Saturday, October 6, 2007

The Answer Is: Between 7 and 25

So then: What is the Question?
Perhaps you might think the question is: How many different jobs am I likely to have in my lifetime? Or how about: How many houses will I look at before I buy one? These are both questions that could reasonably precede the answer "between 7 and 25". However, the question the Covered Calls Advisor is looking for is: How many covered call positions should I have in my portfolio?

This advisor intends to maintain between 7 and 25 covered call positions in the Covered Calls Advisor Portfolio (CCAP). It is recommended that you also consider the advantages of maintaining between 7 and 25 positions in your own portfolio.

To specify why 7 to 25 is the recommended range, let’s consider two questions:
(1) What are the fewest number of covered call positions I should own?; and
(2) What are the largest number of covered call positions I should own?

The first question above is one that I often receive. On the one hand, people usually want to be adequately diversified, but on the other hand they have limited resources to invest. Although there are some very successful investors that do not practice diversification (for example Warren Buffett and Ken Heebner), the overwhelming majority of successful investors and financial advisors do recommend diversification, as do I. So the first question really becomes: What are the fewest number of covered call positions needed to be adequately diversified?

There are three primary components related to diversification: Asset Allocation, Sector Diversification, and Position Sizing -- Each of these will be discussed in greater depth in future postings. For now, this advisor will simply present my own guidelines for diversification:
(a) Asset Allocation
Domestic Equities – 70% (roughly 40% large cap and 30% mid/small cap)
International Equities – 25%
Fixed Income – 0%
Cash – 5%
Note: This advisor maintains an aggressive investing approach. You might be more conservative in your own portfolio with a lower percentage of equities and a higher percentage of fixed income and cash.
(b) Sector Diversification - Invest in at least five of the six sectors listed below:
Consumer (includes both Consumer Staples and Consumer Discretionary)
Energy (including Materials)
Financial
Health Care
Industrial (including Telecom and Utilities)
Information Technology
(c) Position Sizing – No single position more than 20% of total. This is the same guideline used by this advisor’s broker, Charles Schwab & Co.

So again, what is the recommended minimum number of positions?
To diversify across all sectors shown above, a minimum of six positions would need to be established. And to achieve a 25% allocation in international, without exceeding the maximum 20% position size for each position, a minimum of two international positions would be required for a total of 8 covered call positions. The Covered Calls Advisor recommends that you be invested in at least 5 of the 6 sectors listed above at all times. So although not recommended, it is acceptable to not be invested in one of the six sectors at any given time if you feel strongly that a particular sector will under-perform the others in the near future. Therefore, the recommended minimum is 7 positions (5 different sectors plus 2 international). This can be achieved while still honoring the max 20% limit for any single position).

The second question above is as important as the first:
What is the maximum number of positions I should own? The short answer is: ‘no more than you can continually monitor without feeling overburdened by the research and recordkeeping’. The second part of this statement, ‘without feeling overburdened by the research and recordkeeping’, is the most important. To be a successful investor in the long-run, which is our primary objective, we need to feel both mentally stimulated as well as to receive enjoyment from the research we are undertaking; but without feeling burdened by it.

Now for the first part, ‘no more than you can continually monitor’. What does ‘continually monitor’ mean? There are four primary aspects to ‘continually monitoring’ a portfolio:
(a) Read all news on the companies – Preferably daily, but at least once a week.
(b) Monitor prices – Preferably daily, but at least weekly.
(c) Listen to earnings conference calls – Quarterly.
(d) Maintain a good understanding of all positions currently held in your portfolio – That is, you should be able to name every equity held in your portfolio from memory without having to look them up; and be able to provide a clear and concise rationale for each position (4 to 6 sentences) as to why it is now a good covered call investment opportunity.

For this advisor, 25 is the upper limit for being able to perform all four of the ‘monitoring’ tasks above and also ‘without feeling overburdened’. However, while 25 is the max for this advisor, it can also be stated that my most common range is from 10 to 20 total covered call positions at any given time. That is my ‘comfort zone’ so to speak; that is, where I feel I am achieving both very good diversification while simultaneously maintaining a good handle on key information about each of the companies -- and most importantly, really enjoying the whole process! The max number for you might be different; perhaps 10, or 20, or even 30 – and that’s fine! Find your own personal ‘comfort zone’.

Regards and Godspeed

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