Use the basket approach to buy new stocks

When you invest in a new industry, it’s best to use the ‘basket approach’. Spread your investment over a basket of stocks. That way you’re more likely to end up with a big winner. Specialized funds make it easier than ever to apply the basket approach.

The basket approach

When you invest in a new industry, it’s best to spread you investment over a basket of stocks.

The basket approach is a term used when investors buy a ‘basket’ of, say, five or more stocks. This increases your chances that one or two may rise dramatically in price to pay for the others—which could very well end up worthless.

We adopted the basket approach with regards to marijuana stocks. The fact is, there are lots of companies entering the industry. Some are bound to be winners. But with no long-term track records and changes to regulations, it’s difficult to initially identify the winners. That’s why we recommend an ETF (exchange-traded fund) that gives you ownership of the largest companies.

Specialized ETFs give you ‘baskets’

The basket approach has become easier than ever. That’s because there are many specialized ETFs these days and new ones keep popping up all of the time. We find that it’s most profitable to invest in broadly-diversified ETFs based on market indices—such as the S&P/TSX Composite index or the Standard & Poor’s 500-stock index. Even so, when you’re buying into a risky or unproven industry, specialized ETFs may suit you.

The basket approach pays off well in newer industries. Consider automobiles which, in the industry’s infancy, were called ‘horseless buggies’. Most investors could see how millions of customers would buy cars in the decades to come. The difficulty was to find the car manufacturers that would survive and ultimately thrive.

Baskets work best for new industries

In the early years, there were hundreds of car manufacturers. Most were made by ‘geniuses’ who knew all about how to make internal-combustion engines power comfortable vehicles with shock absorbers and so on. At that time, cars were mostly toys for the very rich.

Then Henry Ford developed the assembly-line and hired unskilled labourers to do just one thing, over and over. Ford made cars accessible to most Americans. Ford put most other manufacturers out of business. Under the basket approach, you would’ve increased your chances of buying Ford or General Motors and overcoming the losses from all the competitors who failed.

As another example, consider the software industry. Investors could see it spreading rapidly. Most offices these days routinely use software. But as with cars, it’s not easy to immediately spot the winners. Early winners can fade away.

Early winners can fade away

At one time, WordPerfect was a pre-eminent word-processing package. The same was true of Lotus 1-2-3 with regards to spreadsheets. It seemed clear at the time that they would remain winners. But as Bob Dylan sang: “Don’t speak too soon, for the wheel’s still in spin, and there’s no tellin’ who that it’s namin’, for the loser now, will be later to win, for the times they are a-changin.” Indeed, Microsoft Corp. came along with similar software packages and pushed aside WordPerfect and Lotus.

Use our ‘sell half rule’

Knowing when to sell is an investor’s most pitfall-riddled decision. Sell too late and you’ll likely lose money and feel ‘buyer’s regret’. Sell too soon and you’ll likely miss out on tremendous future gains and feel ‘seller’s remorse’.

We came up with our ‘sell-half rule’ to help investors deal with this decision, at least with stocks that go up. The rule goes like this: When a stock that you own doubles in price in a short period, or without any reasonable fundamental justification, it pays to sell half. That way you get back some of your initial outlay. At the same time, the remaining shares can benefit from any ongoing share price run-up.

It rarely, if ever, makes sense to apply this rule to high-quality investments—such as common stocks that we rate ‘Very Conservative’ or ‘Conservative’. Instead, the rule aims at getting you out of low-quality, more speculative issues.

This is an edited version of an article that was originally published for subscribers in the February 15, 2019, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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