The Importance of Scaling

My style is a little different from most contributors to TraderPlanet.  At heart, I’m a value investor, and my holding periods for quality stocks can be months, years, or even decades under the right set of conditions.

This is not to say I’m an ideological believer in “buy and hold” investing, however.  Absolutely not.  But I am a big believer in letting a solid investment thesis play itself out.  If a stock is attractively priced and I judge it to have appealing prospects going forward, then I feel no need to sell it simply because it has enjoyed a recent run-up in price.

But while my approach to the investing process is different from that of a short-term trader, I’m a big believer in a concept that many successful traders follow: scaling.

When you scale in or scale out of a position, you enter it and exit it in stages rather than in a large lump sum, and there are several reasons why this is a good idea.  By taking a small initial position, you can test out an investment idea before committing a large sum of money to it.  This was a favorite tactic of Jesse Livermore, the legendary trader who was the inspiration for the fictitious biography The Reminiscences of a Stock Operator. 

For me, it is more a case of managing my psychological temperament.  Nothing is more frustrating to me than committing a large allocation of my portfolio to a well-researched position only to see it take an immediate nosedive.  I may eventually prove to be right, and the trade may still end up being as profitable as I hoped.  But seeing a new position in the red rattles me and distracts me from the task at hand of managing the overall portfolio.

It is also a way for me to split the difference during times of indecision.  If a stock looks fundamentally sound and attractively priced,  my head tells me to buy.  But if a stock has already had a large run-up or if the market doesn’t “feel” right, my gut tells to wait.  When I have a conflict between my head and my gut, I split the difference by entering a position in increments.  If the stock continues to rise, I have exposure.  But if there is a pullback, I also have my powder dry to take advantage of it.

The same is true of exiting a trade.  I hold several positions I’d love to hold forever.  But now and then, one of those stocks will get a little on the pricey side, or the position will grow to become too large relative to the rest of the portfolio.  In these cases, it makes sense to take a little money off the table.  A trader would call this taking profits; an asset allocator would call it rebalancing.  I call it being prudent.

I’ll leave you with an example.  Mortgage REITs recently took a beating in the market, as investors feared that a hike in bond yields would wreck their book values.  I took the view that any reduction in book value was already reflected in the stock prices of the REITs; as a group, they traded well below their stated book values.

But after the bloodletting in the sector, my gut felt queasy about allocating a large chunk of capital to something that volatile.

Splitting the difference, I’ve been averaging in to the UBS E-TRACS 2x Mortgage REIT ETN ($MORL) over the past month.

Incidentally, I recommended mortgage REITs in TraderPlanet three weeks ago.  I’d like to reiterate that call today.

Disclosures: Sizemore Capital is long MORL.  This piece first appeared on TraderPlanet.