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Little John was proud of his new found knowledge on evaluating companies. L. J. had narrowed his search to ATT ( About to Tank) Industries. ATT had a marvelous balance sheet, great liquidity no debt, a P/E ratio of 10 which compared very favorably to its industry. ATT makes widgets and has five additional products in the pipeline. The ROE is impressive, a good indication that management is doing their job. Earnings per share are growing quarter over quarter for the last three years and forward guidance is awesome. L. J. was about ready to pull the trigger this can't miss opportunity. Price multiples would suggest that ATT should be trading for at least $35 a share. So it was a bargain at $21. The charts indicate a pull back to strong support. No place to go but up and away!! L.J. had $40,000 in the till, so he was all in on this one. He pushed the button and was quickly the proud owner of 1900 shares of ATT. Within a week, the stock was up to $25.50 and L.J. was in tall cotton. All of Little John's due diligence paid off. It was reward time for L.J. He'd been looking into upgrading his wardrobe. So , Friday afternoon after market close he headed for the local clothier "Men of the Forest" and bought ten new tunics and then over to "Bull's Eye Archery" and purchased a custom long bow and quiver filled with handcrafted arrows designed and crafted by "Straight Arrow" the arrow man. Little John was in a zone. Why not? He earned his success. He worked hard for it. The shopping spree set him back about $6000. Of course, it was party time that weekend and L.J. bought rounds at the local brew pub for the Merry Band of Traders. Sunday he was hung over from his night of fun but happily basking in the glory of his stock market triumph. Monday at market open ATT continued bullying its way up on strong volume to 26. A news flash on CNBC, the CFO of ATT has been indicted for embezzling millions of dollars and the stock plummeted to 17. John was away from his computer, so he called his broker on the cell and was put on hold. Finally when someone picked up, he learned that the stock had been halted. L.J. couldn't believe it. He wasn't able to get out and he was down big. Where would it open when trading resumed? The market closed for the day and L.J. was beside himself. What now?? There wasn't much sleep that night. Tuesday morning ATT resumed trading at 15.50. He couldn't sell it there, that's too much to lose besides it's a great company. It'll rebound. He decided to stick it out. ATT traded down to 13.80 and finally the pain was too much to endure and L.J. had to close his position. The stock had lost 1/3rd of its value and Little John had about $6500 on his credit card from his spending spree. There are several lessons here but we're going to talk about Diversification. It's the only free lunch in the stock market. You need to etch this in stone. "Never, Ever plunge into one position with all of your capital no matter how attractive the opportunity may seem." ALWAYS DIVERSIFY!! So what is diversification? In its simplest terms, it means not placing all of your eggs in one basket. The size of your account will dictate the number of positions that you should trade. It's my opinion that the minimum numbers of positions necessary to achieve diversification is five. Obviously, the more positions you have, the more diversification you will have. From a practical standpoint, you must decide how many stocks you can feasibly monitor. After a certain point, it may make sense just trading an index to capture diversification. When trading indexes or ETFs you should also seek diversification. If you can handle the due diligence and maintenance of the portfolio, you may want to consider 10-15 positions. When selecting stocks, I suggest you choose stocks from different sectors and industries. You also need to analyze the impact each position may have on the other stocks in your portfolio. In a general downturn as we are now experiencing, the entire market will suffer. There are some so called "safe haven" stocks that can weather the storm better than others. Under normal market conditions, you should select stocks that are compartmentalized form each of the other positions. Being diversified in your stock portfolio is akin to owning an apartment building (your portfolio) that has several units (each stock position) but with firewalls between each (diversification) so that if one caught fire, it is unlikely for the whole building to go up in flames. Diversification should give you overall market exposure but with firewalls between your stocks. The result is that your portfolio is much safer. Unfortunately, there could be an earthquake and your entire building could be destroyed, but that is part of investing. You can buy insurance on your building for occurrences like earthquakes and I can show you how you can do the same for your stock portfolio ( another discussion for another time). Money management is crucial to your success and we'll talk about that next week. One additional thought. Never spend unrealized gains. By the way, Little John tried to return all the stuff he bought, but the merchants wouldn't allow it. All sales are final. So, he wanted me to tell you that he is having a garage sale next week. His size is triple XL but unfortunately, there isn't much of a demand for that size. It's all about supply and demand.
Article Source: http://www.articlecafe.net
Mark Espy (aka RobinHood Trader)is a full time trader and professional educator. Mark loves to help others master trading skills and is co-founder of a rapidly growing trading education company. Receive a free lesson and learn more about how to improve your trading skills.
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