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Obviously, there are many strategies that can be used in stock investing, but there are certain characteristics to look for in any plan for investing. Before we can develop a strategy for investing, we need to have a set of criteria by which to judge if it is a good plan or not.
Building upon our previous discussions about common investor mistakes and stock-market myths, I offer the following eight criteria as the means by which to judge an investment plan - any investment plan. The degree to which a strategy stacks up well against these criteria determines its desirability. The very best strategies will satisfy the following eight requirements:
Much has been written about what the ideal point is for cutting losses. Some say it is 10%, that is, that you should never lose more than 10% on a stock trade. Others say you should never lose more than 8%. I have found that cutting losses this short leads to excessive trading and excessive losses, and does not allow a good stock enough room for normal day-to-day fluctuations. When cutting losses to 8% or 10%, it is extremely easy to get bumped out of a stock only to have it recover and begin soaring again without your being on board.
For this reason I prefer to take a radically different view of loss-cutting. I aim never to lose more than 3 % of my total account value on a single stock trade. As an example, I might set my stop-loss point back 30% from my purchase point and invest no more than 10% of my account's assets into a single stock. Therefore, I will not sell the stock unless it gets into serious trouble and falls 30%. If the worst happens and the stock does lose 30% of its value, I will have lost only 3% of my account's assets on the trade since I only invested 10% of my accounts assets into the stock. So, 10% times 30% equals 3%. I believe that this approach to loss-cutting is far superior to arbitrary rules which require cutting losses too short. If you can aim to lose no more than 3% of your cash on any one trade, it will take a long string of uninterrupted losers in order to seriously deplete your trading capital. Of course, there is nothing magical about the 3% number, but the point is to keep your possible losses from any one trade to a very small amount. Even in a market dip, it is improbable that all of your positions will drop to your sell point.
However, some approaches cause an investor to plunge a large amount of his capital into and out of the market all at one time. This is the type of approach which must be avoided at all costs. It is risky to enter any market all at once because it maximizes your ability to lose a lot of money in a hurry. One poor timing decision can result in a loss of a large percentage of your capital, and these drawdowns in capital really hurt you. A 33% loss of your capital requires a 50% gain on the remaining capital just to get to the breakeven point. It is also unnecessary to take such daredevil risks because most trends last long enough that there is plenty of time to get on board and a lot of money can still be made by entering a trend in several installments as it is developing.
Occasionally, one will hear statements such as "sell a stock once its earnings growth slows," or "hold a stock as long as its product looks good." Often, these types of statements are hawked as rules for investment. I want to make a point that these types of statements are not really plans at all, in and of themselves. They are far too subjective for the very tangible world of the stock market, where stocks are given a specific price every minute of every trading day. In order to be useful for decision-making by us mere mortals, the system used must tell the investor exactly when to buy or sell, and how much to buy or sell. How can you spot that precise moment when a company's product turns from good to bad, or when a company's earnings have "slowed?" Chances are, you can't. Since a stock's price generally reflects such events long before they actually happen, these subjective sorts of approaches tend to be a day late and a dollar short unless you are incredibly well-connected to the company in question. Even if you were well-connected, then you could be trading on inside information, which is against Federal law.
It is conceivable that if you could develop some non-subjective criteria about how to tell when a firm's product or earnings are losing their edge, you might possibly be able to develop a true (non-subjective) system around it. Even if you could do it, it would be different for every industry, making it very time-consuming to implement. Therefore, this type of approach is not very practical for the average person and definitely violates our requirement that our strategy not be time-consuming to maintain. There is a difference between subjective rules of thumb for trading, and a non-subjective system for trading. Learn to recognize the difference and you will be several steps ahead of the majority of investors.