Every endeavor requires a plan, no matterhow small it is. For example, you wouldn'tget in your car and start driving withoutfirst figuring out your destination. Thesame idea holds true when it comes to investing. It'snecessary to develop a stock investment strategy, butthere is a whole lot more to developing that strategythan meets the eye.
"Defining your goals, objectives, risk tolerance,and time horizons—those are the first four things youneed to do," explains David Rogers, founder of BlueRidge Capital Markets (www.blueridgecapital.net)."You have to have some idea of your resources, whatyou're looking to accomplish, and how much risk youwant to take to get there."
As Rogers points out, the key to developing a successfulstock investment strategy is self-knowledge.You need to understand yourself before you can begindeveloping your strategy. Therefore, it's necessary torecognize what you're looking for and how much riskyou're willing to take. Stocks pose agreater risk than mutual funds.
Bard Malovany, CFP®, of Sagemark Consulting,explains that when an individual invests in a stock,even if it's a conservative stock, they run the risk ofthe company going out of business. That risk might besmaller with large companies, but it's always there. Ifyou remember correctly, Enron and MCI WorldComwere huge companies.
"It's often very hard for people to define risk,"Malovany explains. "People see risk as the possibilityof losing money—but risk is really variable. In somesense, there's risk in buying individual stocks becauseyou might not be well diversified; and there's alwaysrisk when you have someone making buy and selldecisions for you."
Of course, it's not just important to minimize risk.According to Malovany, the key is to be compensatedfor the risk you take. "For example, it might makesense to hire a manager to buy a mutual fund foryou," he explains. "There's some risk involved; themutual fund may underperform the market, but itmight also outperform the market."
While Rogers agrees that most investors understandrisk simply because they've experienced it, henotes that there are a lot of people investing in thestock market, including investment professionals,who don't have a clue about what makes the marketgo up and down or what makes a stock rise and fall.And that's important to understand.
"It's not just earnings and revenue," he points out."The real driver of the stock market is the emotionthat's derived from expectations about future results."Consider the market's response to a recessionary environment.Even in that environment, Rogers explains,smart money recognizes early on that there are somegood value stocks available.
"The Federal Reserve will step in, lowering interestrates to spur the economy, but those value purchaseswill be made weeks, if not months, before thefed actually takes action," Rogers notes. "So a lot ofstock market investing is anticipation of future events.And because of uncertainty, there's an emotional factor.Your predictions are either validated or contradictedby the real events."
Doc's Stock Smarts
According to Ed Noonan, CEO of ContravisoryResearch & Management (www.contravisory.com),diversification is an important element in any investmentstrategy. He notes, however, that many investorsneed clarification on this subject.
When an investor buys a mutual fund, for example,the diversification is typically very broad. Somefunds have as many as 400 positions, while othershave as few as 40. The key, Noonan says, is to havean investment manager who generates superiorreturns. To accomplish that, managers may sometimeshave to be overweighted in an industry.
"There is diversification by number of stocks, but togenerate the above-average returns an investor desires,managers have to take positions that are a little differentfrom the average," Noonan explains. "That meansthere's some element of nondiversification."
Is it more difficult to be diversified if you're onlybuying individual stocks? According to Malovany, it'spossible to be reasonably well-diversified with a portfolioof only 10 stocks. Of course, the more stocksyou own, the better diversified you'll be. But the benefitsof that additional diversification, he points out,are somewhat exponential.
The biggest mistake some investors make,Malovany says, is that they purchase stocks they thinkare going to do well, regardless of their capitalizationor valuation, and that's putting the cart before thehorse. "You really should figure out your asset allocationstrategy and your overall investment strategy, andthen pick specific investments to go into that strategy,"he explains. "You might decide that you want40% of your portfolio in large cap stocks. Once youknow that, then you can pick the large cap stocks."
There are, of course, individual investors who buystocks because they sound sexy or because they happento read about them in an article. And accordingto Malovany, that's okay, as long as it's done withinthe scope of a diversified strategy. Some physicianswill buy stock in companies they're familiar with, likemedical supply companies. "But when they do, it's nota huge part of their portfolio," he explains.
Solid Gold Selections
There is no stock selection criterion that shinesabove all others. Momentum investors prefer to buystocks that are appreciating rapidly relative to their peergroup. Others prefer a value-oriented approach, pickingstocks that have a very low price-to-earnings ratio.
Money manager Jack Rothstein, head ofWealthcast.com, says that no matter what theapproach, any stock that isn't in a rising trend relativeto price movement should be avoided. One way tomeasure that, Rothstein says, is to see whether or notthe stock trades above or below its average price overa period of time (ie, 200 days for long-term investors).
"An example of a stock that is extended, or notreally a good buy right now, is Apple Computer,"Rothstein explains. "Even though the stock has donevery well, at the current price you might be making abig mistake. It would be foolish to buy the stock rightnow because it could pull back significantly." If you'rethinking of buying Apple stock, he adds, the time to getinvolved is when the price of the stock drops down.
Rothstein emphasizes that buying a stock is onlyhalf of the strategy equation. Once you get in, you haveto have an exit strategy for getting out. And accordingto Rothstein, that strategy is continuously adjusted byemploying stop-losses. "If you buy a stock for $50 ashare and it works out that suddenly it's at $85 a share9 months later, you're not going to keep your stop-lossesat $47, right?" Rothstein asks. "You're going toadjust your exit strategy along the way. So it's a constantprocess of work when you get involved in thestock market. The risk will never go away; it willalways be there. But you can control your own risk ifyou have the discipline to utilize stop-losses."
How important is it to understand the companiesin which you're investing? Rothstein says it dependson the investor. "Some investors must understandwhat they're getting involved in, and others don'thave to," he explains, "as long as they understandhow to recognize a change in the trend. That's crucialto the performance of a portfolio."
If selecting stocks tends to upset your stomach andrattle your nerves, consider adopting Malovany'slight-hearted yet serious stock outlook. "Picking individualstocks, trying to figure out which stocks aregoing to do well, is a fun thing to do," he admits, "butyou should do so in the context of an overall balancedportfolio."