One of the key criteria to astute investing is to consider when and how you will take your profits - in other words, you need to consider your exit strategy before you invest. Most investors never give this any consideration because when they invest they expect the asset to rise. And while the asset may rise, the value of the asset is not realised until you sell. Consequently, this is considered unrealised profits as the asset could fall in value. Therefore, you need to consider how and when you will exit if your investment turns sour or does not perform as expected.

Unfortunately, many investors mistakenly believe that if they have not sold a share that is falling in value then they are not losing. But let me demonstrate why the opposite is true.

If I buy a blue chip share that is rising in an uptrend, I know with high probability that the stock will rise a minimum of 20% in price over the next 12 months. Let’s assume I invest in five stocks throughout the year. Four of the stocks rise in value (all by 20%) and only one makes a loss (also by 20%). Now let’s convert this into dollar terms. If I invested $1,000 in every stock then I would have made $200 on each winning trade and lost $200 on the losing trade; therefore I would make $800 and lose $200, which would give me a net profit of $600 or a 12% return on my capital of $5,000.

Now let’s assume I decide to hold onto the stock that was falling in value, because I believe there is a chance it will turn around and start to rise. However, by the time it has decreased by 50% in value I realise that this is not going to happen. So what is the effect of this on my portfolio? On the losing trade, I lost 50% or $500, meaning the unrealised net profit changes to only $300 ($800- $500 =$300) or 6% profit on my $5000 capital. By allowing the losing trade to fall below 20% halved the return on my portfolio from 12% to 6%.

The longer a stock continues to fall the greater the effect on your overall profitability, which is why it is so important to ‘cut your losses short and let your profits run’. In essence, allowing your losses to run into bigger losses turns a good investment strategy into an average one.

I was recently talking with an auditor of self-managed super funds who claimed that more than 90% of the funds he audited were either running at a loss or achieving at best a 5% return.

The poor performance was simply attributed to the investors’ lack of knowledge in how to select stocks and how to manage a portfolio. Unfortunately, this is a common problem for many investors who are attempting to invest directly in the share market.

In my experience what investors need is a practical framework that will allow them to select stocks in their portfolio that have a higher chance of ensuring they are consistently profitable. Therefore, my aim in writing this article is to provide you with a set of guidelines that will enable you to construct a portfolio that will consistently perform year in year out.

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 included tips from mates, family, taxi drivers or the fact that they liked the name of the company or they used the companies’ products and services.

Let me say up front, this is not the way to select stocks if you want to consistently profit; these methods are both inconsistent and ineffective. What I have discovered is that most people spend more time deciding what to eat at a restaurant than they do selecting shares to buy. As individual investors we usually only have a small amount of money to invest, and it is because the amount is small that we often give little or no thought as to how or where we should invest this money in the share market.

If you were to invest $500,000 in an investment property right now how much time would you spend learning and researching not only the right way to do it, but the right property to invest in so that you get a good return? Your answer, no doubt, is probably lots of time. Now let’s assume you wanted to invest $500,000 in one stock (although not advisable), how much time would you invest in learning and researching not only how to invest in the share market, but how to select the right shares so that you invest your money safely and get a good return? Again, the answer would be a considerable amount of time.

The amount we invest, however, tends to change our perception of the risk we are taking and the research required to manage that 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

Pick up any investment magazine and you will undoubtedly find an article sprouting the importance of investing for the long-term to achieve financial independence. And while this is true, you will often find that the article favours one particular investment over another depending on the writer’s bias. Indeed, the perennial debate comparing the returns on shares with the returns on property continues year in, year out depending on market conditions. If the writer has interests in the share market then the article will usually favour shares; but if the writer is a property investor then property comes out in front. So which is the better investment vehicle? And why do we get conflicting answers in this debate? I will address these issues in this article, as well as discuss why a long-term ‘buy and hold’ strategy in the share market is financial suicide.
 
Before we get started, let me clarify what I mean by long-term. Generally, the perception is that to yield an adequate return on any investment you need to hold the asset for 10 years or more. And while I would argue this is the case in the property market, the same cannot be said for the share market, which I will demonstrate to you throughout this article.

As a share trader I could write this article in favour of shares, however, I am also a property investor and believe that any intelligent investor needs to be in both markets. The truth of the matter is that it is very hard to compare these two markets, simply because we are not comparing apples with apples. There are many different variables to consider when investing in either of these markets; for example, leveraging, taxation, interest rates and holding costs to name a few. Then we need to consider what aspects of these markets we compare to provide a fair and unbiased analysis. Do we compare the All Ordinaries Index with the Melbourne property market, the Victorian property market or the Australian property market? Do we compare raw capital growth or capital growth and income? The combinations are endless and as evidenced in other articles, it is possible to deliver any outcome depending on your bias and make it look like we have settled the dispute once and for all.

If we examine the share market over the 10 years from July 1992 to July 2002, the All Ordinaries managed 92% growth rising from 1643.60 to 3163.20, which sounds impressive; however, this is slightly less than 7% per annum. In any good investment property you would have doubled your money within 7 to 10 years, which is better than the 7% return had we invested only in shares. If we examine the 20 years from July 1982 to July 2002 the All Ordinaries rose 671%, which is better than 7% per annum, but only because of the bull run (a period of market optimism and rising values) of the late 1980’s.

If we analysed the returns on the results above using capital growth over a 20-year period then shares outperformed property, although not by much. However, if we only look at the last 10 years then property has outperformed the share market and it is generally the comparison of this one variable that spurs on the perennial debate between the two investment mediums. In my opinion both investments vehicles are essential for accumulating wealth as each assists you to invest in the other, given that shares provide the cash flow to invest in property and property provides leveraging opportunities to invest in shares. 

As I mentioned, property is a long-term buy and hold investment strategy where ‘time in the market’ yields good results. When buying a property today it will remain relatively unchanged as an investment for decades with the exception of general maintenance requirements. Shares, on the other hand, should never be treated as a long-term investment, rather they are a short to medium-term investment vehicle where ‘timing’ the market is far more important than ‘time in’ the market. In fact, timing the market is everything simply because it is about buying low and selling high, which is where the savvy investor has a huge advantage. This is because shares are organic and consistently changing as a result of stock splits, takeovers, delisting and many other market actions that take place. A share bought today will generally not be the same share in the next decade.
  
Buying a good performing property portfolio for the long-term is a simplistic approach and will yield high returns if you buy in good capital growth areas. For example, Melbourne property has risen on average at a rate of 8% per annum since recorded history. Buying and selling property over the short-term, however, generally yields very little results due to the high transaction costs and long periods of low growth. Indeed, it is a well known fact that property generally has strong growth for two to three years within a ten year period, and then only increases marginally better than inflation during the other seven years.

The reason why most of us hear the words ‘buy and hold’ or ‘it is time in the share market that yields returns’ is because the financial industry cannot time the market. Many of you would have heard the industry catchcry that you need to hold a portfolio for 10 years or more to yield an adequate return. In reality, this results in the investor experiencing a rising market for 30% to 50% of the time, to compensate for the years that the market is moving down or sideways. If you don’t believe me, just look at the returns on managed funds over the past 10 years. At least 80% have underperformed simply because funds are too large to manoeuvre with any speed. Therefore, to accept that time in the market is more important than timing the market is probably the greatest down fall of anyone wanting to beat the market average.

While the recent sub-prime mortgage market meltdown has created significant volatility in the share market, it has also brought with it the graphic realisation of the close relationship that exists between the share and cash markets. One such relationship is the currency carry trade between the Australian dollar and Japanese Yen, which involves borrowing Japanese Yen at low interest rates to invest in high growth investments in the Australian markets.  While the Australian dollar was rising against the Japanese Yen, which it did by slightly under 14% to the end of October, this strategy was proving to be very profitable. However, in November the Australian dollar fell away against the Yen to around 4% eroding any gains and in turn reducing the inflows of cash into the Australian markets. Obviously many investors would be considering whether they would continue with this strategy or if they should pull their money out. If this occurs we may see some downward pressure on the Australian cash and share markets. That said I expect the Australian dollar to strengthen in the not to distant future, therefore I do not believe there is cause for concern right now.    

 So what can we expect in the market? 

As expected the market has risen this week and is looking surprisingly strong given that we have now experienced a 5 per cent rise in the past two weeks, with more than half of the rise occurring this week. Even though the market looks bullish right now there is still a high probability of it turning to fall away in late December or January, which may just result in the current rise becoming what is known as a ‘suckers’ rally. If the market does continue to rise throughout next week, my opinion may change to being more bullish as there is still a small probability that the market may rise through to late December or into mid January and make a new all time high. As I have said previously, right now it pays to be conservative. While there a number of stocks looking quite bullish, it may benefit the inexperienced to wait for the market to decide on a direction before investing.             

The ASX launched its CFD platform on 5 November with 16 listed ASX equities and in less than a month it now has 50 listed equities, foreign exchange, indices and gold CFDs. While the ASX brand adds creditability to this product, I am concerned that it may give the retail market a false sense of security believing CFDs are low risk simply because more and more individuals are being attracted to trade this highly leveraged market when in my opinion they lack the knowledge and skill to do so.

Over the past month, the overall market has fallen, yet the volume of trading on CFDS on the day following a market rise increases substantially, while the opposite occurs on days when the market has fallen away. This indicates that those trading CFDs are very emotional and uncertain of the market direction, which in my opinion is a recipe for disaster. Remember, there is a saying in the share market that trading is the transference of money from the ignorant to the well informed and right now, it appears this is certainly the case in the CFD market.
    
So what can we expect in the market?

During five of the last six weeks, the All Ordinaries Index has closed lower with the market falling 7.27%. While the volatility has continued this week, the market has found some support and is rising which may see it close higher in only the second time in seven weeks. In my report last week I indicated that I expected the market to find support and rise briefly over one or possibly two weeks before falling away to between 6200 points and 6020 points by late December or January, and I still believe this is likely. That said given the erratic and unpredictable way in which the market has behaved in the last few months, anything is possible. Right now I recommend investors take a conservative approach until the market decides on a direction.