Risk Management Investing

When it comes to investing in the stock market, you have to be humble.
Nobody is bigger than the market.
You can never predict a top and never predict a bottom.
Nobody’s that good.
If you’ve done your research and found the stock that you predict will give you a 20% return, there are still certain rules you need to stick to, in order to manage your portfolio correctly.

The following are five rules that I abide by. If you apply these strategies, your margin of safety and return on your money will be that much greater.

Rule #1: Invest in Market Leaders
If at all possible, try to invest in best of breed companies. Figure out who has the biggest market share in the sector, or compare each companies financials and you will know who’s the better company. In the long run, market leaders outperform the sector and command a higher P/E premium.

Rule #2: Buy in Wide Scale Stages
Never buy all at once. Like I said before, nobody is that good in predicating a top or a bottom. You need to buy in stages. With discount brokerages like TD Ameritrade and Etrade, commissions have come down so low, it shouldn’t be a costly issue.

Example: ABC stock at $20 and you plan to buy 100 shares.

Buy 25 shares at $20 and hope it goes down some more. Wait for it to go down 10-20%. Don't keep buying every time it drops 1%. Buy in wide scales and only add to your position if you believe it’s still undervalued (future prospects still look bright). Buy at $17, $14.50, and $12. Arrogance is a sin and if were to buy $20 all at once and the stock is at $12, that’s a 66% loss. By staging your buys in wide scales, you lower that % loss.

If the stock goes higher, please don’t chase. It only lowers your return and the stock might come right back down. Keep your money in cash and wait for a pullback and if it doesn’t, look for other stocks to invest elsewhere.

The stock market is like baseball. Each ball coming over the plate is the price of a stock. You don’t have to swing at every pitch that goes over the plate. Just swing at good pitches that are in the strike zone (bargain prices of good companies) and go for singles rather than home runs (buying in wide scale stages). You’ll strike out less and have a better batting average. That’s the disciplined investor.

Rule #3: Diversify or Die

You’ve probably heard the old adage “Don’t put all your eggs in one basket”. This is true when it comes to investing. Whether you have $100,000 to invest or $2000 to invest, diversification is important to protect yourself from downside risk.

The “all in one basket” portfolio example is much like gambling. It’s either lose big or win big. If the stock is down, you’re stuck in the mud waiting for it to go up. By diversifying, it allows you to stay in the game and trade the ones that are up. You can still get a stellar return with a diversified portfolio and lower the volatility. I advocate no more than 10% of your portfolio in one stock.

If you don’t have a lot of money to begin with, don’t be ashamed to buy 10 shares or even 1 share of a company. So long as you calculated a good return on investment factoring in commissions, 10 different stocks getting 20% is the same as 2 stocks getting 20% return. But you have reduced your risk.

Diversification also entails diversifying in different sectors. Usually if one sector is out of favor, another will pick up. That’s called “sector rotation”. If you were to buy all retail stocks for example, and the sector is in a slump, you’re stuck waiting for a rebound while others are handsomely profiting because their sector is moving up. Stocks tend to move in groups and if you get the sector right, normally you get the stock right too. This is why you need to invest in different industries to keep you in the game.

Rule #4: Buy, Sell a little, and Hold strategy
A big question always is when to sell. As a rule of thumb, if your stock goes up 15-20%, it’s time to ring the register and sell a little and let the rest of your position in the stock ride. You haven’t really made a profit until you sell. If it were to go back down, you missed that potential profit. But if you sold some, and it were to go down, you can buy back what you’ve sold. That’s called “trading around your core position.”

By not selling all of your position prevents you from kicking yourself if the stock doubles or triples in value. So I am not advocating a “Buy and Hold” strategy, but a more prudent approach of “Buy, Sell a little, and Hold strategy.”

Rule #5: Sell on strength, Buy on weakness
“Be fearful when others are greedy, and be greedy when others are fearful” – Warren Buffet

Most traders like to buy in a bull market (market rallying higher) and sell in a bear market (market correction). But as a contrarian value investor, I do the exact opposite. However, it’s easier said then done because it takes a lot of discipline. Nobody wants to miss a huge run up and greed sets in. But believe me, when the market keeps going up, you need to build your cash reserves because at any time, the market can change in a heartbeat. When the market is up and rallying in a bull market, sell a little into the strength. When the market is irrational and feels invisible in a bull market, cash is king!

Sooner or later, the market will correct itself and you will be ready to stage your buys.
Honestly, the best time to buy is when it feels most awful.

When the market’s crashing, there’s tons of negative news, and you’re patiently picking up stocks in wide scales while others are panicking and waiting on the sidelines because they have no cash to buy.