A Three Step Plan To Investing

Invest for growth

Over the years I have made many good and bad calls regarding investments.  Don’t worry, you will too.

My experience, learning from my successes and failures, has helped me discover the kind of investor I am, my tolerance for risk, and the type of stocks I look for.  The journey was at times painful, stressful, and rewarding.  If this sounds scary to you, don’t worry – everyone goes through the exact same thing.  The concern, confusion and even fear regarding investing your own hard earned money in the stock market is there for everyone.  The important thing is to come up with a process that limits risks, appeals to who you are as an investor and makes you feel comfortable with the possible outcomes.  This process is not set in stone, is based on trial and error, experimenting, and will constantly change over time.  It is a process that everyone will and should go through.

I don’t claim to know everything, or that I am an expert adviser but I have come up with three basic tenants for investing which I try to constantly keep in mind and follow.

Here they are.

Rule #1)      Preserve capital:

  • All the clichés here apply but the most important one is this:  It Takes Money To Make Money.

Take a look at this chart.

Your Money % Loss % Needed to Gain it back
$10,000 -10% ($1,000) 11%
-20% ($2,000) 25%
-30% ($3,000) 43%
-40% ($4,000) 67%

You have worked hard to save this money and you want to keep as much of it as possible to work for you to make more.It does not take long to realize that the subsequent percentage gain needed to recover losses is more, sometimes much more, than the original loss.

You can’t do that if you keep losing money.

At first glance, my number one rule appears to fly in the face of much of the buy and hold strategies you hear and read about.  In fact some will even go so far as to say that if you own a stock you believe in and it drops, you should buy more.  This will lower your average cost per share and limit you potential losses.

This is a valid statement, however, you need to balance it against your tolerance for risk and how you want to constantly invest you money.  I prefer to not to have good money follow bad and limit my risk as much as possible.

This leads me to:

Rule #2)      Come up with a plan – Any plan – But make it yours.

  • Let’s start with rule number one – preserve capital.  At what point do you say “enough!” I don’t want to lose any more of my money.  Is it 5%, 10%, 15%?  It can be anything you want.  The important thing is to figure out what you are comfortable with.  For me, this magic number is based on how volatile the stock is but my threshold is almost always between 8% – 10%.
  • Secondly, and this is important, at what point do you want to sell?  And how much?  After all, no stock, no matter how good it is, goes up forever.  There are a whole host of ways one can approach this but let’s use the “comfortable” factor mentioned above.  At what point would you say I’m happy with this return?  Would 10%, 20%, 30% be good.  I think if you ask any investor if he or she would be happy with at least a 20% return on their money, year after year, they’d be pretty darn happy.  Generally, when I sell a particular stock I sell my whole position and then when I decide to reinvest that money back into another stock, I generally reinvest that whole amount .  In other words, if I had invested $10,000 made a 20% gain, and decide to sell, I would sell all of it, and when I found another stock, I will generally invest the whole $12,000.
  • This is the most subjective part of the plan.  But no less important.  Figure out what interests you and how to go about finding stocks to add to your watch list.  With over 5000 stocks between the NYSE and NASDAQ exchanges and twice as many Mutual Funds, it is easy to see how someone might feel intimidated by the prospect of finding stocks for a watch list.  But don’t worry about that.  Remember, I said to come up with a plan – any plan – just make it yours.  You could decide to be a dividend investor, a momentum trader, a value investor, contrarian, small cap, mid cap, large cap, pattern investor: or even any combination of the above.  My watch lists are the output of a couple different screens that I run.  There are plenty of good screens out on the internet, many of them free, and most of the more popular online investment brokers have decent screeners.  TD Ameritrade and  E*TRADE are two of the more popular online brokers with good screening programs.  Some of the better free screeners include Yahoo Finance , MSN Stock Scouter, and FINVIZ.

Rule #3)      Follow the money.

  • By this I mean, when and where are the most people investing the most money.
  • You can measure “follow the money” a number of different ways but perhaps the two best are by tracking the following:

Trading Volume vs Average Volume

Money Flow Index

When lots of people and big institutions buy a stock the volume of trades will increase.  If the daily volume increases significantly, greater than 40%, above the average daily volume,  AND the price goes up; that is usually a signal of a breakout.  A breakout is a technical trading term for a stock breaking though a particular buy point or point of resistance.  Of course high volume AND a price decrease can signal just the opposite pattern called a breakdown.

Money Flow Index is a good reference point to check if you do not see huge increases in price or volume.  The Money Flow Index gives an indication of the strength of a stock price with volume and is a good indicator of a reversal or confirmation of a trend.

Remember, when it comes to picking stocks, not every stock will be a winner and you will make mistakes.  Treat each trade as a learning experience and a chance to develop your investment style.  The key to investing is to preserve capital, have a plan for when to buy and when to sell (you can take a lot of worry out of this by automating these events) and doing your research and following your watch lists.

Good Luck, Do Well, and Have Fun!

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