Last week, I met a gentleman who told me he has more than 400 open options positions. “That’s too many,” I told him point-blank. “How do you possibly manage 400 positions?”
He brushed aside the question and said he’d taken a beating this year.
I wasn’t surprised. No one can actively manage 400 positions. It’s a completely undisciplined approach that is sure to lose money.
Look, I’m all about diversification. You should have stocks from a wide variety of industries, geographies and market caps. But if you have hundreds of stocks or options, not only is it impossible to manage, but I guarantee you have a lot of garbage stocks in there.
In An Economist Walks Into a Brothel – an interesting and very readable book on understanding risk, written by Allison Schrager – there is a chapter on poker champion Phil Hellmuth.
The “Poker Brat,” as he is called, is known for his volatile personality and explosions of rage when he loses a hand that he thinks he shouldn’t have.
However, in the book, Hellmuth discloses that he plays only about 12% of his hands, much less than the 25% to 50% of hands most players play.
It’s his discipline that keeps him a winning player.
Investors could learn a thing or two from the Poker Brat.
Many investors try to make up for lost time and get rich quick. Sometimes it works. Sometimes you pick that great stock or options play that goes through the roof and you make a lot of money. But I guarantee that for every one of those, there have been several losers. If you’re disciplined and can keep your losers small and your winners big, you can make money.
But for most investors, discipline comes in the form of picking quality investments and leaving them alone, regardless of what the market is doing, interest rates or who is in the White House.
A disciplined player like Hellmuth will mostly play very strong hands, like two aces, or two kings, or an ace and a king, etc. He’ll also play weaker hands if he is one of the last to bet (what is known as being in late position). When you’re in late position, you have more knowledge because you’ve seen what the other players have done (bet, called or folded). And, of course, every good poker player will bluff occasionally.
Here’s how you can set up your portfolio according to the same principles.
1. Play a Strong Hand
For most of your portfolio, you should own the equivalent of holding two aces. Own Perpetual Dividend Raisers. Holding two aces doesn’t guarantee you’ll win the hand and owning a quality dividend growth stock doesn’t either, but it greatly improves the odds.
A company that has a decent dividend yield and grows the dividend by a meaningful amount generates a solid return each year even without price appreciation. But Perpetual Dividend Raisers tend to outperform the market over the long term and especially in bear markets like we’re in now.
A company like Merck & Co. (NYSE: MRK) has a nearly 3% dividend yield and has raised its dividend every year for 11 years in a row. Over the past 10 years, the dividend has grown an average of nearly 6% per year.
Meanwhile, the stock has greatly outperformed the market, up 30% this year, while the S&P 500 has fallen 16%.
2. Give Yourself an Edge
Sometimes, a good poker player will play lower-quality hands, like a nine and an eight of the same suit, if they’re in late position and believe they have an edge.
That would be the equivalent of buying a stock in an industry that is poised to benefit from current conditions. For example, if energy prices rise this winter because of the war in Ukraine and OPEC refusing to cooperate on lowering prices, most oil stocks will probably do well as the entire sector climbs higher. You don’t necessarily need the top stock in the industry to make money.
3. Know When to Fold ‘Em
Then there’s the bluff, when a player has a garbage hand, like a 10 and a six, but plays it like it’s two kings. A good player will know when their opponent won’t fold a good hand and instead will have to lay down their cards to avoid losing a lot of money.
In the investing world, that could mean taking a flier on a small stock or option with an upcoming catalyst. If you’re right, you can make some great money. If you’re wrong, you need the discipline to get out quickly so a small loss doesn’t become a big one.
Don’t let a trade become an investment. Have the discipline to fold your cards if it’s not working out… so you have enough money to play another day.
Like poker players, investors who are undisciplined can get lucky once in a while, but they will lose over time. The ones who are disciplined almost always make money over the long run.
Yell and scream like Phil Hellmuth when a trade goes bad if you want, but if you make smart decisions like he does, there likely won’t be many opportunities to do so.