3SOF

Good morning !

I received an interesting message from stocky, asking which were my specific money management rules, and which ones would be more appropriate for his trading capital.

I know that many subscribers have the problem of not being able to spread their capital through 15 different holdings as the 3 Stocks on Fire Portfolio does.

So I think a general money management/risk control discussion thread is useful and important. Probably as important as learning to pick the right stocks.

Generally I follow Alexander Elder's money management rule of thumb, which is "never lose more than 2% of your equity in one single trade". Since at the 3 Stocks on Fire Portfolio we invest 6.66% of capital in each holding, I should never lose more than 30% in on single holding to respect the rule.

(the math goes like this: 0.066*X = 0.02 <=> X = (0.02/0.066) <=> X = 0.303 => X = 30.3%)

I've checked the 3 SOF previous trades table and that only happened once, when we lost 30.97% in SVA (a slight miss of the 2% rule). Also it is interesting to know that most 20% plus losses were trading OTCBB shares, fortunately we've moved away from those, to build more solid long term results with less risk.

Anyway, moving on, you can use the following simple math to establish your own money management rules that fit your trading style:

2% - maximum loss of total equity in one single trade
X% of loss allowed in one single position

- If X% is 10%, you can spread your capital over 10/2 = 5 different holdings
- If X% is 20%, you need 20/2 = 10 different holdings to be able to respect the 2% rule
- If X% is 30%, you may have 30/2 = 15 different holdings as the 3 Stocks on Fire Portfolio does.

The important thing is that then you need the necessary discipline to cut losses when the time comes, defending your equity from a big drawdown (setting the rules and then follow them without hesitation). Sometimes it isn't possible, as a stock may gap down 40% or more from the previous close due to unexpected news (try to avoid stocks with that possibility, like a single drug biotech stock, not yet approved, or for example low liquidity penny stocks, etc).

Another way to see it is:

- If you spread your capital through 5 different stocks (with equal size) you need to use a 10% stop loss to respect the 2% rule;
- If you have 10 different stocks you need to respect a 20% stop loss on all your holdings;
- If you have 15 stocks you can't bear to lose more than 30% in one single stock.

Another question stocky raised was something like this: "If I were to invest only in 5 stocks, which ones would you recommend from the 3 Stocks on Fire Portfolio?". He suggested that I do a ranking of the stocks, from the best to the worst in the 3 SOF Portfolio. I think that would be kind of hard, but fun.

I think to put a number on stocks, say "this is the 1st", "this other one is 7th best" is almost impossible, but maybe establish groups for them, that is, to categorize them in groups, perhaps that's possible and a nice improvement to our service, so I welcome his suggestion.

For example, it could work like this, but I'm opened to suggestions:



The group that I like most is group B (Long term value/momentum (small cap)), which combines fundamental and technical analysis with the growth potential of a small cap. For example, I would insert GOAM and BFLY in this group.

But I'm not able to hold all 15 stocks in this group (at least not now, since I haven't found 15 attractive stocks of the group), but you may want to invest only in those, and I should be able to tell, from the start, which ones are those.

I think I need some more groups ... for example, TGB can't be inserted in any of the groups above, it is a small cap macro play. I'll wait for your suggestions.

It looks like these are two discussions in one thread, I didn't meant it to be that way when I began writing. With time it will be just a money management thread, after we conclude this "stocks groups" issue.

Thank you !

Hey David -

Have you thought anymore about trying to classify the 3SoF picks into categories?

QuoteI know that many subscribers have the problem of not being able to spread their capital through 15 different holdings as the 3 Stocks on Fire Portfolio does.

I personally would like to limit my holdings to 5-8.  I'm working with considerably less money than the 3SoF portfolio (about 20k), and I feel if I spread myself too thin I may miss out on some of the positions that 3SoF deems more worthy than others within the portfolio.

I agree that rating the stocks would be very difficult and probably time consuming, so the grouping method sounds like it would be easier - and allow people following the portfolio to go with the investing style that suits them.  Then again, a rating system withing the 3SoF portfolio could prove to be a dynamic way of showing how excited you are about each position and provide a way to do things such as "putting a stock on notice" when it drops to the bottom of list...

I'm sure most of us here have some combination of the 3SoF picks along with some of our own picks and some kind of system would be a great addition and tool for us to use when making decisions.

Thanks for all your hard work!
Derek