Four Golden Rules to Investing in Shares
By Dale Gillham |
Over the past twenty years, at both commercial and social events, I have met literally thousands of people who invest in the stock market. Inevitably, the conversation always gets around to their portfolio and how they select stocks they want to buy and sell. A common theme among many of these people is a firmly held belief that all they need to be successful in the stock market is a “kick-ass” set of trading rules. Their focus is on achieving quick returns rather than setting the foundations required to build a solid portfolio. But this is like driving a car towards a cliff, only you don’t know that the cliff exists, so you just keep driving...and we all know where that ends.
The unfortunate reality for many is that when it comes to investing in shares their investments are performing well under expectations. This can often be attributed to the individuals’ lack of knowledge when it comes to how to select stocks and how to manage a portfolio.
In my experience, what investors need to be truly successful investing in shares is a practical framework that will allow them to select stocks for their portfolio that have a higher chance of ensuring that they are consistently profitable. Given this, my aim in this article is to provide you with a set of guidelines that will enable you to construct a portfolio that consistently performs, year in, year out.
Golden rules to investing in shares
Whenever I am presenting to an audience, I always ask how attendees select stocks. I must admit the answers always astound me. The most common responses include recommendations from newspapers, magazines and stockbrokers. Others include tips from friends, family and taxi drivers or the fact that they liked the name of the company or have used the company’s 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. I have even discovered that most people spend more time deciding where to go on a holiday than they spend selecting stocks to buy.
Think about it this way. If you were to invest $500,000 in an investment property right now, how much time would you spend researching the type of area and property you want to invest in in order to be confident you will get a good return? Your answer, no doubt, is probably a lot of time. Now let’s assume you want to invest $500,000 in one stock (although this is, in itself, inadvisable). How much time would you invest in researching not only how to invest in the stock market, but how to select the right stock so that you can invest your money safely and get a good return? Again, you would expect the answer to 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 a $1,000 mistake 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; they both represent the same amount of risk.
Applying the golden rules to investing in shares
What follows are the four golden rules I believe you need to consider when investing in shares so as to reduce your risk and ensure your long-term success.
Golden rule #1
Irrespective of the amount of money you have to invest or the instrument you are trading, you should always spend the same amount of time researching your options to ensure you are protecting your capital on each and every occasion.
Golden rule #2
When constructing a medium to long-term portfolio, you should always aim to have between 5 and 12 stocks in your portfolio (if you are an active trader, you may want to have closer to 5). The idea is not to 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. The result is increased returns.
- You will have fewer transaction costs when buying and selling stocks simply because a smaller portfolio will have fewer transactions.
Golden rule #3
Never invest more than 20 per cent of your total capital in any one stock. If you invest in the stock 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 minimizing 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 twenty per cent of your total capital. If, at the end of your first year, one of the stocks has dropped by 50 per cent, you will have lost $10,000 of your initial capital. But if the other four stocks have risen in value by 10 per cent, then you will have made $8,000. Therefore, your total loss would be $2,000, or only 2 per cent of your initial capital. In effect, you will have minimized your exposure to risk by spreading your capital across a number of stocks.
Golden rule 4
You should only ever invest 10 percent of your available capital in trading short-term highly leveraged markets and allocate the remaining 90 percent to trading a medium-to-long-term portfolio. This is a very solid money management rule that allows you to take a low-risk approach with your money while still achieving good returns on your capital.
The goal with this rule is to have the 10 percent allocated to trading short-term highly leveraged markets achieve equal or better returns when compared to the 90 percent. Let me explain...
Let’s say you have $150,000 to invest. You would place $135,000 in a medium to long term portfolio and allocate the remaining $15,000 to short-term trading. Leveraging or trading on margin at 10:1, for example, you would have $150,000 to generate cash flow in your short-term trading account.
Now, let’s assume you need to make $50,000 in income per annum. If you averaged 11 percent return on your medium-to-long-term portfolio of $135,000, including dividends, you would receive around $15,000, which means you only need to make approximately $35,000 from your short-term portfolio.
In my experience, when trading leveraged markets, your watch list should consist of no more than ten stocks (or indices/markets) that you know inside out, and you should hold no more than four leveraged positions at any one time so as to minimize your risk. Therefore, you would place no more than $30,000 (20 percent of the $150,000 in your short-term trading account) in each trade. That way, you have the remaining cash accessible in the event of a margin call, which is the requirement for a debt to be reduced or extra security to be provided if the leveraged asset loses value.
So there you have it, the four golden rules to investing in shares that will enable you to construct a profitable portfolio that will perform year in year out. I have been teaching these rules now for well over 17 years and applying them personally for over 25 years, so I guarantee you they will work if you work them.
Others who read this article also enjoyed reading:
- The ABC of Share Trading
- Trading the Stock Market - Why Most Traders Fail
- The Laws of Wealth Creation
- Protect Your Portfolio from a Stock Market Correction
You may also want to consider buying my latest book Accelerate Your Wealth, It's Your Money, Your Choice.
And If you would like to learn how you can gain the required knowledge to ensure your profitability in the share market on a consistent basis click here. You can check out the success of our clients by viewing their reviews and testimonials.