I've been spending a lot of time reading books on investing during this correction, tightening up my plan with any holes as I go along. Four great books have been:

  • Smith, Amy: How To Make Money in Stocks - Success Stories
  • Galgani, Matthew: How to Make Money in Stocks - Getting Started
  • Minervini, Mark: Trade Like a Stock Market Wizard 
  • Tharp, Van K.: Trade Your Way to Financial Freedom
  • Schwager, Jack D.: Stock Market Wizards
  • Note: I also watched every single Marketsmith webinar since I started subscribing


I know my system of picking stocks and creating a final buy list is pretty sound and works well. It seems to pick out great quality stocks that are holding since the correction (which arrived conveniently as I became a Marketsmith subscriber, of course). I always favour stocks that appear the most frequently in each of my fundamental screens. During a bull run, this should definitely give me enough of an edge.


So how do I turn this into a positive return every year? In the books that I've read, it seems like there is a huge emphasis on position sizing and portfolio management (especially from Tharp).

  • IBD mentions cutting all losses at 8 %, and less if possible. A 50,000$ account should have no more than 5 stocks, therefore a full 8% loss is 1.6% of your portfolio. You should also aim for being right 3-4 times out of 10 and keep a profit loss ratio of 3:1.
  • Minervini also emphasizes portfolio management in both his book and in his Market Wizards interview, and how it's responsible for the vast majority of your profits.
  • Tharp goes even further, introducing risk multiples (R) as a way of assessing risk/reward ratios
  • He also advocates the 1 % portfolio risk strategy.
  • All empathize stepping on the gas in good market conditions and holding back when the bears are running wild. 


So what does this all mean? 


Since I use an CAN SLIM/SEPA/growth strategy to decide what I should buy and sell, I can assume my maximum risk should be < 8 %, which I'll define as 1R. I will also never risk more than 1 % of my portfolio at once, so that I can survive almost any probable length of a losing streak.


Let's say we're looking at Kroger. IBD's Stock Market Today says it broke out of a flat base at 35.64 so this makes a good example for this purpose.


Looking at the chart, I can now assess risk in the trade in the following way:

  • 1R risk is 8 % below ideal pivot of $35.64, or $2.85
  • Breakout of a 2nd stage base has no overhead supply, so I can set my profit target easily to three times my risk from the ideal pivot, or '3R'.
  • My primary initial stops usually include:
    • 50 day SMA at 34.49 or 0.4R
    • Support at ~32, or 1.27R
    • Three times the Average True Range (3xATR), is 2.24 or 0.8R, therefore my volatility stop is at $33.40


Looking at the chart it seems like 32$ has been the biggest giver of support as the 50 day has been treated like swiss cheese, so I will set this at maximum risk. Since the 50 day isn't offering much I will set my minimum risk to the 3xATR. Therefore I can make this trade with decent confidence that I will risk between 0.8-1.27R, although nothing stops me from cutting losses to even less if things are obviously going sour prior.


Now that I now this is a pretty low risk trade given my chosen comfort level, how many shares do I buy? Assuming 1R risk, this means I'm risking 2.85 per share. If my current portfolio balance is $100,000 and wish to risk only 1% of my portfolio per position, this means I can lose up to 800$. Dividing by my risk per share, this gives me about 280 shares or 9979$ worth of merchandise.


Sizing this way, I'd have to lose 69 times in a row to lose half my money. Who can be that bad?


One thing I noticed using simulations is that stepping on the gas in the market (scaling up with each successful buy) and tapering off when you're losing is extremely, extremely beneficial. The differences when I was betting willy-nilly and when I used focused portfolio management and scaling are absolutely stunning. I encourage you to try by either programming a portfolio sizing simulation or you can use Van Tharp's simulator on his website.


This is great and all but how does this factor in to my performance in buying and selling stocks? Let's take Bill O'Neil's goal of 30% on the money and you average a 3:1 profit/loss ratio. How much can I expect to win using CAN SLIM? If we simulate this at 50 trades per year over 10,000 years, you get the following probability distribution:



In the figure above you can that you will most likely make money if you can achieve that performance. What happens if you're not that good, let's say you get 20%, 2:1? Well you're not likely to make much, but you won't wipe out either, meaning you have time to get your butt into gear, study and practice more:



Also in an effort to prepare myself psychologically, what kind of losing streak can I expect? At 20%, 2:1, I can expect a 8.7 % chance of a 10 trade losing streak. Thus if I'm feeling panicky or break out into cold sweats at 5-6 losses in a row, I can look at this and perhaps put things into better perspective:




Thus by sizing my portfolio so I can lose way more than I probably will, and also figuring out how long losing streaks can be at poor performance, I can now say I can lose with confidence on the roads to riches.  :)