Long Haul Stock Investing: You Need Working Rules for Success
By SmartProInvesting.com Stock Investing Team,
April 8, 2009
You must have seen from the events of the recent months that making money from stock investing is not for the faint of heart. If anybody spoke to you about the gains of the market without stressing the risks, he only stated half the truth. Now we all know better. Yet, everything said about that possibility of more-than-normal returns, when you invest in stocks, remains true. It's just that to hope to do so successfully, you not only need to dig in for a relatively long stretch, you also desperately need a set of proven rules to guide your actions. It's not so much of any complicated strategies as it is of a commonsense, disciplined approach.
Stock Investing Success
If you want to challenge yourself to a golden performance in the stock market in the years to come, consider building a set of operating rules to work with. Such rules provide a framework to guide your actions and minimise (even eliminate) the likelihood of decisions dictated by the emotions of the moment. Driving investment decisions by emotional dispositions often leads to unsavoury results. With a set of sound guiding rules, you only need to apply the discipline to stick to them. On the whole, that substantially boosts your chances of success. Why? Because you actions are based on principles that can stand, over time.
If you are working to draw up your stock investing rules, you can consider including some of these ideas:
- Discipline is Key
Most times, investors act on the spur of their emotions at a point that proper reasoning has taken flight. The market may be extremely bullish and they expect
it to ever remain so, or it is very bearish and they fear the market is dead and act accordingly. To perform more than averagely, you need to exercise the discipline to operate by your rules, not the fears or unbridled greed that can result from market trends. That should be your rule number one.
- Core Business Fundamentals, Not Price Action, Count More
Market price movements drive a lot of investor action. The price is moving up and you rush in to take advantage. Sure, taking advantage of opportunities for gain is the reason you invest. Yet, not all price movements add up. You need to be sure that the core business activities of the company support the action you want to take. Watching and following price may work for a short term, but is likely to fail you going forward, if not supported by business fundamentals. That's why you need to vigourously evaluate companies you want to invest in, except you're simply gambling. If a company's business is not trending well and there are real difficulties, but its market price is pushing up notwithstanding, can that be a good candidate for long-term investing? Even in the short-term, it can only be crazily speculative. Target companies based on your findings about their business strengths and potentials and you can plug in an wait. If the price is driving up and your analysis can support that trend, that's timely, too. If you can't explain what's going on or in fact, it runs counter to your expectation based on available information, you should spare yourself the agony. If your join in what you don't understand in this market, you will be left in the cold when those who undertstood it have pulled the rugs.
- Protect Your Capital & Keep Your Profits
That's easily a laudable investment objective, but how hard it is to accomplish! Yet, simple rules and the discipline to stay with them is all that it will cost. Big losses set you back. It takes so much to recover from a major loss. If you've lost 50% of your portfolio value in the current market downturn, it will require a 100% rebound for your portfolio to get back to its original position. Not impossible, but obviously a tall order. Your best bet: prevent huge losses. First, of your capital investment. That requires setting a limit of loss tolerance, even before you plough in your money. If you want to weigh issues and evaluate them while your stock is heading down, it could be substantially gone before you realise it. If you pre-set your action parameters, you act when conditions are met and that could save a lot of trouble. If you allow, say, a maximum of 15% loss on your investment, you're out by the time a N1 million investment is down to N850,000. Without a clear guide, you'll still be studying the trend and consulting "experts", even as the value hits N500,000 and less.
Even for your unrealised gains, you need that protection to ensure you don't lose them. If your stock is up 70%, that's great, but remember it's not in your pocket until you sell. If the stock is still heading up, there is certainly no justification for cutting short your gains by selling off a winning stock. But how do you ensure the sweet story doesn't suddenly turn sour? As often happens, the price can come cascading down suddenly and all your gain is gone before you realise it. Part of the difficulty is that the early price drop will seem like a correction. Most times, stocks on a power drive will still halt along the way at some resistance levels, but will power on after some correction drop. Thinking a correction may be the case could mean that you wait too long, just as selling at the least slow-down could mean selling prematurely. Your solution to all that headache: set rules you will follow, without any regret. Ensure that before a substantial part of gains already made on your stock could be gone, you've sold and crystallized your profit. The market is dicey and needs alertness, all the time. It certainly doesn't help your financial growth to watch gains accumulate and then fizzle off. Consider a trailing stop strategy or other protective system, but set it before you need it.
- You Need a Margin of Safety
When you buy, it helps your position to have a significant margin of safety. All major investors seek this margin of comfort. Simply put, it means you buy at a price substantially below the current valuation of the stock. The market today could be said to be ripe on this count: many key stocks are trading far below computed value. That minimises your risk of going wrong. Chances are more that the price will edge towards the real value, which is great for your investment. So decide on your acceptable safety margin and check that potential investments offer that much.
- Limit Your Exposure
It's great when a stock is performing well and you'd want all your money it it or in a particular sector that is thriving. You can call it a concentration strategy to maximise impact. Problem is that it is grossly risky. No individual stock performa well forever and no sector can be on a cruise all the time. The business environment is marked with ups and downs and individual companies and sectors have their difficult moments. Plugging large chunks of your resources into concentrated positions over the long haul will prove too risky and could cause a major damage. Your safer bet is to spread out. You need to specify your limit of exposure
in single stock position. Position sizing will help you limit risk and avoid finding yourself suddenly with paper investment that has lost all its value. Imagine if you invested heavily in once-solid Barings Bank. Or Enron. Or Tate Industries. Even Transcorp. You might be surprised, but we've seen a portfolio of multi-million value that consisted only of bank shares. What if there is a major upheaval in that sector? Limit your exposure with pre-set sizing limits.
- Know When to Sell
Investing for the long haul assumes you stay invested over a long term. You can call it a 'buy and hold' approach, but that's only if there is a preset strategy for exiting stocks that fail to advance your objective or which meet your sell conditions. if your stock hits a 200% gain but you watch it go down to a 40% loss because you must hold, you don't need a diviner to show that you won't get anywhere. At best, you drive yourself poorer. While trading stocks on frequent basis may not pay a non-trader who
has to bear costs of buy and sell transactions, sticking with stocks when it doesn't pay to do so will be as counter-productive. That's why you need some sell rules. When does a stock shout for sell in spite of your long term perspective? If you define your sell rules, you will avoid carrying dead horses, prevent losing major gains that accrued on your stocks and have the room to re-balance your portfolio in a way that advances the strength of your investment.
- Don't Ignore Signals
You also need to
decide how to respond to signals that emerge. Most market developments don't drop suddenly: hints are emitted, but often ignored by investors. If you want to do better, you need new rules for picking valid signals that throw up and using what is beneficial to your interest.
Don't Go to War Unprepared
Stock investing may not be war, but the hazards are as threatening. While the spoils of war are the reward of victory at battle, the ultimate price is the possible corollary. The stock market has always offered the opportunity to earn good returns, forget the bear market that may be all you see about the market presently. Yet, the potential to lose money is always as high, as the same bear market has driven home. Run, run, run, right? Not if you realise that there is no shortcut to making money, especially big money. Because that is still possible from the stock market, your best response is to go in better prepared. Now, you know it could prove bloody, so you can't leave your flanks open. A strong set of investing rules will help you position for the long haul and strive to find gold in the market.
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