Five Questions to Ask Before You Start Investing
The map to Wall Street starts with a plan. Here's what to ask yourself before making the trip.
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Are you investing -- or want to start? You best have a plan then. Having a plan can make the difference between making money and becoming just another stock market loser. But where do you start? Here, I'll tell you five questions to ask yourself based on what I've learned in my decades in the field that includes being among the first Chartered Market Technicians, working as a commodities broker, and many years lecturing at Baruch College.
1: How much money do you have to invest or trade with?
Look at your personal balance sheet and take just a part of what you feel you can risk. When I was a commodities broker in the late 1970s , we were taught that "risk capital" was money that wouldn't affect your lifestyle if you lost it tomorrow. The reason you take just a part of your risk capital is that if you lose only part of your trading capital, you still have another chance to change your strategy and maybe recoup. You need to have some money left when you come back the next day.
If you have a stake, you will be able to come back. If you have tapped out, then you are out of the game. There is a second reason to not be fully invested. If you are 100% long and a new investment idea comes along (think of AI) that is very desirable, you will have to decide what to sell to make money available for this new idea. Having something in reserve is good in case all your open trades lose more money than you anticipated.
How much of your money or net worth to allocate for trading or investing depends on a number of factors. Consider your age and willingness to risk money; this is likely to change as you get older (ask me, I know). Examine your motive for trading; it could be to make money or it could be for excitement. Your occupation and the time you have available to trade also enter into the decision.
2. How much are you prepared to risk or lose?
Establish an overall figure, and decide on how much to risk on any one trade. I remember a number of my finance students at Baruch College would trade penny stocks between classes. They got "tips" from other students and many of them jumped in with both feet and all of their trading capital. When they lost on the trade it was their book money. I don't recommend it. You may think you have designed and tested an instant winner, but despite all the confidence you may have about making money right away, you must allow for market adversity (think about the June-July decline in a number of tech names). Typically, the loss allowed on trades is 10% or less per trade. If the stock moves 10% against your entry price, get out of the position (this is why I often recommend buying on strength. When you buy a dip you really don't know how deep the dip will become). No matter how convinced you are of the merits of the investment or the soundness of the company, when the position goes against you by 10%, get out. Your plan might use 5% as the trigger to get out. Readers of Investor's Business Daily are used to learning about cutting losses at 8% below the purchase price.
We feel better when we are right, but with investing the only thing that matters is the final result -- how much money you made. Discipline must be exercised and even planned. Without discipline, you are very likely to become an investment statistic - just one more loser.
Futures traders might consider losses of only 1% or 2% of their capital on any one trade. By keeping your losses small, you can handle a string of losses without going broke.
3. What are your specific investment plans and objectives?
It's interesting how people react to this question. Sometimes people respond with the comment, "I want to make as much as the market allows me." Other people respond by saying we should just let our profits run, simply trail our stops along until we are stopped out. Another way to take profits is not to get out until you see a top or bottom pattern on a candlestick chart. Candlesticks form quickly and can help you in marking reversals. While these answers seem somewhat logical and may work, one psychologist, who works with one of the most successful hedge funds, has found that goal setting has helped good traders become even more successful.
If you take the approach of deciding just "let your profits run" and you don't have a predetermined profit objective of 25% or 50% or 100%, then risk becomes the key. I think it is better to find a target on the chart and look at risk with the target in mind. For years, commodity traders have been applying the method of taking trades on which the profit objective or target is three or more times the risk. If you seek out trades with a risk/reward profile of at three to one, and you are diligent, then you don't have to be right half of the time to make money.
4. How do you enter your trades?
What signal will you use? For this part of devising a plan, you will find a lot of books with chapters on when to buy or how to buy. What is usually given short shrift is the method of getting out of trades. You could use moving average crossovers to enter trades. One moving average or two or three can be used. You could use mechanical methods like going long or short when the market made a new 2-week high or low, or use the 4-week rule.
There is also a breakout model that was supposedly used by the famous commodity speculator Richard Dennis. That approach was to go long if today's price is the highest for 30 days, or to go short if today's price is the lowest for 20 days. A short position would be closed if today's price were the highest in 20-days. Profits were taken using the same rules as for stop losses. When you think this approach through, you find that the exit rules are the same for profitable and unprofitable trades. In application, this means you are looking to catch the trending moves and to get out of breakouts that fail. The losses can be quite big, but you should still have money to commit when the really big move comes along.
Another model that is simple, elegant in my opinion, and sensible, comes from Stan Weinstein in this book, "Stan Weinstein's Secrets for Profiting in Bull and Bear Markets." He used some simple tools like the 30-week moving average combined with breakouts from base formations and expanding volume to buy stocks and mutual funds as they broke out. Some methods are based on buying retracements or pullbacks to bases, but Stan recognized that some of the most powerful breakouts did not have profit-taking reactions back to the base to provide a low-risk buying opportunity.
5. How do you add to positions, take profits, or move stops?
Let's assume that you bought near a breakout and the market has moved in your favor. You can increase your gains by adding to the position, but what does experience tell us?
First, always add to positions in the direction of the trend. If you are long, then add to positions on strength. If you are short, add on weakness.
Second, smaller positions or equal positions are added. If you start by buying 1,000 shares of XYZ, then add 1,000 or XYZ or less. Equal amounts will build a rectangular position, and smaller added positions will build a pyramid, with the largest positions at the lowest price. Never add to your position if the market is going against you. Always let the market tell you that you are right.
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