.
My recommendation: It would be easier to make his target by gambling at the casino.
The result: He decided to go for it alone and—within three weeks—had panicked and lost all his capital in three quick trades.
More to come ….
So, before you can start, have a plan, think about wealth and how much you really want to spend time in building that wealth. Once you have created a basic trading plan to achieve long-term wealth, start by taking a step back: think about a retirement free of financial stress—one in which you can enjoy life in a relaxed manner due to the income streams you have created through a disciplined and long-term approach.
The first portfolio is admittedly boring and not the excitement many novice traders expect when they start out in stockbroking. This is the basic equity portfolio that enables you to invest your funds in longer-term blue-chip shares, but it does give you a number of very important benefits over other portfolios:
• You own the stock, so there is no close out or geared effect over the growth of the share, as in futures positions.
• A long-term benefit is that you have time to build wealth through compounding.
• The time also gives you building blocks to learn how more complex risk management techniques work when you move to the second phase of portfolio management.
• Any related emotion is removed if you have well-thought-out strategies to enter and exit shares.
Recommendation
Methods |
Portfolio strategy |
Balancing |
• You should have a maximum of 12 shares in your long-term portfolio. • The shares should be evenly balanced. • Timeframe: more than three years. |
• These should be diversified across at least three sectors. • Risk profile: The shares should be split as follows:
|
70 percent in blue chipsOverall portfolio cash to be invested in Portfolio 1 = 70 percent of the total funds.
Portfolio 2: Trade Market Anomalies
Once you get bored, it is time to start thinking about the second form of portfolio. Take a step back—my definition of being bored does not equate to the boring task of setting up Portfolio 1 or not making the wealth you first expected when you decided to enter the market.
By being bored, I mean that you have successfully set up Portfolio 1 and are now managing the portfolio in a manner that is disciplined and are now gaining experience and skill. So, you now have 12 shares, split into blue chips, middle caps, and higher risk ones. These are, in addition, diversified and balanced.
You have invested 70 percent of your total wealth in Portfolio 1, which consists solely of equities.
What do you do with the remaining cash? Here is where the Ken Smith’s example comes back in.
Example continued:
I took some time to set up Ken’s Portfolio 1, which we eventually did. After trying his patience, he finally understood enough to start with Portfolio 2.
More to come …
The second portfolio is a geared futures one, either in single-stock futures or contracts for difference. The choice is yours. The aim of this portfolio is to have a medium term one, less than three months, as opposed to Portfolio 1, which is a much longer term one.
In addition, traders in geared markets need to have an understanding of what beta means and how it is calculated. All I want novice traders to learn is that beta is calculated by using regression analysis, which comes with most standard technical packages.
It is defined as the securities’ movement in relation to the overall market. Therefore, if the security’s price moves with the market, it has a beta of 1. If beta is less than 1, it indicates that the security will be less volatile than the market. Conversely, beta that is greater than 1 indicates that the security’s price will be more volatile than the market.
For example, beta of 1.25 indicates that a security will be 25 percent more volatile than the overall market. Here is the aim: you have 30 percent of your funds available to buy geared instruments.
Example of trading market anomalies:
• Split the trading capital into no more than four trades.
• The trades must be in equal portions.
• Ten percent of your funds must be in cash to offset any margin call.
• Trade in blue chips only.
• Look for small growth, that is, 3 percent growth in the underlying securities’ share price.
• Note that these are geared instruments, so a six-time geared instrument will give you 18 percent growth.
• In the first year of trading futures, only invest in shares that have already released interim results. The full-year profits should be more stable.
• In the following years, trade companies that have already released full-year results.
• Review all positions weekly.
• Ensure that the positions you have will not be closed out.
Back to Ken’s example: after selecting four futures positions, one went wrong, and before he started to panic, he realized that the one loosing position had not influenced his whole portfolio.
• Ken had $2 million to invest.
• He, thus, had $600,000 to trade the futures market.
• He had bought four positions in equal amounts.
• Assume that the loss of his one bad trade was complete, that is, lost all that entire investment.
If Ken’s portfolio had been 100 percent futures (as he had done when he first came to me), he would have lost 25 percent of his wealth, which is $500,000 (25 percent of $2 million). Instead, he lost 25 percent of the 30 percent of his entire wealth. Remember that 70 percent was invested in Portfolio 1. In essence, Ken lost $150,000 and that represents only 7.55 percent of his entire initial investment wealth of $2 million.
Conclusion
• No panic.
• This means that Ken can assess what he did wrong, check his trader’s journal and ensure that strategies are in place to avoid similar mistakes in future.
• Remember that the 70 percent to 30 percent ratio should be maintained. So, profits from shorter-term trades should be used to increase the value of Portfolio 1.
Portfolio 3: Day Trading to Ultra Wealth
Note that I have not recommended that cash be set aside for this portfolio, that is, 70 percent in Portfolio 1 and the remainder in Portfolio 2.
The reason is that you need to make money before you can become a day trader. You also need to develop trading habits that enable you to research and assess companies around the world to ensure that your “trading retirement plan” is working. In relative terms, you already have a foundation of wealth and a higher-risk trading portfolio to expedite growth by trading market anomalies and opportunities.
So, why do you need a day trader’s portfolio?
Day trading is actually simple to do if traders have effectively set up the first two portfolios and are making money. The recommendation is that you cannot move to Portfolio 3 until you have made between 20 percent and 30 percent combined growths in your wealth.
When you have done so, take enough cash to invest in a separate account to trade the highly volatile foreign exchange and physical commodity markets. The aim of this portfolio is to take advantage of global markets and its correlation. Some professionals include futures and commodities, like platinum, gold, and uranium markets.
A risk approach is to ensure that you always trade for short periods and always close all positions overnight.
Chapter 2 helps you to create your own share trading filter.