A question worthing an answer

A reader asked the following question in a comment:

How do you recommend allocating the money for each stock?

That's avery good question and books have been written about portfolio allocation. My approach is to allocate my portfolio in a way that statistically (or usually) works.
Let's take our current portfolio and look at our stocks' industries:

• APOL: Services: Schools
• BUCY: Capital Goods: Constr. & Agric. Machinery
• CSKI: Healthcare: Biotechnology & Drugs
• ENDP: Healthcare: Biotechnology & Drugs
• EROC: Energy: Oil & Gas Operations
• LHCG: Healthcare: Healthcare Facilities
• MIR: Utilities: Electric Utilities
• WDC: Technology: Computer Storage Devices

We currently own only two stocks in the same industry: CSKI and ENDP that are in the Biotechnology & Drugs industry.

As a very generic rule, differentiating industries reduces the risk. Think of the Energy sector, Oil Well Services & Equipment industry from May to December 2008.

This industry lost 60% when the S&P500 lost only 36%. A mixed portfolio would have lost 35-40% while an Energy-Oil based portfolio would have lost 60% of its value.

Thesame for Basic Materials: Metal Mining from May to October 2008. The industry lost 66% against a 30% loss of S&P500. More than double.

It is true that in some circumstances an unbalanced portfolio may be a good thing. Suppose a particular industry gets severily hit by news, recession or whatever you want at the point that its average PE ratio goes down to 5. That is a good time to buy all the best companies in that industry, even if we end up with half of our portfolio in that specific industry. Our stop losses will keep us safe anyway...

What I like to use on my portfolio is a correlation test. I like to have stocks that behaved differently in the last 12 months. That reduces the risk of seeing my portfolio taking a unique (downward) direction. Let me take a couple of examples:

If we calculate the correlation between END and EROC over the last 12 months we get a 0.4%. That means these two stocks moved independently over 99% of the times.

LHCG and MIR show a correlation of 42%, meaning that almost every second day their prices moved the same way.

An experimental web page calculating correlation can be found here (beware: it is very slow).

Another point to cover is "how many stocks should our portfolio have"? I usually buy stocks for 5% of my portfolio value, so to equally balance my investments amongst 20-30 stocks. OK, I know you are thinking "5% times 30 makes 150%". Usually I own 15 to 20 stocks (thus keeping 25% of cash). In very good time I use margin and invest over 100% of my money. This adds risk but sometimes it can be done (always using stop losses).

A final note: I am not a professional trader. I like to invest abd I like to share my ideas. You do not neccessarily need to agree with my opinions and you do not have to follow my hints.

Happy trading