Trimming Winners Can Be a Winning Move

08/14/2013 12:00 pm EST

Focus: STRATEGIES

John Heinzl

Reporter and Columnist, GlobeInvestor.com

Recently, John Heinzl of the Globe and Mail was asked a question about trimming a profitable stock in order to free up some opportunities to make some other investments and here's his response, and what it means for you.

I've seen a significant increase in some of my dividend stocks in the last six months—Magna is one example. I am tempted to peel off some profit and invest in other stocks in the portfolio that may have had a dip. Can you comment?

Let me tell you a quick story about a friend who had a stake in Research In Motion (long before it changed its name to BlackBerry). As the shares soared in price, the stock accounted for a sizable chunk of his portfolio—well into the double digits. I urged him to sell a portion of his holdings to lower his risk, but he was so convinced of (RIM's) bright future that he held on.

We know how that worked out.

That's an extreme example—and I don't mean to compare RIM to Magna—but it illustrates why it's important to keep your investments well diversified.

In my own portfolio, I try to manage risk by capping the weighting of each stock at about 5%. Fund managers often place similar limits on their holdings, which necessitates trimming winners when a stock exceeds the limit. The rationale is simple: If a stock's weighting is excessive and something goes wrong—see RIM—the portfolio will get thumped.

It's all about controlling your risk. That said, it's not always easy to do. One of my stocks—Enbridge—has posted hefty gains for several years and now accounts for nearly 6% of my portfolio. I haven't trimmed it, because I think Enbridge has plenty of growth ahead, and because the weighting isn't egregiously out of line, but I doubt I'll be buying more shares.

Because I am still adding money to my portfolio, I can rebalance by allocating cash to new stocks or to those that are underweighted. I have not studied Magna and am not in a position to comment on the company's prospects or the outlook for the stock. If you know the company thoroughly, are comfortable owning the shares at current valuation levels, and if the stock's weighting in your portfolio is reasonable, then you may want to do nothing. The fact that Magna's share price has roughly doubled in the past year is not, in and of itself, a reason to sell. The rise may be justified.

On the other hand, if Magna—or any other stock—accounts for such a large percentage of your portfolio that a setback in that company would have a material impact on your portfolio—and on your emotional well-being—then you may want to consider trimming back. You'll probably be upset if you sell part of your stake and the price keeps rising, but you'll save yourself some grief if the shares run out of gas.

The same principles of diversification apply to sector weightings. A portfolio of 20 stocks—each weighted at 5%—isn't diversified if all of the stocks are in the same industry. You need to spread your bets across multiple sectors—financials, pipelines, industrials, real estate investment trusts, energy and consumer staples, for example—to achieve the benefits of diversification. Just as with individual stocks, one way to accomplish that is to put a cap on your exposure to each sector.

Diversification is especially important for Canadian dividend investors, because it's easy to go overboard on a few sectors such as utilities, pipelines, and banks. Investing a portion of your funds in the US market—which has a much broader selection of global consumer, health care, and technology names—can help. Adding broadly diversified exchange-traded funds (ETFs) to supplement your individual stock holdings—or going with an all-ETF portfolio—is also an option.

Read more from the Globe and Mail here…

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