There are different investing strategies for different people because no one has the same objectives and tolerance for risk. Some people prefer to wait for stock prices to fall so low before they start buying while others like to chase stocks when share prices are surging strongly to all time-highs. But therer are certain rules you need to follow in order to make money in the stock market.
Whatever your style is, your investment approach will always relate to your ability to assume risk for higher returns. Successful investing is not just making money from buying and selling stocks. It is about being able to manage your risk.
How much money are you willing to lose if you make the wrong investment? How much returns do you expect to earn given the prevailing risks in the market? When you understand your risks, you will know how to control it to maximize your investment returns.
Here are the five rules you can follow to lower your risk and win in the stock market:
Rule No. 1: Know your stocks before you invest
There is a story behind every stock’s rise and fall. Try to understand what is going on first before you proceed to invest.
What is the historical background of the company? How reliable is the company’s management team? What are the latest ventures of the company that will help sustain its earnings to grow in the long-term?
Read the latest disclosures about the company and evaluate how these events will likely affect the valuation of the stock in the future.
If you find a compelling reason to invest, you should also check the historical performance of the share price to see where you can possibly pick up the stock.
Knowing the track record of a stock and its risk-reward profile can help you lower your risks.
So, before you buy any stock, it is important that you do your homework first.
Rule No. 2: Know how to evaluate and analyze
The use of Price-to-Earnings (P/E) ratio is very common in the stock market.
When a stock has a higher than average P/E ratio, people will normally say that the stock is expensive and when its ratio is lower than market, the stock is deemed cheap.
Without the knowledge and training, you may not know that a high P/E stock may also mean that the company has high growth prospects and therefore positive, while a stock with low P/E may mean low growth, which is negative.
There are many other tools that you may need to familiarize yourself with.
One example is the Price-to-Book Value (P/BV) ratio. You may discover in your research that the stock is currently trading at 25 percent discount to its book value per share.
It may look cheap at first glance but if you evaluate further, you will know that the reason why the stock has low P/BV ratio is because its return on equity has been historically low.
In other words, not all stocks that trade at low multiples are cheap. You need to know the reason why they are priced low by the market.
Perhaps, you may need to equip yourself with the right tools to evaluate the fundamentals of a company by attending a training course or doing self-study to improve your skills.
Rule No 3: Know how to diversify to lower your risks
It may not be advisable to invest all your money in just one stock. To lessen your risk, you need to diversify by allocating your investment into different stocks.
The more stocks you have in your portfolio, the lower your total portfolio risks. Ideally, you can divide your investments up to a total of eight stocks, but if you need to diversify more, you can possibly expand it up to 20.
Depending on your risk tolerance, you can design your portfolio exactly the way you want it to achieve your investment objectives.
For example, you can allocate 50 percent of your money to PSE Index stocks such as Meralco, SM Prime Holdings or Ayala Land. These stocks are relatively more stable than the non-PSE index stocks because of their large market capitalization and earnings track record.
For the remaining balance of your money, you can allocate a portion to preferred stocks that yield around seven percent annually.
You can also allocate a portion of your portfolio in special situation stocks that are riskier but have higher potential returns.
Rule No. 4: Know when you need to cut your losses
It is not easy to hold on to a losing position especially when your emotions are involved.
You need to have the discipline to take losses when you need to. As an investor, you want to keep your losses as small as possible.
When losses are kept at manageable amounts, there is a very good chance that you can recover it in your next trade.
For example, if you cut your losses at 10 percent, you easily make it up in your next trade by gaining almost the same percentage at 11 percent.
But if you hold on for too long before you decide to take your losses at 50 percent, it may be difficult for you to recover because you will need to make a 100-percent return.
You need to set and apply your own stop-loss rules that are aligned with your risk preferences.
Perhaps it will help if you take time to observe your target stocks historical performance, so you can understand its different risk and return profiles.
Rule No. 5: Know when to sell and take profits
What is the use of picking good stocks if you are not able to benefit fully from them?
When you plan to invest in stocks, make sure that you also set your minimum target returns. In the same way, you also set your maximum target loss in case your stock price falls.
Buy and hold strategy may not always work. There will be times when you need to cash in on your investments. Setting parameters can help you become more objective when you make decisions.
Trading in the stock market can be a rollercoaster ride. Sometimes you fall in love with the stock that you want to hold on to it forever even at the risk of missing the opportunity to take huge profits.
Remember, it doesn’t matter how much you make from the stock, it’s when you sell that counts.
Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice email@example.com or follow him on Twitter @henryong888