A regular guy learned a few investment lessons—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):
- I keep a vigilant eye on the market. When the market is in a confirmed uptrend, I am in buying mode. When the uptrend is under pressure, I wait and watch. When the market is in correction mode or is about to enter a bear market, I take my profits where appropriate and assign tighter stops. Most stocks typically follow the market trend because the stock market is influenced by a combination of investors' moods, fear, and greed, as well as the movements and manipulations of currencies and commodities, governments’ financial decisions, and political situations that may affect the direction of major markets. Even the good stock in the uptrend can be sold in the market’s correction.
- I safeguard my investments with the use of stop orders. You've likely heard the saying: “It is not important how much you earn but how much you save.” Let's discuss stop orders. There are various strategies and pieces of advice regarding stop orders. IBD (Investors' Business Daily) suggests setting 7-8% below your purchase price, while the Oxford Club (from which I used to subscribe) recommends establishing a 25% trailing stop immediately after purchasing 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 a bear market, it could happen to several stocks…
Some professional investors suggest abandoning stop orders altogether because market makers can sell your stock by swinging it 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 adhere to a single strategy – I employ a versatile, combined approach that enables me to adapt to various market conditions.
If I have the dividend-producing stock, let’s say the one that pays a 7% dividend, I set up the stop order 7%-8% below the purchase price.
If I engage in momentum trading, I set up a 2-3% trailing stop. If I am correct in my assumptions, the stock will advance; if not, I will incur a loss of only 2-3% of the initial position.
In many cases, I set stop orders in accordance with the stock's price movements for longer-term investments, after studying the chart. I examine 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 a trailing stop, typically around 5-6%, since they rarely generate a dividend yield of more than 5% per year.
I have a few stocks that I intend to hold for a long time because the companies are excellent, will withstand global disturbances, and generate dividends of 6%-8 % or more. For them, I set 25% trailing stops in the case of a sudden market disaster.
That strategy works well since I am not allocating more than $6,000 to $7,000 per stock.
I am aware of situations where the price has dropped dramatically overnight, and the stock has opened with a sharp decline. Would my stop order protect me from significant losses? It depends… but as I mentioned earlier, I no longer let the stock run down without 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. The 'delta' is the difference between the current stock price and the stop price. When my 'delta' is close to the prospective sell order, I monitor it closely and sell the stock based on the end-of-day price, rather than on the stop that can be triggered during daily fluctuations. This way, I avoid the tricks of market makers.
3. I use position sizing. If I decide to buy the stock, I usually invest around 50-55% of my maximum for any single entity, and then I set a 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 if I were to sell the full position. When I see the new high of the typical cup-and-handle formation, a technical analysis pattern that indicates a potential price reversal, I add more shares until I reach a target of $6,000 to $7,000.
4. Profit-taking rules. In the confirmed uptrend, a technical analysis term that indicates a consistent upward movement in stock prices, I am waiting until the stock has gained 20%, and then I will sell part of the shares to take the profit. During the downtrend, I do not hesitate to protect any earnings of $200 or above and sell the entire position, with a waiting period for a better entry price. Other tactics include setting the trailing stop at 2-3% and letting the winner ride up.
How I diversify liquid assets
In the first part of the article, I explain my approach to investing and share a few key strategies and investment rules. I have also emphasized that traditional asset allocation (stocks versus bonds) is an outdated approach from my perspective.
Now, I would like to explain my approach to liquid investments, including stocks, ETFs, and their variations. Under liquid assets, I include all investments (including holding some cash) that can be easily bought and sold at a moment's notice.
I am adding the prospective stocks into my watch list (see below) and buying them when several conditions are met (of course, it does not always apply for CEFs or ETFs that might have different criteria):
- The chart pattern confirms the underlying strength with a volume that exceeds the average by at least 40% - the indication that institutional investors are actively buying the shares.
- The chart pattern signals that the target price has been reached.
- 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.
- The investment represents the group that performs better than 75-80% of the other industries, sectors, and groups.
- 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 I explain it further, I'd like to share with you what I decided to do after, honestly, experiencing more losses than gains for the first 10-12 years of investing, and how my results have drastically improved over the last few years. The 2008 financial crisis 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 essential 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! As an IT professional and mentor, I have always taught my students the importance of building a comprehensive IT knowledge base without gaps, so that they can continually add to and benefit from it. The result is that you outperform your peers - thanks to the knowledge you have previously gained.
I have missed the dividends.
You may laugh now, but for many years, I have considered dividends only as a good add-on, like cream on top of a cup of coffee; however, I have never truly appreciated their importance. Just a few years ago, I realized that in the seesaw market, dividends play an essential role for for-profit makers.
As I approach retirement age, I have shifted my view on dividends from something not worth my attention to the second main reason to invest, after growth: income. Let's face it: if you have chosen the right investment that generates a sizable dividend, the stock or ETF needs to be growing much because you are still making profits. You may use the dividends as income or reinvest them (which helps increase your investment even better, thanks to compounding interest). To me, it was like a revelation.
After redefining the importance of dividends, I have developed one more rule that applies to specific investments. My goal is to have a 10% profit (or more) per year on a single, dividend-producing stock or ETF. To reach my goal, the stock with a 7% dividend yield should have a growth rate of at least 3%. Similarly, the low-dividend stock with a 3.5% dividend yield should grow at a rate of at least 6.5% per year. I have some investments to which this rule does not apply (i.e., preferred stocks and municipal bonds).
Now, if I see in my Investment Tracking spreadsheet that the "Yield%" field is set to 0%, it's likely the reason: I'm trading this stock using the momentum strategy. Otherwise, it should have a dividend yield of at least 3.5%. Period.
Do you keep extra cash in the bank? You are losing money, my friend! You should invest cash into that 3.5% dividend stock and 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 significantly better outcome over the last few years, as the dividends were added to the gains, generating a substantial profit.
Key Takeaways
1. The world has changed. Could you 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 any 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 for you, but if you find anything useful in my investment strategies, use them and improve.
Read Part IV of the article.
Author's Note: I am not an investment professional (and have never been). I don’t have any stocks mentioned in my portfolio, and I do not plan to buy them in the next 72 hours.
Sources: I have no associations with the mentioned websites or businesses and did not intend to promote them. I also do not sell investment software, but rather share it “for free” with fellow investors, since I did not pay for any part of it.
Disclaimer: This article is intended to provide information to interested parties. As I do not know 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.