3 Golden Rules That Can Save You From Financial Ruin
There are countless investing rules, mantras and cliches out there ranging from extremely useful to downright dangerous.
One of the most widely accepted and potentially detrimental to your portfolio is, “Buy low, sell high.”
When taken literally, of course, to make a profit you must sell a stock for more than you paid for it. But the essence of buy low, sell high has become one of the costliest myths on Wall Street.
Investors have been trained to think that “undervalued” stocks have the most upside potential. The problem is that this approach often causes investors to overlook the market’s best-performing stocks in favor of the ones doing the worst. Since underperforming investments usually sport lower valuations, investors tend to think these stocks are the more attractive buys.
And nothing could be further from the truth.
I’ll get into this in more detail in a moment, because today I want to share my three golden rules of investing.
I’ve honed them over my two-decade-plus career in the markets. They are the foundation of investment success. They are non-negotiable. And while they may seem simple, many investors fail to abide by them, which all but guarantees failure.
Golden Rule #1: Ride Your Winners
It doesn’t matter if you’re a fundamentalist, technician or astrology-based stock picker, people buy stocks to make money, which happens when prices goes up.
The problem is “buy low, sell high” has conditioned investors to look for dark horse stocks that will come out of nowhere to provide big gains rather than betting on a stock that’s already proven itself a winner.
The easiest way to quantify which stocks are winners is with an indicator known as relative strength (RS). RS compares a stock’s performance over the past six months with all other stocks in the market, giving it a score between 0 (weakest) and 100 (strongest).
Study after study has shown that outperforming stocks tend to continue to outperform.
Eugene Fama, a famous economist at the University of Chicago, won the 2013 Nobel Prize in Economics for his studies that identified relative strength as a key factor in driving individual stocks upward. In fact, Fama named it the “premier anomaly” driving stock prices higher.
I only buy stocks with a RS of 70 or above, meaning they have outperformed at least 70% of all other stocks in the market during the past six months.
Of course, it’s not as simple as running a screen and buying any stock with a RS over 70. If it was, anyone could be the next Warren Buffett.
You must also have the fortitude to stick with the trend. A recent study revealed that the closer a stock’s current price is to its 52-week high, the stronger that stock’s performance will be in the following months — the exact opposite of what the buy low, sell high crowd has been led to believe.
And you must have the discipline to sell when momentum turns against you, which brings me to my next rule for investment success.
Golden Rule #2: Cut Your Losses
Losses are a part of investing. Yet, traders often become attached to an investing thesis or stock and fail to pull the trigger when it’s time to sell. If only they can hang on until the “next rally,” they can get out at a better price and cut down on their losses.
With this kind of mentality it may only take a few sour investments to ruin a portfolio. Remember, a 50% loss requires a 100% gain to break even.
Van Tharp — a trading psychologist who’s studied and modeled world-class traders like Ed Seykota — believes exits are even more important than entries.
In his book, “Trade Your Way to Financial Freedom,” Tharp created a system with randomized portfolio entries and a defined set of rules that told him when to sell. And it was profitable.
Think about that. The buys were totally random, but his system still managed to be profitable. All thanks to the sell rules.
Having set rules also takes the emotion out of selling. For instance, when RS on any position I own falls below 70, the trend is headed in the wrong direction and I sell — no questions asked.
Golden Rule #3: Manage Risk
The final golden rule may be the most important.
If you bet the farm, you risk financial ruin when natural investing losses come. If you bet too little, the losses won’t hurt much, but the wins are meaningless.
They key is to find the right position size for your risk personality and stick with a system.
With more than two decades of successful investing experience behind me, I’ve seen it all. I’ve profitably navigated everything from the roaring technology bull market of the 1990s to the bear markets of 2001 and financial collapse of 2008.
And now I help individual investors with my Alpha Trader system, which abides by these three golden rules while still helping traders find breakout stocks that go on to return double- and triple-digit profits.
At the core of the system are two profit triggers that alert us when it is time to buy a certain stock. As you might have guessed, one of them is relative strength, which, by itself, has proven to be a great tool. But the second trigger adds an element of safety that weeds out undesirable stocks that are soaring simply because they’re popular rather than because there’s something substantial happening.
I recently put together a presentation detailing how these two profit triggers work to uncover stocks that have returned up to 242% in less than a year. I want to share them with you so you can become a more successful investor.
Click here to access my presentation free of charge.