Five Ground Rules For Investing

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Ground Rules – Investing

In any game, there are rules. Some visible; some hidden. In the trading game, most are invisible. But then most beginners don’t know that. The ‘doing’ part of trading is actually very simple. You deposit some money into a broker account, select any tradable instrument, and click “Buy”. That’s about it.

If trading is so simple, why is that many are called and few are chosen? And perhaps you have always wondered: ‘Are there any trading secrets?’

Unlike other physical activities, the defining factor behind trading and investment successes is ‘thinking’.  That’s right, trading is a 90% mental game.  The best investors you see are world-class thinkers, including Buffett, Soros, Dalio etc. From their annual letters, books, articles, and interviews, you know that these successful investors not only understood markets inside out, they pick on an area they know better than others and capitalise heavily on this.

But if you’re not a ‘thinker’, can you still be successful in trading? From my experience, the answer is ‘yes’ To stack odds in your favour, however, you must understand some ground rules.

Ground Rules

Rule 1: Trade with primary market trends.

Rule 2: Always protect yourself.

Rule 3: Know your strategies.

Rule 4: Trade within your means.

Rule 5: Knowing when to stop.

 

Trade with the primary market trends

Primary market trends are there for you to profit from. Far too many people ‘overthink’. They mistook action for brilliance. You should not. A secular bull market last many years. This is where fortunes are made – only if you play your cards correctly.

This first thing to do is to spot one. Is there a secular bull market somewhere right now? Clue: instruments that are making new price highs. Dow!

Second, buy in the direction of the trend. Be a contrarian in a big bull will cost you. Third, buy right. Buying sectors with good relative strength is a start.

Always protect yourself

Within a secular bull market, there will always be sectors falling out-of-favour, bankruptcies, big corrections etc. So an important rule is this: Sell when your positions are going against you. Always set protective stops around your trading positions. Even for long-term investments, there should be some kind of a ‘get out’ rule.

Take note of this example. After owning Tesco shares for many years, in 2015 Warren Buffett decided to chop this underperforming British investment. It was a festering losing position in his portfolio. He regretted not exiting much earlier because he had ‘hoped’ Tesco would turnaround. That ‘hope’ cost him dear: $444 million.[link] If you have a stock that’s down 35% from your purchase, don’t pray. Get out fast. Chances of another 25% price drop are high.

Know your strategies

To trade or invest with some reasonable success, you need to know what type of investment strategies to use. Strategies that you know will work (because you tested them) and that you will be able to follow them (because you like the behaviour of these strategies). In fact, you should be able to anticipate your actions given alternative market directions.

Some investors like to use medium-term trend following strategies; others long-term breakouts. Fundamental-oriented traders will focus on accounting. Macro traders work on big picture. You need to know three things: a) which areas you are comfortable in, b) are reasonably proficient in, and c) are able to generate winning insights. Compatibility is the key. This has got to be personal.

Trade within your means

Too many funds and speculators trade too furiously. Unless you’re a high-frequency trader, you don’t need to do that, especially if your portfolio is relatively small. Overtrading is a fast way to poorhouse because you will be overly dependent on slippage, fees, commissions, and spreads. Financial prices over small time frames are fairly random. There will be trends but they are far too fleeting to be traded with.

Another point worth highlight is leverage. Even the best traders will fail if they get this wrong. You can buy the wrong stocks. Most of us do at some point in our investment journey. But you buy the wrong stock with leverage, the investment will eat a huge chunk of your equity. Why did Lehman Brothers and Bear Stearns go bust? Because their equity is far too small to support their leveraged investments which went sour (subprime). LTCM was a brilliant fund that failed simply because of its sky-high leverage. Remember, with leverage you can not afford to be wrong.

Lastly, we would recommend some form of diversification within the portfolio. If your portfolio is small, then diversify with ETFs (say, FTSE 100 ETF). But don’t over diversify because you will lose focus. Strategy diversification is another of diversification.

Knowing when to stop

Most investors will go through a dry patch once in a while. When performance is down, it is perhaps a good idea to step back and assess. Is my strategy working or out of date? Is this underperformance due to a permanent or temporary change in market behaviour? Is it time to change strategies?

Again, highlighting an example from Warren Buffett. In 1967, Mr Buffett found himself unable to invest further because of pricey market conditions. He penned this: [link]

Essentially I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean foregoing large and apparently easy profits to embrace an approach which I don’t fully understand, I have not practiced successfully and which, possibly, could lead to substantial permanent loss of capital.  

He chose to stay with his strategy and closed his fund in 1969. He only restarted his operations when market conditions are better suit for his approach.

Conclusion

Investing is a mental game. It is won by not only what you did do, but what you didn’t do. In the weeks ahead, we will discuss the above-mentioned concepts with more concrete examples including trend-following strategies, stop loss strategies, position sizing methods,  identifying risk-reward trades, and backtesting strategies etc. So tune in.

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Jackson has over 10 years experience as a financial analyst. Previously a director of Stockcube Research as head of Investors Intelligence providing market timing advice and research to some of the world largest institutions and hedge funds.

Expertise: Global macroeconomic investment strategy, statistical backtesting, asset allocation, and cross-asset research.

Jackson has a PhD in Finance from Durham University.