PORTFOLIO CONSTRUCTION AND MANAGEMENT

PORTFOLIO CONSTRUCTION AND MANAGEMENT

Thus far, in the book we have dissected the puzzle and examined each piece separately. Let’s take a few moments and succinctly sum up the investment process. Think of this method of portfolio management as an operating system. This operating system is not unlike the operating systems one might download on a com- puter. A computer can do absolutely nothing until it has an oper- ating system, like Window’s, installed on its hard drive. Even the newest comer to the computer world knows this universal truth. Investing is no different. In fact, everything in life is a software program of sorts that is installed in your mind (hard drive) and you are in essence the sum total of the software programs running on your mind’s hard drive. To be successful at investing, you need some way of evaluating the firehose of information available on the subject of investing. You need some way of constricting that firehose of information down to the trickle of a garden hose. This whole book is in essence the operating system we have found to be the most logical, easy to understand, sensible, and organized method of constructing and managing your portfolio. In the end, you must have accumulated more money than the market and the government can take away from you or you have failed in your quest for a sound retirement. Isn’t that what we are all ultimately striving for? At the end of the road, we need more dollars in our account than when we started. We are more or less aggressive in this endeavor at various points in our life.

361

362 Apply the Methodology to Your Investment Process

I want this chapter to be more of a cool down period. So sit back, relax—you have already done the heavy lifting. Let’s just briefly look at some of the steps that were covered in detail in the book to summarize the overall game or operating system if you will. Remember there is a CD Study Guide along with this book to help you solidify the concepts presented here. Here you will find all of the important concepts reinforced along with study questions. The CD was purposely constructed with a number of examples, and investment situations, for each topic. These exam- ples and tests are designed to help you take the concepts you learned in the book and apply them to real-life situations that you are likely to experience when investing real money.

One of the best ways to learn how to use the Point and Figure method is to practice with real examples. Whenever we conduct our Point and Figure Institutes, we always teach a particular sec- tion then do some practice examples relating to the section just covered. We culminate the seminar with several practice exer- cises, and in some instances a full case study, incorporating all the concepts taught at the institute. Therefore, as you finish read- ing this book, which is like attending a Dorsey, Wright Point and Figure Institute, it is fitting to do some practice examples that bring all the information together. One of the things I recom- mend is that you get a sheet of paper and just write down the pros and the cons for the stock. Create a checklist with two columns, one positive and one negative, as well as a comments column. Then as you examine each of the attributes of the market, sector, and stock, put it in the positive or negative column. Your evalua- tion sheet would look something like this:

Portfolio Construction and Management 363

Continue to do this exercise whenever you evaluate a position. It’s like the notes you took in college. Writing it down helps to re- member it. Once you feel comfortable with evaluating a stock you are ready to visit our web site. The DWA Internet site makes this easier because with the click of a computer mouse, will see an evaluation sheet automatically completed for you on your stock of choice. As well, the Point and Figure Charting, Third Edition CD has a section entitled “Resources.” Here you will learn about the resources available at www.dorseywright.com to help make the implementation and study of the Point and Figure methodology as seamless as possible. So sit back and relax. Let’s talk concepts with a step-by-step discussion of constructing and managing a portfolio.

Steps for Constructing an Investment Portfolio

Step 1. Evaluate the Broad Market—Who’s Got the Ball?

Evaluate the market to determine whether it is supporting higher prices or lower prices. Any type of business comes down to sup- ply and demand—it’s that simple. I don’t care whether we are talking about the oil market, iPods, golf courses, lemonade stands, or the stock market. Simply said, when there are more buyers than sellers willing to sell, price will move higher. When there are more sellers than buyers willing to buy, price will move lower. When supply and demand are in equilibrium price must re- main the same. In the end, there is nothing else. The reason that the price of produce in the supermarket changes is the very same reason the prices on Wall Street change. The Point and Figure methodology is just a logical, sensible organized way of recording that supply and demand relationship. It simply arranges the infor- mation in a way that makes sense to the viewer. When demand is in control of the market we want to focus on wealth accumula- tion strategies and when supply is in control of the market, we want to focus on wealth preservation strategies.

The indicator that tells us whether supply or demand is in control of the market is the Bullish Percent. This is kept on a va- riety of markets but the two most important are the NYSE and the OTC. We consider these indicators our main coaches. The

364 Apply the Methodology to Your Investment Process

first thing I do each morning is check this indicator to see what team the coach is telling me to put on the field. I often log on at night to see how the Bullish Percents did before I go to bed. From there, I’ll pick my individual stock plays. Here are just some of the plays from our playbook, segregated by field position. Use this as a starting point for developing your own playbook.

Portfolio Construction and Management 365

Step 2. Evaluate the Sectors

Seventy-five to eighty percent of the risk in any particular stock, ETF, or fund is the market and the sector. Because of this, we take a top down approach when evaluating the market. Once we have determined the stance of the overall market, we move to individ- ual sector evaluation. We are simply moving from the whole to the parts. Numerous internal and other academic studies have shown that over time a successful sector rotation strategy is para- mount to portfolio success. Never deviating from the basic laws of supply and demand, we rely first on the Bullish Percent con- cept to tell us which sectors are on offense and which are on de- fense. Like the blobs in a lava lamp, you’ll generally find that at any one given time, some are down at the bottom, some are at the top and have been hot for a while, and others are huddling in the middle of the lamp. The beauty of the Bullish Percent concept is that once you understand it, its easy to apply to different market segments. In some cases most sectors will be huddling together in the middle and there are no great opportunities and other times there will be an overabundance of opportunities. That’s life on Wall Street. Simply stated, make the best of what you have.

To increase our odds even further with respect to sector rota- tion, we will overlay the Bullish Percent concept with a Relative Strength (RS) reading. This allows us to stack yet one more thing in our favor. We try to keep our focus on those sectors with the

366 Apply the Methodology to Your Investment Process

strong RS. This allows us to identify major themes and turning points in the market. Typically, these themes last for several years. Where so many investors go wrong is they don’t believe that the stock that has been strong can continue to stay strong. There’s an old stock market adage that says the first stocks to double in a bull market usually double again. Or, as Sir Isaac Newton would say, “things in motion tend to stay in motion.” The Point and Figure charts, Bullish Percents, and RS indicators will let us know when an investment theme is coming to an end. Having a sell discipline allows us to be comfortable owning those winners and letting them run. One of the fundamental truths to portfolio success is to cut your losses short and let your winners run.

Step 3. Creating an Inventory

There are many right answers in investing and all too often I see investors and brokers alike try to get their arms around too large of a universe of investment vehicles. My dad taught me “life’s a cinch by the inch, life is hard by the yard.” Take it inch by inch. In the DWA database we follow over 7,000 domestic stocks, 15,000 mutual funds, almost 400 ETFs, and over 25 exchanges across the world encompassing 3,000 international stocks. I don’t throw out these figures to overwhelm you but rather to point out the importance of determining your inventory. Do you like mu- tual funds? Pick a couple of fund families you believe in and con- centrate on those. Maybe as an advisor you like working with money managers. Compile a list of managers whose management style you like and they will become your inventory. Maybe the ETF product is what appeals to you. There is a terrific universe of those available. Do you prefer to work with individual stocks? If so, start with a fundamental inventory. I feel more comfortable working with a list of fundamentally sound stocks. I know full well a fundamentally sound stock can act like a “cat” or a “dog” at any time because supply and demand imbalances are the only economic concept that drives price change, but I still feel more comfortable with a list of stocks that appear to have no funda- mental cracks in their armor. The point is you take that firehose of products available to you and take it down to the trickle of a

Portfolio Construction and Management 367

garden hose. It’s easier to take a sip from a garden hose than a fire- hose. Once you have your inventory established, you can use Point and Figure methodologies outlined in this book to enhance the portfolio strategies you are already using. Just keep every- thing in perspective. This is not a science. It’s simply best to op- erate in a logical, organized manner. That’s the key to success.

Step 4. Evaluate and Monitor the Point and Figure Technical Picture

Once your inventory is established and culled down to a reason- able number that gives you a cross section of exposure to asset classes and sectors, evaluate the technical’s of each stock (ETF, fund, manager, etc.) in the inventory to answer the question, “What to buy and When to Buy it, and what you will do if all these plans go your way and what you will do if these plans do not go your way.” It is essential you know this and you write it down for the future. It helps to go back and reevaluate exactly what you did and why you did it. Our computer systems can answer this ques- tion in a matter of 2 seconds. I am continually amazed at where we have come technologically over the last 20 years. Twenty years ago we did it all by hand. Today, we have even taught the com- puter to evaluate any investment vehicle from stocks to bonds to ETFs, then explain in writing what it saw, what it recommends doing with the position, and alternative ideas. I have been in- volved in the thought process on these technological advance- ments over the past 20 years and I’m continually amazed at where we are today at being able to provide such a great productivity sys- tem to you the investor. It’s hard to figure where technology goes from here but I know we are only limited to our ability to commu- nicate and these technologies continue to expand on a daily basis. Here’s an example of our ability to communicate. We held a tech- nical analysis and option strategy seminar in Kuala Lumpur, Malaysia, at a prominent hotel, while we taught from our offices here in Richmond, Virginia. That’s technology.

Once a position is established, continually monitor the posi- tion for signs of impending change in the trend or RS of the stock. This is a pretty simple step but an important one. You must evaluate all your portfolios each day to become aware of

368 Apply the Methodology to Your Investment Process

something that might require action. The best way to do this is to put all your portfolios into our system separately, like Mr. and Mrs. Jones Retirement Account, and so on. Our system will watch the portfolio or group of stocks for you like a cyber assis- tant. It will inform you by simply clicking on the activity but- ton for each portfolio. This activity screen will outline any changes that require your attention with respect to the underly- ing portfolio. The process to do this is so simple. Just key in the symbols of each stock, mutual fund, bond, and so on that each client owns in their portfolios, into the DWA portfolio system or I prefer to simply place all the stocks all my clients own into one portfolio. The point I am getting at is this: the system will do the rest once it knows what to evaluate. Say you wanted to view each day anything that might require your attention in all your portfolios. You would simply go to your portfolio system and click on the “activity” button. In one second the system will separate all the stocks in all your portfolios and place them in groups like Double Bottom sell signals, RS change to nega- tive, RS change to positive, Peer RS turned positive, and so on. In one click of the computer mouse you just evaluated every portfolio under your management in a matter of a few minutes. This activity would be done each morning before the market opening but since our charting system is updated the night be- fore, you can get a jump on things by taking a minute to review the portfolio after the kids are in bed.

Each of you will find your own way of managing this informa- tion. We have clients who spend hours each night with the data and others that can easily manage their accounts with some easy 1, 2, 3 steps. As you work with Point and Figure analysis you will be amazed and delighted with your new found ability to take con- trol of your and your client’s investment endeavors.

Summary

When I was a broker back in the mid-1970s, I came to work un- prepared every day. We simply didn’t have a logical way of operat- ing our business back then. We simply took firm research and

Portfolio Construction and Management 369

passed it on to our clients hoping the stocks would rise so we could sell and replace them with other stocks that would then rise in price. It simply did not work, period. It wasn’t until 1978 that I came across the Point and Figure method of analysis purely by accident. When I learned it, I realized I had found the Holy Grail of Investing. It was ECON 101, supply and demand. I knew then what I was put on this earth to do and that was to teach this method to my brothers and sisters in this business for the rest of my life. It is now 28 years later and I’m doing just that. This is not a book that is generally read once and then abandoned. I have read and reread this book and, even though I’m the author. Every time I read a chapter again, I am refreshed on something I have lost focus on. This book should be highlighted, underlined, dog-eared, scuffed up from use, and passed along to others. There is an old saying: “You can’t keep it unless you give it away.” You are one of my emissaries now and you should pass this on to others. With- out you they may never have the opportunity to truly take control of their finances and, in the end, their retirement. Possibly be- tween all of us passing the word we can help others attain a se- cure and comfortable retirement. This book will take an individual and his or her family much further in this endeavor than any government program can. Having read this book from cover to cover, you are now in the DWA family. Welcome.