Investing Club mailbag: Why trimming winners is key to keeping your portfolio diversified

Published Wed, Dec 28 202212:20 PM ESTUpdated Wed, Mar 29 20233:43 PM EDT

Could you please ask Jim if he can do an education piece on when and how to balance a portfolio. Since joining the club, some of my positions have increased to 7-10% of holding [portfolio weighting.] I am finding it difficult to trim the winners. — Richard Rebalancing your portfolio This is a great question about managing the size, or weighting, of positions in your portfolio — and one for which there's no clear-cut rule to follow but rather some guiding principles to consider. The one driving principle to keep in mind at all times is this: Discipline trumps conviction. Put another way, no matter how much you believe in a company or its management, you must not let that belief take priority over your discipline. Regarding the practice of rebalancing, many mutual funds and money managers may opt to rebalance based on a set schedule — be it monthly, quarterly or annually. However, as active investors, we don't think so much in terms of predetermined dates to rebalance. Instead, at the CNBC Investing Club with Jim Cramer, our team attempts to do so based on position size. As a position grows larger, you are inherently losing the benefits of diversification and you are moving toward a portfolio that's going to be influenced too much by one stock or just a few. Avoiding putting all your eggs in one basket is the reason we strive to construct a diversified portfolio in the first place. Maybe you don't believe in a diversified portfolio — after all, some great investors have earned their reputation by making a few highly concentrated bets. However, that's a risky proposition. Keep in mind, you don't hear about the thousands that made those concentrated bets and got them wrong, only the few that got it right. By simply asking the question about rebalancing, you are acknowledging the benefits of diversification. With that in mind, here are some things to consider when looking at winners that that are getting bigger on a percentage basis compared to the rest of your holdings. When a position gets too big Similar to the scenario described by Richard, we rebalance based on a position exceeding predetermined thresholds — around a 5% to 6% weighting range. When a position exceeds this weight, we know we have to take some off. We may not do it all at once or the moment the position exceeds 6%. But we will become more mindful of the outsized exposure, and look for any reason to book a profit. The reason you don't necessarily want to do it immediately or all at once: when a position exceeds the threshold, it means the stock is rising. While you don't want to be greedy, you may want to let a winner run a bit. However, you can't let it go unchecked. Instead, think about levels at which you are going to trim: it could be every dollar higher, or even every few percentage points higher, or you could look at some technical levels, such as past resistance or how far the stock has moved off of key moving averages. When it hits those levels, whatever they are, sell. Don't get emotional and caught up in the momentum — again, discipline trumps conviction. If you are prone to letting emotions take over, you can always put the limit orders in ahead of time. One other thing to keep in mind to help determine how aggressive you need to be is the reason behind the stock's appreciation. If the stock is up because earnings expectations are increasing (perhaps management just provided a positive update) then you may not need to be overly aggressive. The stock price is higher but the valuation (price-to-earnings multiple) didn't increase. On the other hand, if the stock is up but earnings are static, you'll want to be more aggressive because the stock actually is getting more expensive on a valuation basis. Thinking about it another way, if you are letting a stock run a bit because it's on a move, then acknowledge that while you may have a fundamental reason for owning it, you are now playing the momentum game. It's fun when it is going in your favor — but when the momentum reverses, it can be swift and brutal. Don't beat yourself up for not catching the absolute top. Nobody does it without some degree of luck. Rather, acknowledge that the momentum has run out and you still have to right-size the position. (So, just as you might be thinking about levels above the stock price to sell at, think about stop losses as well or determine ahead of time exactly how many shares you are going to sell should momentum run out before it hits that next higher level.) When to trim a winner The size of your portfolio is also a consideration. At the Club, we aim to own thirty-some positions at any given time. Currently, our portfolio stands at 33 stocks. That's far greater than what we recommend for individual investors because it becomes near impossible to stay on top of the homework. After all, we have Jim, plus two analysts covering the stocks in the Club as their full-time job (and an entire team supporting them). So, your own individual threshold for when to rebalance may not be 5%. It could be closer to 10%, depending on how many positions you have and what those positions are. As for how much to trim, the goal is to get back down to the threshold you're comfortable with, whether it's with one sale or several. We generally advise that members not own more than five to 10 individual stocks, given that we estimate that homework amounts to one hour per week per position; and it gets hard to keep up beyond that point if you also have a full-time job outside of the stock market. That doesn't mean you need to own five positions at 20% each. Instead, you can determine an appropriate level of exposure based on your willingness and ability to accept risk. You could always supplement with an exchange-traded fund (ETF), such as one that tracks the S & P 500. For example, you may opt to own five stocks at 10% each, keep some cash on the sidelines for opportunities, and put the rest to work in an ETF. Again, this comes down to risk tolerance. Case study in our portfolio Going back to the notion that discipline trumps conviction, we think the best example we can provide is in how we manage our position in Apple (AAPL). As members know, this is a name we constantly reiterate should be owned and not traded. Of course, as the longest-standing position in our portfolio, we have obviously had to trim it along the way or we would now be known as the "Apple Trust." It's tempting to look back and say that would have been quite profitable over the years. But hindsight is 20/20. There's no way to say for sure that any one company is your ticket to fame and fortune. Again, discipline trumps conviction. If you feel like you've read that line over and over, that's good. You won't forget it. The last time we sold Apple shares was on April 11. At the time, Apple was at a 6.75% weighted position in our portfolio. We sold it down to a 5.06% weight. In that trade alert, we noted that there was a need to rightsize this position because the run it had gone on resulted in it simply taking on too much weight in the portfolio. At the time of our Apple trim, no other position was appreciably above 5%. And while we stand by our desire to own Apple and not trade it, we have to make it more manageable. Any time a position is above 6% of our portfolio, we typically like to trim it back and reduce its weighting so that on any given day, the portfolio's movement is not directly tied to one individual stock. As much as we love Apple for the long term — due to our confidence in the ecosystem and management, as well as its commitment to returning cash to shareholders — we still had to stick to our discipline and trim the position back down to size. Bottom line Like most areas of investing, the determination of when and what to trim is part art and part science. The art is in figuring out how to get the position back down to size and when to pull the trigger on a sale (or sales). The science is in predetermining exposure levels and sticking to them no matter how much confidence you have the future trajectory of any one stock. It's always difficult to trim winners — after all, you certainly don't want to trim winners to fund losers — but it's also wrong to be too greedy. So remember, bulls and bears make money while pigs get slaughtered; and discipline trumps conviction (seriously, we mean it, we've said it like five times at this point). (Jim Cramer's Charitable Trust is long AAPL. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

Traders work on the floor of the New York Stock Exchange (NYSE) on August 5, 2022 at Wall Street in New York City.

Angela Weiss | AFP | Getty Images

— Richard