The golden rule that we’re all familiar with in belief systems is essentially the ethic of reciprocity. Treat others the way you want them to treat you. In the investment world, we can redefine this as the expectation of rewards equivalent to or greater than our risk.
Confused? Think of this way. If you’re willing to invest $500 in a single holding, you want some assurance that you’ll get that $500 back, along with a significant profit. You have enough faith in that stock, based on research, that the return will equal or exceed the investment.
Do unto others. Human beings tend to do this only when they expect reciprocity in form. That goes for positive and negative actions. Love begets love. Hate begets hate. Why not look at stock trading in exactly the same way? If you love it, buy it. And expect love in return.
Okay, that’s enough of the philosophical banter. This article is about the “golden principles” of investing. We brought up the golden rule to remind you, as a trader or investor, to expect profit when you buy quality stocks. The principles outlined here will ensure that happens.
Principle #1: Diversification
Investors can’t be one-dimensional when constructing a portfolio. Certain segments of the market do better at times while others struggle. Diversifying your holdings ensures that damage from any one sector will be minimized by gains in another.
Recognized market sectors in stock trading are broad categories developed by major indexes like the S&P and MSCI. This system is known as the Global Industry Classification Standard (GICS) and consists of eleven primary categories:
Diversified investors typically build portfolios with holdings from each of these sectors, though not necessarily in equal portions. Traders, since they are not actually holding any positions as long term investments, tend to focus on favored sectors with high volatility.
In addition to sectors, there are twenty-four (24) industry groups, sixty-nine (69) industries, and one hundred fifty-eight (158) sub-industries. Professional analysts will do a deep dive that incorporates all of these. Most investors stick to the eleven major sectors.
Why is this important? If you want the market to be good to you, don’t ignore key components of it. Social movements, governmental changes, and market conditions affect all sectors, some positively and some negatively. Long-term success comes from being prepared for anything.
Principle #2: Set Clear Financial Goals
A day trader will wake up in the morning with the simple goal of executing fifty or one hundred trades between the opening and closing bells. Investors have a longer-term view. Therefore, their goals are different. Investment portfolio managers focus on three areas:
Accumulation of Principle: Eventually, with proper planning, your money should start making you money. That doesn’t happen without consistently building the principle. This is particularly true during down markets when stock prices are low. Set up a goal to invest a certain amount into your principle every week, regardless of market conditions.
Rate of Return: A goal for rate of return could be a specific number (10%) or a comparison to market indexes. For best results, do both. No one is going to consistently beat the market over long periods of time, but it’s still nice to known when you’re ahead. By monitoring return percentage, you know when you need to reallocate.
Disbursement Strategies: Everyone is in this to make money, right? Unfortunately, it’s all just numbers on paper until we start to withdraw it. Long term investors should set a goal for disbursements, similar to a retirement plan. Ideally, you’ll want withdrawals to be lower than gain dollars, so the portfolio keeps growing.
Obviously, the triumvirate of goals above is related solely to portfolio construction and management. Don’t overlook life goals here either. We all want to make money in the stock market, but why? What exactly do you want to accomplish with that money?
In some cases, folks just like winning, but most people want something better out of life. A new home. A comfortable retirement. The ability to travel. These are the goals that motivate us to keep going. Make sure you know what yours are.
Principle #3: Risk Tolerance
This one is for investors and traders alike. It’s also multi-faceted. Risk can be defined as how much you’re willing to invest or how long you’re willing to hold a position before selling. Setting goals in both of those areas is critical to any investing or trading plan.
Let’s examine monetary value first. If you’ve ever gone to a casino, you were likely told to not bring anything with you that you couldn’t afford to lose. Treat investing the same way, but not because you’re going to lose it. You just can’t use that money anywhere else.
The best way to decide on increments to invest is to create a budget. Pay yourself first and allocate enough to cover living expenses, incidentals, and unexpected life occurrences. Deduct all of those from your income and draw investment dollars from the remainder.
Once you know how much you can afford to invest, evaluate your appetite for risk. How much are you willing to lose or risk losing before pulling the plug on a trade or investment? This varies by the individual and is definitely affected by life circumstances.
Learn to separate emotion from stock trading. There’s a minimal element of chance involved in the stock market, but that can be offset by using tools like Tickeron to analyze trades and investments before you make them. Set your goals based on the science, not your feelings.
Principle #4: Look for Undervalued Stocks
An undervalued stock is a stock that is selling at a price that is significantly lower than its intrinsic value. That value is based on predictable future cashflows, something you can only see by doing additional research on the company. Tickeron can help you with that.
There’s a huge upside to finding the right undervalued stocks, but not all of them will eventually become winners for you. Sometimes, there’s a reason for the low valuation. The company could be struggling with excessive debt or inefficient management.
Overall market conditions can also drive the price of a stock down. Petroleum stocks during the pandemic of 2020 are a good example of this. With an overabundance of supply and no demand during national shutdowns, prices plummeted.
Does that mean all petroleum stocks are undervalued and should be bought right now? Absolutely not. Some of the smaller companies won’t recover, despite what their future cashflow projections show. That’s why expert advice is important in this area.
A useful indicator of whether a company is undervalued or overvalued is the price/earnings (P/E) ratio. This number is a ratio of the company’s earnings versus the price of their share price. Undervalued stocks typically have lower P/E ratios. The average PE on the S&P is 15.
Principle #5: Respect Market Capitalization and Profit
Price to earnings ratios aren’t the only way to evaluate stock potential. As an investor, you must respect market capitalization and profits. Market cap tells you the cumulative value of all outstanding shares on the market. Profits alleviate concerns over excessive debt.
The debt to income ratio (DTI) is calculated by dividing monthly debt payments by monthly gross income. You can calculate it yourself from company financial reports if you choose, but typically market cap and P/E should be all you need to make an investment decision.
As for market capitalization, the price of a share is meaningless if there’s a limited number of shares on the market. This is particularly true with an IPO (initial public offering), where the share price was pre-set before trading was opened and only so many shares will be sold.
For more established companies, you’ll see a higher market cap. Let me use eBay as an example here. Their current share price is $50.68 with a market cap of $35.47 billion. Their trading volume is 6.343 million, telling me that the company is solidly established on the market.
A more detailed dive into eBay shows me a P/E ratio of 7.85 and Tickeron tells me the odds of an uptrend are 73%. That’s a strong buy signal. As an investor, I want to put some money into eBay. It’s within my risk tolerance levels and likely to be good to me in the long run.
Patterns and Consistency Lead to Investing Success
Much of what we write about here at Tickeron is geared towards traders. The importance of sticking with a plan consistently is clearly apparent to them. Losses pile up quickly during the market day when plans are ignored. That’s a painful reality for traders.
Investors work with longer time periods, so it’s not clear immediately whether a plan is working or not. Stick to it until you have some data to analyze. Make changes at that point if you must. In the meantime, employ these golden principles and you’ll be successful.