By Sam Eder. Get updates of new posts here.
It all comes down to this.
You have read all the books. Stalked all the blogs. Done all the courses you need.
You’re ready to create the future you deserve by investing in the stock market.
But have you set yourself up for failure or success?
Everyone has heard the horror stories of investors who meticulously research every facet of their chosen stocks, only to come unstuck as soon as the battle begins.
It’s different in the trenches than on the sidelines. Sometimes you get your butt kicked, while at other times things are as easy as you hoped they would be.
To give yourself a fighting chance of success, you want an investing strategy that is simple, robust and insightful.
To do this you need to make sure it includes all of the following ingredients.
Ingredient #1: Magnetic Goals
Goals inspire you to make the right choices about how to invest and compel you to take the right actions when you are investing.
In your investing strategy you should be clear about exactly what you want to achieve from the markets, then you will be much more likely to get it.
Good top-level goals come in two parts:
- A specific dollar amount you wish to make (perhaps to achieve financial freedom);
- A very clear picture of what it is that money will get you (and your family).
Saying you “want to make as much money as you can” is not helpful, so stop right there if that’s you.
Magnetic goals should also be made in conjunction with all “stakeholders”. Not considering your partners’ hopes and dreams is a sure way to create difficulty for you down the track.
Ingredient #2: An Insightful Model of the Market
A model of the market provides you with a big picture view of the global landscape.
In your investing strategy you should answer at least the following questions:
- How do you think the global financial system works?
- In what countries are there opportunities to invest?
- What type of investment strategies are likely to work?
- What are your specific edges or advantages?
- What tools do you need to have to invest successfully?
The answers to these questions, along with your goals, serve as a guide to how you will apply the rest of the essential ingredients.
Ingredient #3: Carefully Crafted Strategy Objectives
Strategy objectives are the evolution of magnetic goals into specific targets for return on your investments.
In order to achieve your overall goals, you divide your investing capital into a number of different tactical strategies.
For example, you might decide to allocate 40% to the stock market, 40% to investment properties and the remaining 20% to active trading strategies. Each of these is its own investing system within the overall strategy.
For each of these investing systems you should have two objectives:
- A targeted return (i.e. I want to make 10% a year by buying Exchange Traded Funds);
- An acceptable drawdown (i.e. I am prepared to risk 10% a year to make 10% a year).
Ingredient #4: A Position-Sizing Model that Achieves Your Objectives
Position sizing is where the magic happens.
Position sizing is the “how much” stock to buy on an individual trade question. Most people put very little thought into this area, but it will be responsible for the majority of the variance of your investing performance.
How much to buy when you trade should relate back to your specific objectives in ingredient #4, which in turn links back to your magnetic goals.
Can you see how it all comes together now?
When you understand position sizing at a deep level, you can also do things like risk market money instead of your own, or scale into the best opportunities for outsized gains.
Ingredient #5: Awareness of the Market Type
Would you invest the same way no matter what the market is doing?
If the markets are tumbling and all around you is a sea of red, it will not serve you well to apply the same approach when you are surrounded by skyscrapers of green.
This is where most investors go wrong. They buy and hold – even in bear markets!
A successful investing strategy caters for different market types and applies different investing systems to each one.
Ingredient #6: Mental Preparation like an Elite Athlete
Here we borrow a lesson from sports psychology.
Elite athletes prepare for their event mentally as well as physically.
- Visualise themselves winning;
- Mentally rehearse perfect execution;
- Plan what they will do if things go wrong.
As investors we want to do the same three things before we place a trade.
Ingredient #7: A Damn Good Set-Up
Would you rather buy a cash-rich stock making bucket-loads of profits that is undervalued by 20%, or a stock wallowing in debt and dramatically overpriced?
I know which one I would choose.
Set-ups provide you with the conditions you need to have in place before you enter into an investment. For example, your set-up could be:
- We must be in a bull market;
- The stock must be at least 20% undervalued;
- The stock must have a return on equity of 25% or greater.
Once you have these conditions you then move onto ingredient #8.
Ingredient #8: Stalk an Entry like a Hunter
Patience is a virtue.
Top investors don’t jump in at the first sign of promise in a stock. Instead they stalk a low-risk, high-reward entry point for their trade.
To do this, some investors turn to technical analysis. Price patterns are based on the same market psychology so they repeat themselves.
By waiting for a technical show of momentum, they can buy into a value stock as it’s beginning its journey up – instead of falling into the much-feared value trap.
Ingredient #9: An Unbreakable Exit
A good investing strategy has an ironclad initial stop-loss.
Taking a loss is not to be feared. It’s a natural part of investing and should be seen as simply a cost of doing business.
The best stop-losses are based on the market. They are deliberately hidden in places that are difficult to get to, such as below a support level.
Ingredient #10: A Specific Profit Objective
Know when to get out before you get in.
Prior to entering into any investment, you should have a very clear idea of what you are planning to achieve.
Without a specific profit objective it becomes difficult to make decisions about when to take profit. Should you take your money off the table or leave it there for a big win?
These decisions are difficult in the heat of battle so come armed with the right decision-making framework.
Ingredient #11: Complex Exits
Have you ever had a winning stock turn into a losing one?
A fully developed investing strategy does not let good trades turn bad.
A skilled investor has a number of exits that protect profits, achieve outsized gains, and consider opportunities and risks that the market presents.
Ingredient #12: A Scientific Approach to Improvement
In his book The Tipping Point Malcolm Gladwell suggests that it takes 10,000 hours or practice to master a skill.
Mozart took 10 years before he was able to compose his first masterpiece and Bill Gates notched up thousands of hours programming before he had the skill and insight to build Windows.
Importantly, not only do you need 10,000 hours of practice, but it needs to be “good” practice. There is no point practising doing the wrong thing!
As an investor, the more experience you gain the better you will become. So long as practice is structured and scientific.
After you have started to execute your investing strategy in the market, make only controlled changes. Isolate problems and test changing one variable at a time, just like a scientist conducting an experiment would.
This means that you are knocking up the hours of the right type of practice and steadily improving your investing as you go.
Ingredient #13: The Master Investor Mindset
Master investors think differently than the rest.
They tend to do the opposite of what amateurs do. This does not have so much to do with their market knowledge, rather it has to do with their own mindset.
Too many investing strategies focus on stock-picking first and the mental game last.
Seek to model the routines and discipline of the investing masters, rather than being distracted by the next “hot” technique that comes along.
The master trader mindset has a mix of the following traits to model:
- Optimism about the future;
- Ironclad discipline;
- Confidence in their trading plan;
- Humility; and
For some investors, it also includes a deep connection with an inner guiding power.
Now over to you…
Any investing skills you gain now will last you a lifetime.
The sooner you get started, the more you will benefit from the compounding returns that you will create.
So it’s time to be smart about it.
Write down your investing plan and include a section on each of these 13 essential ingredients. Start with one at a time. Pick the one that sticks out to you as needing attention or begin from the top and work your way down.
Your investing account will thank you for it.
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About the Author
Sam Eder writes at spoonfedinvestor.com about how to master the art and science of investing. If you enjoyed this article, join his newsletter or get the free report: The Honest and (Somewhat Brutal) Truth about Investing in 2014.
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