Limit Losses and Buy China

02/17/2009 10:43 am EST

Focus: GLOBAL

Paul Goodwin

Emerging Markets Specialist and Analyst, Cabot Heritage Corporation

Paul Goodwin, editor of Cabot China & Emerging Markets Report, offers some suggestions on what to buy and how to protect your portfolio.

Loss limits and equal dollar positions are key to building a sound growth portfolio.

Begin with diversification into growth, value, and income stocks, covering the spectrum from large-cap to small-cap stocks. The more holdings you have, the lower your risk, decreasing the likelihood that the failure of any one of them will deep-six your results.

However, it’s correspondingly difficult for a big rally by one stock to make a lot of money. For maximum results, you need a concentrated portfolio. And that requires following two rules to keep risk under control.

First, set loss limits that kick in at the close of a trading day, based on purchase prices. When markets are challenging—as they are now—your sell discipline should kick in at a minimum of 15% below your buy price. No exceptions. In supportive markets, you can push that limit to 20%. Intraday moves don’t count, unless a stock is clearly in free fall after bad news, and then, the quicker you get out the better.

Secondly, use equal dollar positions to build your portfolio. For an aggressive portfolio, divide the amount of money you have allocated into ten equal-dollar positions. The number of shares you own is totally irrelevant. If you have 100 shares of a stock that trades at $25 and 100 shares of one that trades at $50, your risk exposure in the second stock is twice a big.

A good way to follow another key principle—exposure to the Chinese market—is investing in an exchange-traded fund (ETF) called iShares FTSI/Xinhua China 25 Index (NYSEArca: FXI). 

The FXI follows the Dow Jones Industrial Average of China, representing 25 of the largest and most liquid Chinese stocks that trade here in the US.  As such, it serves as a snapshot of the health of the market—not rising as fast as the hottest Chinese stocks, but not falling as quickly either.

FXI is a good choice right now because it has been rising strongly since mid-January, and recent volume clues—specifically, above-average volume on February 4th and 5th—indicate increasing institutional interest in the future of Chinese blue chips. 

FXI offers a chance to benefit from the continuing growth of China without doing the detailed work to select likely winners from among all of the Chinese stocks that trade as American Depositary Receipts (ADRs) on US exchanges.

In mid-January FXI was trading at $23. Now it’s at $25. There is possible resistance at $31-$32 from December and January, but another piece of good news to silence the China doubters could sweep that all away. I think it’s a reasonable bet.

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