Colin’s Note: Today, we’re featuring an essay from our colleague, Daily Cut editor Kris Sayce.
Kris has been writing at the Cut about a coming “Big Switch” where investors will start moving out of large-cap and mega-cap stocks in favor of small caps.
So, he shared with his readers four steps to stay risk savvy while playing the Big Switch… And how it all starts with the “10×10 Approach” to diversifying your portfolio that he’s been putting on readers’ radars.
It’s all in the essay below…
The “Big Switch” is coming.
We’ve been all over this idea for the past couple of weeks.
It’s a practical way of playing what we see as investors moving from large-cap stocks to small-cap stocks.
The key, of course, is to play it in a way that reduces your overall risk rather than increasing it.
That’s super important.
The last thing you want to do is destroy all the hard work you’ve put into growing your wealth during the current bull market cycle.
We’ll go into more detail on how to do that today.
The Best Way to Profit from This Bull Market
Before we get to the details, we need to remind you of the “10×10 Approach.”
This is an important part of the story.
As a refresher, the 10×10 Approach is an idea developed by investing legend Doug Casey. It simply involves dividing your investible capital into 10 groups.
Within each of those 10 groups, you build up to 10 individual investments.
If one of your groups is gold stocks, you would pick as many as 10 individual gold stocks. If it’s uranium stocks (we’re not sure there are 10 that are worthy, but anyway) you’d select up to 10 individual uranium stocks.
And if one of your groups is small-cap stocks, you would pick up to 10 individual small-cap stocks.
This is exactly how we suggest you play this… take advantage of what we believe will be a late-stage rally in small-cap stocks… while, at the same time, you begin reducing your large-cap stock exposure.
So, how does it work?
Look, this isn’t rocket science. It’s simple common sense. The problem is that, oftentimes, many investors don’t use common sense… especially when they see a market roaring along.
And, oh boy, has this market roared for most of the past 18 months.
But with tech stocks especially, up so much, it makes sense to lock in gains and reallocate some of that capital elsewhere. Notice the emphasis on some.
Here’s how you do it.
Step 1 – Cut Losers
It’s a plain fact that many investors can’t cope with the idea of taking a loss! As ridiculous as it sounds, many investors do subscribe to the idea that if they haven’t realized the loss by selling it, then it’s only a paper loss… not a real loss.
That thinking is total humbug.
Whether it’s the beginning of the year, the middle of the year, or the end of the year, it’s OK to sell. Don’t just think of December as the time to sell due to tax reasons.
An old boss of your editor’s always used to remind us that it’s “easy to go broke by selling your winners.” That’s the idea that folks find it easier to sell a winning stock than it is to sell a losing stock.
That often means after they’ve sold all their winners, they’re left with a portfolio of — excuse our language — a portfolio of crap.
So don’t do that. Assess your portfolio today. Do you really need that stock that’s down 30%, 50%, or 70%? Chances are, you don’t. Sell it. Move on.
Step 2 – Trim Winners
Despite what we’ve just said, it’s OK to sell winners too. Just not necessarily your entire position.
Every time one of your winning stocks doubles, you should take money off the table. A neat strategy is to sell your initial stake when it doubles. That means you’re playing with “house money” and you’ve secured your initial stake.
But there are alternative ways of doing that. Another strategy is to sell one-third of the current value of your position when it doubles.
Here’s what that would look like…
Let’s say you start with $1,000 in a stock. The position doubles to $2,000 over 18 months. You then decide to sell one-third of the current value.
That amounts to taking $666 off the table. That leaves you with $1,334 still in the stock. The benefit of this approach is that you’ve effectively locked in a 33% stop loss on the entire position.
Even if the stock eventually falls to zero, the most you have lost from your initial investment is $334. Of course, you’ve lost more than that in gains. But the point is, if something terrible happens, it hasn’t wiped you out.
Further, you can take more off the table at a later stage. Let’s say the position goes to so that your remaining $1,334 is now worth $2,000 again. Well, how about taking another one-third of the current value off the table?
That’s another $666. You’ve now recovered $1,332 from your investment, effectively locking in a 33% return on your initial investment (remember you started with $1,000, and you now have $1,332 back in the bank, with $1,334 still in the stock).
Anything you make from that stock from here on in is pure profit.
We know we’ve used a bunch of numbers here. And it’s easy to get confused. So if you’ve lost track, read through steps one and two again, until you get the hang of it.
It really is quite a simple strategy. Of course, these are examples. And different scenarios will always play out. You can adapt this idea as you see fit.
What do you do with the remainder of the stock? That depends. If it’s a stable long-term dividend-payer, you may be happy to keep that remainder invested for the long term.
If it’s a growth stock and it feels like we’re getting “late in the cycle,” maybe you start to sell more, just leaving a relatively small exposure. (That’s mostly what we’re addressing here with large-cap tech stocks. We suggest being more aggressive with taking profits.)
Step 3 – “80 to Safety”
This next step depends on your attitude to risk. Again, we’re using a bunch of numbers, so feel free to stop and re-read if it feels confusing.
For this step, we suggest taking 80% of whatever you’ve sold from those growth stocks and allocating it to your idea of safety.
That could be cash, a certificate of deposit (CD), a government bond, or even a selection of super-safe dividend stocks.
The idea here is we’re trying to reduce our risk exposure to a potentially devastating market fall if the market cycle ends sooner than we expect.
To clarify the “80%,” this means if you’ve (say, using our example) just sold $666 of profit from a risky large-cap stock, you should take 80% of that ($532) and put that into one of these “safer” ideas.
The remainder ($134) you should put into the types of stocks we mention in the following step. Remember, we’ve just used $1,000 as an illustrative starting point. Your portfolio may run into the hundreds of thousands or millions, so your position sizes would be bigger.
Regardless, the principle is the same.
Step 4 – “20 to Risky”
Finally, the “20 to Risky.” This is where we’re making the big switch in our portfolio to adding riskier stocks. But we’re doing so by using much smaller amounts.
Note that we’re not taking the full amount that we may have had in Apple (AAPL), Nvidia (NVDA), or Microsoft (MSFT). We’re only using a fraction of that amount.
In fact, it’s a maximum of 20% of what you would have had in those large-cap stocks. And if you’ve profited from them over the past couple of years, you’re only using profits (“house money,” if you like).
By the end of this strategy, your portfolio could have transformed itself from what you see in the “before” column to what you see in the “after” column:
Again, this is just an illustration. So don’t worry too much about whether those numbers in the table perfectly match with how we’ve explained it above. This isn’t a one-size-fits-all strategy.
You will mix things around as best suits you. The point is to get you thinking and even perhaps jolt you out of any complacency you may have.
Also, that example in the table assumes you make the entire “Big Switch” in one day. In reality, your portfolio will likely evolve over several months as the markets play out and as various stocks perform in their individual way.
Anyway, we hope that has helped you think about how to play this market. We hope it does make you start thinking more and being more active, rather than assuming stocks will just keep going up.
It’s entirely possible they will… in fact, our view is they will keep rising. But we could be wrong about that… or our timing could be wrong. And so could yours.
That’s why having a strategy like this can help you protect against the worst that the market can throw at you, while at the same time maintaining exposure to growth stocks if we’re right.
Cheers,
Kris Sayce
Editor, The Daily Cut