Active Investing: Use Your Trading Skills to Enhance Investment Returns

The two great certainties of the stock market are short-term volatility and bear and bull cycles. Whatever stocks you buy will be subject to those two forces.

Long-term investors simply ignore those issues and are confident that the quality of the stocks they buy will be recognized in the fullness of time. The market may not value them correctly at times, but ultimately, their true value will be appreciated and generate substantial returns.

The best investors in the world, including Warren Buffett, are not passive. They don't just make a single large buy and then sit and hope that it works. They manage the stock, and their position size may vary substantially.

Small investors have a great advantage over someone like Warren Buffet, whose Berkshire Hathaway BRK.A BRK.B is now so large that there are very few investments that can have any significant impact on his returns. Flexibility allows small investors to use volatility and market cycles to their advantage when managing their positions.

The key to this active investing approach is a willingness to employ effective trading strategies. The biggest mistake that most investors make is that the only trading they do with investment positions is to average down. The logic is obvious — when you like a stock, then buy more of it when it's cheaper. Big funds are always looking for ways to reduce their cost basis in their favorite investments.

The problem is that if you just average down endlessly, then you have an increased risk of a substantial loss if your great investment is not so great. Often, emotions take hold as a position grows too large, and it leads to panic selling when the misery becomes too great.

If you are going to actively invest, then you also have to be willing to reduce your favorite investments over time. The key is to be very clear about your position size and to adjust your position up and down as you take advantage of normal volatility and bear and bull market cycles.

Even a stock like Apple AAPL has had pullbacks of 50% along the way. Many long-term investors just sit idly and wait for the recovery they believe is inevitable. Professional investors take advantage of these moves, but they can only do that effectively because they are also willing to reduce positions at various times when they are strong.

4 Steps to Starting an Active, Long-Term Investment

1. Take an initial position. The key here is to keep it small and leave room to add as the stock develops. A "tracking" position, or what famed trader Jesse Livermore called a "probing" position, will force you to watch the price action more carefully and help you develop some feel for the movement. Livermore generally started with a 20% position when a stock first caught his attention. Once you are holding the stock, you will be motivated to do more research and uncover potential negative and positive catalysts. Once you are invested in a stock, it becomes much easier to develop a plan for subsequent moves

2. Look for a second entry. If the stock immediately disappoints, then dump it and move on. There is no shame in making a mistake — it is just part of the investment process. Maybe you will revisit it in the future when conditions change. If the stock is acting well and market conditions are good, add some more. Take advantage of routine volatility. It doesn't necessarily matter if you buy lower or higher as long as the chart remains healthy. It is important to make sure you have a clear understanding of the interplay of market conditions and volatility.

3. Stay patient and watch for catalysts. Now that you have a foothold in the stock, you want to see how it acts. Does that low hold? If not, then reduce the position. The longer the low does hold, the longer support holds, and the more confidence you can have in ramping up the position. Watch for catalysts like earnings or FDA decisions and adjust your risk levels for the news.

4. Stay disciplined. If the price action weakens and support comes into play, cut some and try it again. Don't just sit there and hope the trade works. Cut it quickly if the price action deteriorates. When you have a big move, then reduce some and look for opportunities to rebuy at lower prices. I often find that selling down a position into strength enables me to be much more aggressive on pullback opportunities. While other investors are complaining about the poor action, I'm happy to have the chance to rebuy at lower prices.

Active investing isn't easy, and it requires plenty of time and effort. However, it can pay off by reducing risk and enhancing returns.

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At the time of publication, James "Rev Shark" DePorre ha no position in the securities mentioned.