How did you do in 2005?By the numbers, my portfolio had a good year. My picks were up 33% for 2005 vs. a 0% return for the Dow Jones Industrial Average and 4% for the Nasdaq Composite. But numbers aren't the only way to measure a portfolio's performance. The other ways to measure performance are far more squishy and subjective, but I think they're just as important for anyone who wants to make a consistent profit -- in good years and bad years -- in the stock market. They're so important because scoring well on these subjective measures keeps a portfolio on course over the long term and prevents a good year or two (or a bad year, for that matter) from leading a portfolio into dangerous territory. Here are the other ways that I measure my performance.
I'd give myself a grade of good on this performance measure this year: I did a decent job of taking what the market gave me by overweighting the energy and gold sectors. I do wish, however, that I'd put more money in utilities and transportation stocks. Did I keep the wind at my back at all times? Investing, to continue the sports metaphors, resembles batting in baseball. A successful batter still makes an out roughly two-thirds of the time. No player hits a home run every time up at bat. No investor makes money every trade. A successful investor strikes out at least 40% of the time, I'd guess. The difference between success and failure lies at the margin. Do 40% of your trades make money? Your portfolio is under water. Do 55% of your trades make money? Your portfolio is profitable. With so little separating profit and loss, it makes sense to me to keep the wind at your back as much as possible. To me, that means going long in periods of the year when market history shows stocks have a tendency to go up -- from the end of October to the end of January, for example. It means being invested in specific sectors when history, again, shows that these sectors outperform -- natural gas and oil stocks in March, April and May, for example. And it means staying away from even the most attractive stocks in weak sectors. It is, of course, possible for a stock to climb when the rest of its sector is down, but weak sector performance stacks the deck against that stock. I'd give myself a grade of good on this measure. For example, I largely stayed out of financials when interest rates were climbing, and out of technology until the end of the year.
Many investors who understand how this applies to the downside of a stock investment don't grasp that it applies to the upside as well. You can correctly identify an upward trend in the market, and in a sector, but still pick the wrong stock and miss out on all the profits. The goal is to create a match between the profit opportunity you identify and what you buy to participate in that opportunity. I did only a fair job on this measure in 2005. Buying one of the strongest railroad stocks, Burlington Northern Santa Fe ( BNI), was a smart way to participate in the upward trend in the railroad sector and in transportation stocks in general. But buying Cell Genesys ( CEGE) as a way to profit from the upward trend in the biotechnology sector created a huge mismatch between opportunity and risk. The opportunity was sectorwide, but by picking just one small-cap stock, I took on more individual-stock risk. I compounded the mistake when I kept Cell Genesys and sold off the Biotech HOLDRS ( BBH) position that gave me exposure to the entire sector. Today I'm looking at a 25% loss in Cell Genesys. If I'd held on to the Biotech HOLDRS, I'd be showing a 43% profit from that purchase. Did I stick to a trading strategy that I'm comfortable with? It's tough to stay in your own comfort zone when buying and selling, but I think it's essential. It's tough, because all of us see, from time to time, opportunities to make money that just require an adjustment to our normal investing behavior. This year, in October, I thought I saw a good opportunity to make money twice by short-term trading. First, after the energy selloff after Sept. 30, I thought adding volatile energy-sector stocks, such as Ultra Petroleum ( UPL) and Dril-Quip ( DRQ), would result in good short-term trading profits. Second, I thought I could load up on technology stocks, such as Arris Group ( ARRS), at the end of October and pick up short-term profits in the year-end rally.
I'm not especially good at short-term trading. I find it hard, as any but the most gifted technical analysts do, to pick short-term bottoms and tops with anything resembling accuracy. But I thought I could force profits from this situation despite my own discomfort with short-term trading. Because of my own discomfort with this trading strategy, I fell back on stop-losses for these positions. It all added up to quick losses of 15% or so when I did, indeed, miss calling the bottom for the stocks. I wound up getting stopped out of the positions before the stocks rallied. If I'd held onto Ultra Petroleum, Dril-Quip and Arris Group through the drop and to the end of the year, I'd be looking at profits of 21%, 33% and 23%, respectively. I'd give myself a grade of poor on this measure. Did I strike an appropriate balance between the long and the short term? This is a tough one. I certainly bought and sold more rapidly this year than in years past. Some of that change was, in my opinion, an appropriate response to the choppy nature of the stock market in 2005. Trends didn't last very long, and rallies were rapid and tended to end abruptly. One danger of seeing that pattern and investing to match it is that, as time went on, I tended to get impatient. I definitely sold some things this year -- Joy Global ( JOYG), for example -- way too early because I had become trigger happy. I saw a trend shift in the making and sold a stock that had a good way to run before the larger trend of a stronger dollar cut into company earnings. On the other hand, I consciously decided to hold most of my energy-sector stocks through the last quarter of the year, even though they weren't likely to burn up the track during that period. The hold decision, which I still believe in, was a tradeoff of (potential) short-term profits for (potential) long-term gains in 2006. I'd give myself a fair on this measure in 2005. This kind of performance scorecard is less satisfying than hard numbers -- you can't brag about the results at New Year's parties. But it does have one advantage: Last year's performance number doesn't carry over into 2006. The lessons of this subjective rating do. If I can learn from the past, I have a chance to be a better investor in 2006. And maybe the market will reward that.