My new stock purchasing rules

new stock purchasing rules for 2018I’m changing my individual stock purchasing rules, which, to be honest, I haven’t paid too much attention to this year. Here’s an explanation of what I’m changing and why.

What’s Gone Before

When I first started investing, I wanted a lot of mechanical rules around my stock purchases. I looked at dividend yield and expected growth, price / earnings and tried to diversify across different market sectors or industries. Originally I was aiming for about 50 or 60 stocks across 10 sectors.

The mechanical rules were there to remove emotions about the purchases. I shouldn’t buy a stock because simply because I felt the company might do well. There should be numbers and metrics that justified the purchase and simplified the decision.

I’ve always been more dividend-income than dividend-growth focused. Consequently I weighted my stocks by dividend income rather than market value. My intent was to limit income risk by limiting the proportion of income that each holding produced. Since yields can vary greatly then $1,000 of two stocks can pay out very different amounts. And from what I’ve read on dividend investing, capital growth is of secondary concern to the dividend payments.

On preferring Index Funds

Warren Buffett is often quoted on some of the DGI blogs I read. His advice is usually along the lines of “buy good companies, not bad ones”, which is easier said than done. His mentor, Benjamin Graham, is also well regarded as a value investor. Graham’s book, The Intelligent Investor, is a great read by the way! But I digress.

Here’s a Warren Buffett quote.

Berkshire Hathaway, Chairman’s Letter – 1996

Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.

Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

 

And he put his money where his mouth was and bet against professionally managed hedge funds, handily winning his $1 million bet for charity. Now in fairness, after the above quote in his letter, he provides advice on how to invest in individual stocks.

Now I have no reason to believe that I’m an above-average investor. I have no special secret knowledge of which stocks will go up. Nor do I have a magic or secret trading formula to sell. But I can understand enough that a total market index fund will likely win over the long term because it can’t make a bad decision or purchase. It simply provides the average expected return.

So in terms of allocation I’m continuing to limit individual stocks to about 10% of my portfolio.

How many stocks?

One of the more common discussions is the number of stocks needed in a portfolio to be “diverse”. Typically the suggested number is about 30 based on the widely published views of Benjamin Graham and Burton Malkiel from A Random Walk on Wall Street. Another great book by the way!

Of course there are countering viewpoints – such as the 15 stock diversification myth or the 30 stock diversification myth. You can make your own decision on that one, but in terms of dividend income alone, 30 is likely enough because capital growth isn’t the goal.

But I don’t really need to worry about diversification that much since the majority of my portfolio is diversified across hundreds of stocks via index funds. As it is, I hold about 30 stocks and I don’t see a need to buy many more.

On owning any individual stocks

I do struggle with this topic and aside from a large tax bill that I don’t want to pay, I like individual stocks because, well I’m irrational.

Owning individual stocks still seems like a bit of a status symbol to me since it was always something rich people did when I grew up. And because I tend to be loyal to brands, I feel connected to the company somehow when I use the services of a company that I ‘own’. This is probably one behavior that I need to get over as large companies don’t owe me anything.

Maybe as my portfolio increases in value over time, I’ll reduce the 10% allocation a bit. But for now it’s a little bit of play money that may, or may not, do well.

Enough already, what are the new rules?

They’re very simple.

Rule 1: I won’t sell any individual stocks while accumulating.

I did sell out of two low performing positions earlier this year, before buying them back. Both worked out as a net gain in the end. Going forward, I think it’s good enough to just buy and hold.

Likewise dividend cuts or suspensions won’t be a reason to sell. Usually the damage has already been done by the time a dividend cut is announced. Such a rule really implies monitoring and selling based on a dividend cut prediction.

Rule 2: When I add to existing holdings, I’ll buy more of the position with the lowest market value.

The few purchases I’ve made this year have primarily been driven by stocks that had a low P/E. And then I got into my desire to own 100 DAL stocks. Now that I’m over that, I’m just going to buy whatever position is the lowest when I add more money to individual stocks.

The new capital that I’ll be adding to individual stocks in 2018 is probably about $3,000. We’re not talking huge numbers here however and any purchase I make is unlikely to make much impact on the overall outcome.

So this rule basically means the portfolio will be equal weighted over time, although I doubt it’ll ever end up that way because of limited purchases over time.

Equal weighting means an increase in the yield of my individual stocks versus weighting based on dividend income. It also means that I am more likely to add to stocks with a high P/E value than before.

Rule 3: Considerations for new positions

I’m sticking with the concept that I want to own companies that have a wide moat and growth potential. This loosely means the company has a strong position with economies of scale in a field that is hard for new competitors to join. I don’t have a specific set of metrics here or restrictions on industries.

Summary

The more I read about investing, the more I realize that the markets today are entirely different from the markets of 50 years ago. The speed of communication of news and reaction to that news is much faster. And while I don’t think that the market is especially rationale in pricing companies, I also see that it can remain irrational for long periods.

As an analogy I can decide how much I believe my house is worth based on any number of criteria. However that price means nothing. The only price that matters is what someone is willing to pay for it. Even if I was convinced that my house was worth a certain price, I might never sell it for that amount.

So in adjusting my rules, I’m just admitting that I don’t know what an individual stock should be valued. I also don’t pretend to know what it might do over the next 30 years. But I do believe that it’s better to be in the market than out of it. I’m limiting individual stock risk with most of my holdings in index funds.


Quote of the Day

Don’t gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.

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