Manage Your Portfolio Like a Baseball Team

Stock market investing has replaced baseball as the national pastime. Co-workers gather around the water cooler discussing the Ebitda of their favorite stocks the way they used to discuss the ERA of their favorite pitchers. High-gain stocks are called four-, five-, even 10-baggers. (That's a gain of 400%, 500% or 1,000%.) So what strategies that baseball managers use can we apply to the management of stock portfolios?

Have a Deep Bench

The whole point of having a portfolio is to maximize returns while minimizing risk. You should have between 32 and 40 stocks in your portfolio. No matter how much research you do, you are guaranteed to have one or more stocks whose price gets cut in half after an earnings shortfall. If that stock accounts for 2.5% (1/40) of your portfolio, you'll take a manageable 1.25% hit to your total assets. A four-stock portfolio may have some exceptional returns for a short period, but just as likely will have horrible returns in a subsequent period, wiping out your capital. With online brokerage commissions ranging between $7 and $25 a trade, it's possible to invest a $100,000 portfolio in 40 stocks and spend less than 1% on commissions.

Don't Hang the Whole Team on One Player

Remember "Casey at the Bat?" Don't allow your portfolio to get concentrated in a single stock. Our rule of thumb is that whenever a stock exceeds 10% of a portfolio, we automatically cut the position back to 4% to 5%. Doing so obviously incurs some taxes, but it also ensures that your portfolio's returns do not become correlated with a single stock. For example, Dell Computer (DELL Quote - Cramer on DELL - Stock Picks) was one of our original core positions when we started this firm seven years ago. If we held on to every single share we ever bought, Dell would account for about 35% of our assets. This would have been good news through January 1999, not so good news over the past year and a half.

More recently, a position in Incyte Pharmaceuticals (INCY Quote - Cramer on INCY - Stock Picks) swelled as the stock price soared from our entry point last summer in the 30s to a February peak of 289, in some cases accounting for 20% of a client's portfolio. We sold 75% of our position around 268 and have been buying more of this stock recently, now that it's fallen back to a more reasonable 74.

Hit for Average, Not for Homers

Hitters who swing for the fences strike out more often than do players who concentrate on getting on base. If you had a portfolio of aggressive stocks last fall (let's say, half technology, half emerging technology), you made out like a bandit through March of this year. However, you probably gave up most if not all of those gains in April and May. Invest 20% to 35% of your portfolio in aggressive stocks with what we call "Problem Child" characteristics and divide the remainder of your investments between stocks of "Star" and "Cash Cow" characteristics (for details, see Stars, Dogs, Cash Cows and Problem Children: What's in Your Portfolio?).

Different Players for Different Situations

A successful baseball team needs a strong leadoff hitter, several good starting pitchers and relievers, an agile infield and a reliable outfield. Concentrate the team's resources in any one area (let's say, the best bullpen money can buy) and you risk being beaten by a team with broader strengths. In recent years, too many investors concentrated all their stock picks in one sector, technology, then got beaten pretty badly when the climate for those stocks turned negative. In general, we put 25% of our portfolios in technology (the fastest-growing but also most volatile part of the S&P 500 index), 25% in financial services (a growth sector that does particularly well in an environment of flat-to-falling bond yields) and 25% in health care stocks (another volatile growth sector that has low correlation to the technology sector). The remaining 25% is invested in companies with low or negative correlation with the S&P 500, like real estate investment trusts (Reits) and commodity stocks, or stocks with highly predictable earnings and low volatility, for example, General Electric (GE Quote - Cramer on GE - Stock Picks).

It's a Long Season

Opening Day is in April, the World Series ends right before Halloween. Short-term strategies that fail leave a baseball team too far down in the standings to make the playoffs. The same goes for investors -- 90% of those who fail to beat the S&P 500 do so by burning capital in short-term strategies that go awry. To have a chance at beating the S&P 500, you must:

• Diversify your portfolio by sectors and recognize that different sectors perform better in different environments.

• Select at least 32 stocks to minimize risk in any one company.

• Monitor relative positions and cut back on any position of more than 10%.

• Remember that conservative beats aggressive and that singles hitters beat home-run hitters.

• Also remember that long-term beats short-term. A company with good five-year prospects beats a stock with good one-month prospects. Make sure you know the difference before you invest.