Golden rules to share market success
Published in Australian Opportunities Magazine - March 2007
Dale Gillham
During my seminars I always ask the audience how they select stocks to put in their portfolio and I must admit the answers always astound me. The most common responses are the newspaper, magazines and stock broker recommendations. Others include tips from mates, family, taxi drivers, they used the companies products and services or, stunningly, they liked the name of the company.
Let me say up front, this is not the way to select stocks if you want consistent profits. These methods are both inconsistent and ineffective.
The amount we invest also tends to change our perception of the risk we are taking and the research required to manage the risk. Usually this is because it is much easier to swallow when you make a mistake with $1,000 than if you make a mistake with $500,000. But let me assure you - the process you take to invest $500,000 or $1,000 should be exactly the same, as they both represent the same amount of risk.
What follows are the three golden rules you need to consider when selecting a portfolio to reduce your risk and increase your profits.
Golden Rule 1
Irrespective of the amount of money you have to invest, you should always take the same amount of time researching your options to ensure you are protecting your capital on each and every occasion.
Golden Rule 2
You should always aim to have between 5 and 12 stocks in your portfolio when investing in the share market. The trick is to not have lots of stocks with small amounts invested in each. Instead, you only require a small number of the right stocks with larger amounts invested in each.
This actually lessens your risk and increases your returns because smaller portfolios are easier to manage and represent lower risk. The more stocks you have in your portfolio the more work you need to do to manage your risk level.
It is far easier to select a smaller number of stocks that are rising in price. Therefore, the result is increased returns.
You will have less transaction costs in buying and selling stocks simply because a smaller portfolio will have fewer transactions.
Golden Rule 3
Never invest more than 20% of your total capital in any one stock. If you invest in the share market you need to accept that some stocks will fall in value. However, this rule will help reduce your exposure to risk, while allowing you to achieve good returns simply because you are minimising the amount of capital you could lose at any one time.
For example, if you invested $100,000 in five different stocks, you would be investing $20,000 in each stock or 20% of your total capital. If at the end of your first year one of the stocks dropped by 50%, you would lose $10,000 of your initial capital. But if the other four stocks had risen in value by 10%, then you would have made $8,000. Therefore, your total loss would be $2,000 or only 2% of your initial capital. In effect, you have minimised your exposure to risk by spreading your capital across a number of stocks.
