By now, hopefully we’re all in agreement that a boring, globally diversified portfolio of low-cost institutional mutual funds is better than a sexy portfolio of individual stocks, and that your nest egg money should be manged by a trusted, independent fee-only advisor. This means that you’re now wondering what system to use for those individual stocks you’re not telling your financial advisor about – your “mad money” as Jim Cramer calls it.
Investors love to pursue their own “fun” ideas. And by “fun”, I mean that the potential reward is not in sync with the risk, but you want to do it anyway. Whether it’s a portfolio of stocks, in which you’re addicted to the winning streak (Apple anyone? ), or stocks you inherited where you feel an emotional bond, you don’t have to freeze up when it has a big rise or fall.
In the spirit of “harm reduction”, allow me to suggest two ideas for better managing the portfolio of assets you probably shouldn’t own anyway. It may not make logical financial sense to have a mad money account but, if you’re going to do it, you might as well improve your odds of success.
1) Use the 5% Rule
Set a ceiling percentage on how much your individual stocks can be relative to your total investment portfolio (include 401ks, IRAs, and all professionally managed investment assets). Ideally, you should limit this portion to 5%. Why? Because, if your idea (or the hot tip you bought into) becomes the next overnight flop (ahem, Facebook), or long torturous one (Kodak), most people can stomach losing 5% of their portfolio.
2) Rebalance your mad money against your professionally managed money
The pros do this, and so can you. Rebalancing is the process by which you trim the winnings and buy more of the “losers” in your portfolio. If you don’t have a rigid system for doing this, your emotions will interfere and you will lose more money. How many people do you know who have sold some of their Apple stock winnings? The human tendency is to plan to sell something when the losses become too much to bear. Yet, when we go shopping, we pounce on a discount. Go figure.
Instead, set a target (again, the 5%) on your mad money account and set a reminder to review this at least quarterly. When you check this account, rebalance it back to the 5% target if it moves to 3% or 7%. In this case, your “tolerance band” is set to 40% (5% x 40% = 2%). Sell from your mad money account when it grows to 7% and place the proceeds in your professionally managed account. Do the opposite when your professionally managed account is the better performer of the moment.
Oh, and don’t forget that capital gains rates are expected to go higher in 2013 unless Congress acts fast. If taxes are the barrier to your letting go of a stock, think again, as taxes are likely to go up in the future, not down. If you are having a slow year at work, or you’re unemployed in 2012, chances are you’re in the bottom two tax brackets. If that’s the case, you may be eligible to pay ZERO capital gains taxes on the sale of your stock. Consult with your financial advisor to see if that’s your reality.
This content is for general information purposes only and may not be
suitable for all investors as financial needs vary from person to