A Few Investment Lessons. Part III.

November 22, 2018 0 By admin

A few investment lessons were learned by a regular guy. Part III.MY RULES OF TRADING

I have a few simple rules so far that outline my trading habits (most of them are well known):

  1. I watch the market. When the market is in a confirmed uptrend, I am in buying mode. When the uptrend is under pressure, I am waiting and watching. When the market is in correction mode or is to become a bear market, I am taking my profits where appropriate and assigning tighter stops. Most of the stocks usually follow the market trend because the stock market is typically a combination of the investors’ mood, fear, and greed: the end result from currencies and commodities’ movements and manipulations, governments’ financial decisions, and political situations that may affect the directions of the major markets.  Even the good stock in the uptrend can be sold in the market’s correction.
  2. I protect my investments. You surely heard it: “It is not important how much you earned but how much you saved”. Let us talk about the stop orders. There are different strategies and advice regarding stop orders. IBD suggests 7-8% below your purchase price while the Oxford Club (that I used to subscribe to) suggests establishing a 25% trailing stop right after you purchase the stock. Why 25%? To allow the stock to work out on correction and give enough room to get back on track.

Their idea is that you do not allocate more than 5% of your liquid investments for any single stock or ETF. For example: having 20 stocks with a $100,000 investment ($5,000 per stock), you may lose only $1,250 per stock. If your stop order is triggered on any particular stock, you will lose only 1.25% of your total investment. While it sounds like a smart strategy, in the bad bear market it could happen to several stocks…

Some professional investors suggest abandoning the stop orders altogether because the market makers can sell your stock by swinging down and quickly recover forcing you to bite your nails. I have to admit that sometimes my stop orders “punish” me too, however, I’d rather lose a few $$ than lose much more during the market sell-off.

I don’t stick to one strategy – I have a different, combined approach.

If I have the dividend-producing stock, let’s say the one that pays a 7% dividend, I am setting up the stop order 7%-8% below the purchasing price.

If I do momentum trading, I am setting up a 2% trailing stop. If I am right in my assumptions, the stock will advance, if not, I am going to lose only 2% of the initial position.

In many cases, I am setting the stop orders in accordance with the price movements of the stock for longer-term investments: I am studying the chart. I look at the previous “V-shape” formation and set the stop order just 10 cents below the lowest price point but no lower than 10-12% (my comfort zone). For the preferred shares and munis, I am setting up the trailing stop, usually around 5-6%, since they rarely generate more than 5% dividend over the year.

I have a few stocks that I intend to hold for a long time because the companies are very solid, will withstand global disturbances, and generate 6-8%+ in dividends. For them, I set 25% trailing stops.

That strategy works well since I am not allocating more than $6,000-$7,000 per stock.

I am aware of the situation when the price has dramatically dropped overnight, and the stock has opened with a sharp decline. Would my stop order protect me from big losses? It depends… but as I said before, I don’t let the stock run down anymore with no downside protection. I have been burned before.

What I also do (in some cases) is track the “delta” from my Stop Order in the spreadsheet without actually setting that stop. When my “delta” is close to the prospective sell order, I monitor it closely, and I sell the stock based on the end-of-day price rather than on the stop that can be triggered during daily disturbances. This way, I avoid market makers’ tricks.

      3. I use position sizing. If I have decided to buy the stock, I usually invest around 50-55% of my maximum for any single entity, and then I set the stop order ~2% below the purchase price and watch the trend. If the stock nosedives, my stop order is triggered but the loss will be smaller than with the full position. When I see the new high of the typical cap-and-handle formation, I am adding more shares until I reach $6,000-$7,000.

     4. Profit-taking rules. In the confirmed uptrend, I am waiting until the stock has gained 20%, and I am selling the part of the shares to take the profit. In the downtrend, I do not hesitate to protect any profits of $200 and above and sell the entire position with the following waiting period for a better entry price. Other tactics: setting the trailing stop 2-3% and letting the winner ride up.

How I diversify liquid assets

In the first part of the article, I have explained why I have my own approach to investing and shared a few strategies and investment rules. I have also emphasized that traditional asset allocation (stocks vs. bonds) is an outdated approach from my point of view.

Now, I want to explain my approach to liquid investments such as stocks, ETFs, and their variations. Under liquid assets, I assign all investments (including holding some cash) that can be easily bought and sold on the first wish.

I am adding the prospective stocks into my watch list (see below) and buying them when there are several conditions are met (of course, it does not always apply for CEFs or ETFs that might have different criteria):

  1. The chart pattern confirms the underlining strength with a volume that exceeds the average by at least 40% - the indication that institutional investors are actively buying the shares.
  2. The chart pattern signals that the target price has been reached.
  3. The stock/ETF's fundamentals are present: strong cash flow, ROE >17%, PEG <2.0, Yield >3.5%, Payout <75%, EPS is growing from quarter to quarter, and the debt-to-equity ratio is low.
  4. The investment represents the group that performs better than 75-80% of the other industries, sectors, and groups.
  5. The market is in an uptrend.

I don't buy the stocks based on recommendations in articles. One glance at Finviz.com is enough to determine poor fundamentals. There are thousands of stocks and ETFs, so why buy the losers because someone just recommended them?

Before explaining further, let me tell you first about what I have decided to do after, frankly, more losses than gains for the first 10-12 years of investing, and how my results have dramatically improved for the last few years. The hard landing of 2008 has changed my perspective.

How I have rediscovered the dividends

When you have no formal education and need to gather some knowledge, it is easy to miss important matters in any discipline. You usually jump from one piece of information to another while missing many topics in-between. It has happened to me with investing. Big mistake! Being an IT professional and mentor, I always taught my students about the importance of building the IT knowledge-base without gaps when you may add anything on the top and benefit from it. The result is outperforming your peers - thanks to your previously gained knowledge.

I have missed the dividends.

You may laugh now but, for many years, I have considered dividends only as a good add-on, as a cream on the top of a coffee cup, but have never thought about the importance of dividends. Just a few years ago, I have realized that in the seesaw market, dividends play an important role in for-profit makers.

With getting closer to the retirement age, I have shifted my view on dividends from something not worth my attention to the second main reason to invest after the growth: income. Let's face it: if you have chosen the right investment that generates a sizable dividend it is not critical that the stock or ETF is not growing much because you are still making profits. You may use the dividends as income or re-invest (that helps grow your investment even better - thanks to the compounding interest). To me, it was like a revelation.

After redefining the importance of dividends, I have developed one more rule that applies to certain investments. My goal is to have a 10% profit (or more) per year on a single, dividend-producing stock of ETF. To reach my goal, the stock with a dividend of 7%, should have at least 3% growth. Similarly, the low-dividend stock with a 3.5% dividend should grow at least 6.5% per year. I have some investments when this rule does not apply (i.e. preferred stocks and munis).

Now, if I see in my Investment Tracking spreadsheet the field "Yield%" with 0%, it can be the only one thing: I trade this stock using the momentum strategy. Otherwise, it should have at least a 3.5% dividend. Period.

Do you keep extra cash in the bank? You are losing money, my friend! You better invest cash into that 3.5% dividend stock and, perhaps, cover the inflation gap.

I have more than 90% of my liquid assets that generate dividends. This is how much my perception has changed. It resulted in a much better outcome at the end of the last few years when the dividends were added to the gains generating a nice profit.

Key Takeaways

1. The world has changed. Change your diversification strategy. Investing only in stocks and bonds is very risky.

2. Sound diversification is different for everyone and depends on the financial situation, age, and investment experience. No strategy will perfectly align with anyone investor's values or unique circumstances.

3. Not everything is gold even if it is shining… Be cautious.

4. Tangible assets are less susceptible to market crashes especially if they are income-producing.

5. My approach to investing may not be suitable to you but if you find anything useful in my investment strategies use them and improve.

Author's Note: I am not an investment professional (and have never been). Please excuse any typos.  I assure you that I will do my best to correct any errors if they were overlooked. I don’t have any stocks mentioned here in my portfolio and do not plan to buy them in the next 72 hrs.

Sources: I have no associations with mentioned websites or businesses and did not intend to promote them. I also do not sell investment software but rather share “for free” with fellow investors if I did not pay for any piece of it.

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before following any investment strategies or rules mentioned or recommended.