What if the collective wisdom of the universe of stock investing could be condensed onto a single stock investing cheat sheet …?
You could say that would be pretty useful. Or it is just a bold claim that is bound to over-simplify.
Setting these concerns to one side, let’s just give it a go.
Words of investing wisdom
Investing and trading are big and complex subjects that can rapidly overwhelm people who are new to the field.
Pick up any book or read an article on investing and you will soon encounter pithy comments of famous investors, like:
- Investing is simple but not easy – according to Warren Buffet.
- The stock market is a voting machine in the short term and a weighing machine in the long-term – so said, Benjamin Graham.
- Know what you own and know why you own it – to quote Peter Lynch.
If you are a beginning investor you may be tempted to collect these kinds of quotes in the hope they contain some secret investing success formula. But I think the reality is that these nuggets of wisdom will only mean something to you once you have gained some experience.
Knowing yourself as an investor
I guess this could easily qualify as one of the hard parts. In order to adopt an investment strategy that is going to work for you, you have to know what kind of investor you are. Here’s why.
If you adopt an investment strategy that is too volatile for your comfort zone, when your investments turn down you will likely sell out at the worst time.
On the other hand, if you adopt an investment strategy that is too conservative for your tastes, you will likely abandon it when you see the market surge ahead while your portfolio stumbles ahead like a tortoise.
How can you know what kind of investor you are unless you get some investing experience under your belt? Well, unless you are super lucky you probably can’t.
Inevitably you are going to have to do some learning by doing and some of that might come at a price.
Yes, you can and you should paper trade before you trade with money particularly in the short term. But you will almost certainly find out that you will only understand how you cope with risk once you have skin in the game, i.e. money at stake.
Oh, and by the way, the ancient Greeks thought that self-knowledge was a good idea. Written on the entrance to the Oracle at Delphi were the words – “Know thyself”. In Greek, of course.
Risk tolerance, risk appetite
It comes down to knowing your risk tolerance, and your risk appetite.
Your risk tolerance means how much loss you are willing to accept when things turn bad. For example, if the market turns down by 10% and your portfolio drops by 15% and you are OK with that, then you have a higher than average risk tolerance.
However, if the market turns down by 10% and you start to sweat bullets if you see your portfolio drop by 5% and you want to fire your broker, then you have a lower than average risk tolerance.
Risk appetite usually follows risk tolerance. That is to say, if you have a high risk tolerance you will probably also have a high risk appetitive. So if you see the market going up by 10% you will want to see your portfolio going up by at least 10% and preferably 15% or more.
However, if you are one of those really unfortunate individuals who has a low risk tolerance but a high risk appetite then investing is going to be a real rollercoaster.
Active or passive
Another aspect of your investing style you will need to determine is whether you want to be an active i.e. hands-on investor or a passive i.e. hands-off investor.
This is related to your level of financial sophistication but it is also a lifestyle choice. Do you want to be constantly checking and adjusting your investments or whether you want to leave them on autopilot?
To be an active investor you will need to work on your financial education. That doesn’t necessarily mean you have to become a rocket scientist. But if you are going to be an active investor, changing your positions frequently and you’re not really sure what you’re doing then that is a sure formula for losses.
If you adopt a more passive approach to investing then you won’t necessarily need to be financially super-sophisticated. Of course, financial education is always going to pay off even if you do choose a very passive investing approach.
As the name suggests, active investing means closely monitoring the markets and your investments and making frequent adjustments. Active investors often hold positions for the short term of weeks, days, or less. It also tends to mean taking more positions in individual stocks and fewer positions in broader funds.
Passive investing means investing in a number of broad funds, maybe with some individual stocks thrown into the mix. The ultimate passive investing is handing your account over to an account manager and letting them make all the investment decisions.
Actively managed funds and passively managed funds
The active vs passive division also applies to the way funds are managed.
You can buy mutual funds and Exchange-Traded Funds, or ETFs that are actively managed. You can also buy mutual funds and ETFs that are passively managed.
An actively managed fund is where the fund manager is making frequent adjustments to the fund in accordance with the investment strategy of the fund.
A passively managed fund usually just automatically makes adjustments to track a specific market index.
Actively managed funds usually have higher management fees because of the greater degree of human involvement in the management of the fund. Passively managed funds should have very low management fees.
Many actively managed funds will be pursuing an investment strategy that seeks to match and beat a specific index. There will usually also be at least one passively managed fund that tracks the index.
There’s an important question that investors who buy actively managed funds should always be asking themselves. Does the added value and performance of their fund cover the added cost of management fees over and above a passively managed fund that follows the same strategy?
If you find you are into actively managed funds in a big way, you will start to monitor which funds perform well and which funds underperform. You will quickly discover that the whole fund and fund manager ranking business is a big deal. An online search of top fund performers will result in a barrage of useful ranking information.
There are a few facts about the performance of actively managed funds that you will need to know.
At least two-thirds of fund managers underperform their benchmark and the market. 1)Source: Financial Times “Active managers fail to beat the market again” The exact percentage varies depending on whether you look at one-year returns, three-year returns, or longer, but it is always way up there around 80% or higher.
The fund hopping trap
It is easy to get sucked into kneejerk reactions switching your funds around trying to chase the top performers. That is a bad idea because often last year’s top performers will drop in the ranking next year.
There are two factors at play here.
Each fund is following its own defined strategy. They are obliged to do so by the regulatory bodies. The fact is that the strategy that outperforms for one period will underperform for other periods. The other factor is how well an actively managed fund performs against its own benchmark and as we said before its own benchmark will be the index that matches the strategy it is trying to track.
The point here is that let’s say you decide on a mix of funds that follow a mix of strategies on the basis that they will perform well in the long run, while giving you some diversification and downside protection.
That means you have to give them the long run to have a decent chance to perform.
If you drop one fund and replace it with another because it didn’t do well one year, you will kick yourself when you see it jump up the rankings next year. You can easily find yourself selling low and buying high.
Long, intermediate, and short term
One important factor in your approach to investing is whether you hold positions for the long, intermediate, or short-term. There are other designations like day trading or scalping but these trading approaches are less like investing and more like having a full-time job.
For our purposes, long-term means a year or longer, intermediate-term means a few months up to a year, and short-term means anything from a few days to a month or two.
When you start looking at price patterns over time you will start to see the same patterns playing out over different timeframes. But, having said that, the longer-term patterns tend to be easier to see and the short-term patterns can easily seem like noise.
There are some simple facts to bear in mind when you choose your investing period.
Gains on positions held for more than a year tend to be taxed at a lower, capital gains rate whereas gains on positions held for less than a year will likely be taxed as income and therefore at a higher rate.
The more frequently you make changes to your positions, the more you will lose through slippage, bid-ask spreads, and any commissions.
If you choose to hold positions for the long-term you will have to get used to holding on and riding out the shorter-term ups and downs.
Brokers for the 21st century
Brokers come in all shapes and sizes these days. Online discount brokers are now the norm and competition between the big names in this industry has driven commissions down to zero or close to zero.
You can also get investment advice from your retail bank. The chances are that they will recommend a small mix of mutual funds and help you set up an IRA and automatic contributions from your checking account into your IRA. This may well be all you need if you want to take a hands-off mostly passive approach.
So-called full-service brokers still exist and many of the main brokerage providers will hook you up with a full-service investment advisor if you meet the account minimum requirements.
One thing I would say. If you are going to work with a financial advisor make sure that they are working for you in a fiduciary capacity and not on a commissions basis.
A relatively recent innovation is the roboadvisor.
A roboadvisor will actively manage your funds for you according to a strategy established by your account manager following discussions with you on your investing goals. You can also set up an account with many of the main brokerage providers as an IRA working with a roboadvisor.
Roboadvisors usually work with a set number of ETFs. They will move your funds between these ETFs according to the strategy set and often in order to minimize your tax liabilities.
Investing through your employer
If you have a job, your employer may well operate a 401k plan and offer to match. Certainly, you should max out whatever your employer offers since matching is basically free money that you would be otherwise leaving on the table.
401k plans usually operate through one of the main financial institutions. So you will likely find that within your plan you will be limited in the funds that you can select.
That means if you want to actively manage your investment portfolio, then you will have to open a regular brokerage account.
Within the realm of investing there are different divisions and categories. Some of these are obvious and each is a subject in its own right. Each of these can be used to categorize a particular stock or a fund.
The first to look at is the market capitalization which is either large-cap, mid-cap, small-cap, micro-cap. It is the measure of the total market value of a company.
- Large-cap is companies valued at $10 billion or more.
- Mid-cap is companies valued between $2 billion and $10 billion.
- Small-cap is companies valued at $300 million to $2 billion.
- Micro-cap is any company valued below $300 million.
Industry or sector.
Each company belongs to one and sometimes more industries and each industry belongs to a sector. The generally accepted classification divides the whole market into 11 sectors. These sectors are.
- Communications Services,
- Consumer Discretionary,
- Consumer Staples,
- Real Estate,
Sectors are important for many reasons, and here’s a big one. Many institutions have too much money to move between individual stocks only, otherwise, they would drive the prices crazy. Therefore they will tend to move funds in and out of whole sectors.
Amazing! that word has now made it into the dictionary.
There are a variety of strategies. Some of these are opposites and some can be combined. Here are some terms and their common meanings.
- Value – means looking for companies whose market valuations have not yet recognized their full value.
- Growth – means finding companies that will grow in revenues and earnings and whose market price will increase as a result.
- Quality – in some ways closely related to value, but really the focus is on finding companies that have very solid financial balance sheets, strong brands, and excellent management committed to delivering and preserving shareholder value. Warren Buffet is renowned for finding and holding positions in such companies
- Momentum – means taking long positions in stocks or funds that are gaining in value on the assumption that they will continue their upward move. You can also adopt a momentum strategy on downward trends with short positions or options.
- Relative strength – relative strength investing is a refinement of momentum investing. On the upside, it means taking long positions on stocks or funds that are showing more strength in their price movement than others. You can also use relative strength to invest on the downside on weak stocks with short positions.
- Low-volatility – this is an investing strategy that focuses on reducing the downside risk while maintaining upward potential
- Income – means investing in a portfolio that generates income, either as stock dividends, bond coupons, or rents from real estate.
- Contrarian – means doing what most other investors are not doing. There are many ways to do this. One way is just betting against the general trend of the market and hoping that it turns and you can profit from it.
- Index – we already touched on this. It can be as simple as buying and holding a few funds that track some major market indexes.
- Aggressive – there are different ways to be aggressive when you invest. It normally means that you take positions on the basis of first indications of a new trend without waiting for confirmation of that trend.
- Conservative – tends to mean the opposite of aggressive. It can mean taking positions in more stable funds or stocks. It also commonly means waiting to get more confirmation that a new market trend is being established before acting upon it.
There are some terms above that might not be familiar.
The generally accepted wisdom is that it makes sense to diversify your portfolio. Taking positions in different funds and different stocks from a variety of sectors with a mix of large-cap, small-cap, and some that are growth, some value, etc. is a good way to spread the risk of your investments tanking if one of your holdings drops.
It is just the investing equivalent of not having all your eggs in one basket. Makes sense.
Again this is really a big subject but we are trying to keep it simple.
You have to have a system. This is especially important if you investing in an aggressive and short-term way. But equally well, if you invest conservatively you will want to stick with your strategy.
A system is a specific strategy that preferably has a proven track record of sustainable profits over different market conditions. The system will need to define for every position:
- The entry price,
- The exit price at a loss if the market turns against you, and,
- The exit price at a profit if the market does what you want.
All of these price levels should be defined before you enter the position.
The important point is to stick with your system. Most successful investors and traders will have stories of the losses they made when they abandoned their system and the regrets they have as a result.
Questions and answers
Q. What is the trick to investing in stocks?
A. Use a proven system to find stocks. The system needs to define your entry price, the price you exit with a profit, the price you exit at a loss if the market goes against you. Put your emotions to one side. Stick with your system and ignore the news and financial gossip.
Q. How do you know what stocks to buy?
A. Look for stocks with a healthy balance sheet, a five-year history of growing revenues, growing profits, and increasing dividends, a dominant market position, an unassailable brand identity, that sells products and services in growing or stable markets, with excellent management and a massively undervalued stock price. If you do find stocks like that please send me an email.
Q. How do you cheat on the stock market?
A. There are some classic ways to cheat on the stock market. These are all illegal, so please do not try this at home.
Publishing fake news or information about a company to either drive its price up or down.
Pump and dump schemes often involve fake news. The classic way for institutions to do this is to take a large stock position or call options on a stock and then create media buzz. Then email or call their clients to get them to buy the stock. That is the pumping part. After the price has risen as far as they think it can go, the institution sells the stock. That is the dumping part.
Spoofing the tape involves taking a long position in a stock and then placing a very large sell order for the same stock at a much higher price. Other investors see the large high-priced sell order and assume that it is valid so they buy and bid the stock price up. Just before the price reaches the level of the large order you sell your initial holding for a profit. The same process can be applied on the downside.
Wash sales are another way of cheating. Wash sales involve buying and selling the same stock at the same time to create high trading volume. Other investors see the high volume and assume it means there is a lot of interest in buying the stock.
Insider trading is another classic. When the brother or cousin of the CEO of a company suddenly buys a load of deep out-the-money call options just before unexpectedly good news about the company is made public. That is a sign of probable insider trading.
Years ago inside traders often operated through banks in a small town in a country in Europe that I shall not name. It was so predictable that other people in the industry could effectively inside trade themselves just by copying the suspicious trading activity of a few known bank branches.
The funny part is they didn’t even have to know the inside information to benefit from it.
All of these are illegal and can land you in jail and/or paying big fines.
In unregulated markets like the current markets for cryptocurrencies, these kinds of schemes are very common.
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The cheat sheet
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