Financial independence is a goal many strive to achieve, yet only a few accomplish. Why is this the case when we live in such a prosperous country? The most common reason is lack of knowledge in how to create financial independence, while others lack the desire or confidence in their ability to obtain the knowledge. Interestingly, many people are willing to spend years studying to gain a formal education with the expectation that they will obtain a job that will pay enough to enable them to sustain a desired lifestyle. Yet when it comes to educating…………read more

While for many years the banks have been considered good defensive stocks, the recent volatility resulting from the sub-prime crisis has changed this view. Investor returns have fallen substantially as the big four banks have continued to fall away, with NAB and ANZ down 36 percent in around three months, followed closely by CBA and WBC. Despite current prices representing a significant discount on a value basis, the market is still nervous as to whether the worst is over. While some investors are beginning to view banks as an attractive investment given that the dividend yield increases as prices fall, now is not the time to invest in these companies as I believe the banks will continue to be weak in the short term. 

So what can we expect in the market?  Last week I indicated that I expected the market to fall away during the early part of the week before moving up again, although there was still a possibility it would fall away. As we know the volatility has remained high this week with the market continuing to move sideways.  While the market has continued to unfold in an unusual pattern, I expect we will see some direction quite soon. My expectation is that the market will trade down in the shorter term although I don’t expect it to fall below the low of 5222 in January. That said my longer term view is that the market will be bullish over the next one to two years, therefore when the market volatility does ease there will be some great opportunities. Given this, I encourage all investors to be patient right now.

It’s one of the things we always dream about but often never get around to doing – building our own profitable share portfolio.

The truth is that just about anyone can build their own share and achieve good returns without too much knowledge or risk.

The key to being successful is to practice good portfolio management.

So how do we do this?

What follows is a practical framework that will not only allow investors to build a profitable portfolio, but ensure they select only stocks that have a higher chance of being consistently profitable.

The list of stocks you select for your portfolio will depend on the time you have available, your resources and the goal of your portfolio.

That said, for most Australians, I’d recommend not straying too far outside the top 150 stocks on the Australian market. Why?

 Look at the following reasons:

• The stocks are highly liquid.
• They are all profitable businesses with some of the best managers in Australia.
• The stocks are bought heavily by institutions.
• They generally pay good dividend yields that have good tax credits attached.
• Reliable information about these stocks is much easier to obtain.
• The chances of any one of these companies going broke is small.
• Over a 10-year period these stocks will produce good returns.

Unfortunately, many newcomers to the share market mistakenly believe that buying these types of stocks is too expensive and that buying cheap stocks is the best method for achieving higher returns.

This belief not only costs you money, it hinders your ability to generate profits because you are investing your faith in speculative stocks.

In other words, you are speculating that a cheap stock will perform better that a solid blue-chip stock.

You want to buy quality stocks, not quantity, because this is where you will, for the most part, get the greatest returns.

The reality is when you buy cheap you are gambling with your money and taking higher risks.

If you are speculating that smaller stocks will rise faster in a shorter period of time you are taking higher risks, will result in more losses and very average returns.

It has been proven that concentrated portfolios perform better than large portfolios and provide lower levels of risk. I recommend holding no more than five to eight stocks, but depending on the goal of your portfolio you can hold up to 12. Holding more than 12 stocks will dilute your returns and increase the risks you are taking.

Simply reducing the number of stocks held in a portfolio can dramatically increase investors’ returns.

If you take this low-risk methodical approach to investing over the long term, then nine times out of ten, you will achieve far higher returns than if you try to beat the market averages by thinking you can pick the next boom stock.

Recent company announcements of strong financial performance have in most instances been followed by falls in the share price. For example, JB Hi-Fi announced a 60% increase in profits, yet the company’s share price fell just under 20%, bringing the total fall from its all time high since early December to around 38%. Given that the market is currently in a period of uncertainty suggests that that these solid companies are being oversold, which means there will be some great opportunities in the not to distant future for those who are patient.

History demonstrates, in times of significant volatility that it is wise to invest in defensive stocks; therefore the top 50 stocks are likely to lead the market over the short to medium term with opportunities likely to come from the Energy, Materials, Healthcare and Telecommunications sector.
 
So what can we expect in the market?

Following the rise on our market early last week, the All Ordinaries index fell away to close the week at 5723.90 points, down 333.90 points, which suggested that it may continue to be quite volatile this week. However, the market demonstrated some stability during the week by unfolding within a sideways range between 5752.40 points and 5583.40 points.

I still expect the market to be volatile until mid next week with it likely to fall away during the early part of the week before moving up again. Short term I expect the market to rise for 2 to 4 weeks, although there is still a possibility it will fall away. That said I do believe the market will return to being bullish in the second half of 2008, and continue to rise into early 2009

In the last article we discussed one of the biggest challenges trader face, which is knowing when to sell. In this edition, we will address the strategies you need to consider for exiting a trade. 

If your intention is to trade blue chip stocks for the medium term, then setting a price target on a profitable trade is what I call financial suicide. Your job as a trader is to take the lowest possible risk each time you trade. So why would you consider exiting a profitable trade when you know with 100% certainty that the stock is going your way. Not only will you be taking smaller profits but you will most likely enter another trade that you won’t know will be profitable. If you are using trend following indicators such as trend lines and moving averages, let these tools do the work for you by telling you where to exit; do not second guess them by exiting too early.

Setting tight stop losses on blue chip shares is another area in which many traders fail as they exit too early. Remember you need to let a stock settle into a trend after entering, but if you set a stop loss of 5% not only is there very little room for the stock to move but you will decrease your profitability. The minimum you should set your stop loss at on these types of stocks is 10%, although depending on their volatility my preference is around 15%.

If you trade speculative stocks you need to use analysis tools that are very sensitive to market changes, but once again you should wait for confirmation rather than speculate on a move. Tools that work effectively on speculative stocks include Dow Theory, Swing Charts, Fast Moving averages, MACD’s and Stochastic’s to name a few. Your stop loss also need to be tight, but be careful not to make it too tight as you will get stopped out more often than you would like.

If you are an options trader, things will obviously be very different because you are trading a highly leveraged and fast moving market. Therefore your exit strategies will need to reflect this because even if you wait an hour at times to exit a position you can lose a huge chunk of your money. Once you enter an options position you are far better off picking a range in time or price as your exit signal rather than waiting for confirmation as you would with blue chip shares, simply because it could cost you lots of money.

For example, if I was trading Newscorp options I know (from back testing the stock and my trading plan) for the most part when I get an entry I am pretty safe holding onto the option for three days and that I should achieve a good price movement during that time. Therefore I would be looking to exit at the beginning or end of day three depending on how strong the market was at the time.

So where do you put a stop loss on an option? This is a pretty common question and one that I have heard lots of answers to. But the best one in my book is that if after entering the option it turns against you, you should exit. The reason for this is that in options if you get a trade wrong you will, for the most part, lose 50%; therefore you need to limit the loss as much as possible. 

Futures are different again; although they are highly leveraged they are less volatile than options and have less of a spread in the price between buyers and sellers. Therefore you need to select rules and stop losses that are appropriate to trading this market.
  
No matter what market you decide to trade, the most important aspect to your success in the share market is to prove to yourself that your trading plan works by back testing it. Any deficiencies in your plan will dramatically increase your probability of losing. As traders you also need to be aware of your win/loss ratio (how many times you win against how many times you lose) and your profit/loss ratio (how much we win against how much we lose) as this indicator alerts you to whether or not you are profitable. Once you understand these figures you then need to work on improving them so that you can become more profitable.

In my experience the first place traders should be looking to increase these ratios is their trading plan and the exit strategies they use. In reality, however, most traders continue scanning the market for the next biggest and best trade in the hope of increasing their profitability, which as I have mentioned can be their greatest downfall. Remember, the elite in anything are just that because they spend more time fine tuning their skill level and practicing their techniques, not because they just happen to show up on the day.

Let me say, if you decide to heed the practicality of the information in these articles, you will become a very profitable trader. If, however, you decide to enter an investment without a good exit strategy then you are gambling. And unfortunately gamblers always lose. Consistently successful traders, on the other hand, are risk managers not gamblers.