Ch4. Stock Investing — Portfolio Construction & Risk Management
Diversification: The Only Free Lunch in Investing
Diversification reduces risk without proportionally reducing expected returns.
Two types of risk:
- Unsystematic (specific) risk: Can be eliminated through diversification (company or industry failures)
- Systematic (market) risk: Cannot be diversified away (market-wide downturns)
Optimal number of holdings: 20–30 stocks from different sectors eliminates most unsystematic risk. Adding more beyond 30 provides diminishing risk reduction.
Sector Rotation Strategy
Sectors perform differently at different stages of the economic cycle:
| Economic Phase | Outperforming Sectors |
|---|---|
| Recovery | Consumer discretionary, financials, tech |
| Expansion | Energy, materials, industrials |
| Slowdown | Healthcare, consumer staples, utilities |
| Recession | Bonds, gold, cash |
Stop-Loss Rules
Why stop-losses are essential:
- Stock down 50% requires 100% gain to recover
- Stock down 80% requires 400% gain to recover
Common stop-loss approaches:
- Fixed percentage: Exit when position falls 8–15% from purchase price
- Technical: Exit when stock closes below key support or 200-day moving average
- Trailing stop: Stop moves up as price rises; locks in profits
Mindset shift: A stop-loss is not a “loss” — it is risk management protecting you from larger losses.
Rebalancing
When one asset class outperforms, your actual allocation drifts from your target.
Example:
- Target: 70% stocks / 30% bonds
- After 1 year: 85% stocks / 15% bonds (stocks rallied)
- Action: Sell some stocks → buy bonds → restore 70/30
Rebalancing frequency: Annually or when drift exceeds 5% from target
Tax consideration: In taxable accounts, selling creates capital gains — consider rebalancing with new contributions first.
Behavioral Biases to Overcome
Disposition Effect
Selling winners too quickly and holding losers too long. Fix: Rule-based system for when to sell (stop-loss + target price)
Overconfidence
Excessive trading based on belief that you’re smarter than the market. Fix: Track your trades and compare to a simple index benchmark
Confirmation Bias
Seeking only information that confirms your existing investment thesis. Fix: Actively seek out the strongest bear case for each position before buying
Chapter 5 Preview
Next: Investing in US Stocks — how to invest in US markets from abroad, currency management, tax considerations, and ETFs vs. individual stocks.
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