The Two-Step Investment Process

For most investors, the investment process is little more than finding and buying a "good" stock. They identify something that they think will do well, push the buy button, and then sit and wait for it to move higher. That is essentially what the investment community tells us we should do, and they are happy to hold our cash and make some suggestions about stocks to buy.

Researching and finding a great stock is the fun part of the investment process. There is always the hope that we will uncover a hidden gem before the rest of the market and that it will reward us well. Optimism is always running high when we pull the trigger and put some cash to work.

In many cases, the optimal entry point for your new discovery may not have arrived, but there is a tendency to buy it right away so you don’t miss out or forget about it. If it really is a good stock, the entry point may not matter that much, but with some effort, timing can be used to greatly enhance returns.

Far too often, identifying a stock and buying it is the end of the investment process. Investors will watch for news about their holdings and complain if there is a downside move, but they don’t have any concrete plans for what will happen next. There isn’t any real consideration of how to manage the stock as conditions develop.

The solution to this issue is to break down the investment process into two separate and distinct steps. This isn’t a particularly profound suggestion, but it can greatly impact your thinking and mental state. It is a way to be more objective in the way you deal with a stock as it develops.

Doing the Two-Step

The first step in the investment process is to find a great stock. Make sure you are clear about what you are looking for. Is it a short-term trading opportunity, a trend trade, or a long-term investment? Dig into the financials and make sure you understand the potential catalysts that you hope will move the stock. Is it in a good sector, and what are the overall market conditions?

The second step is to design the trade or investment. You have done the work of finding the stock, but how is it going to make you money? How do we optimize your results if you have hit on a winner? One of the biggest mistakes that investors make is to rush into a new investment that is too big and too fast. Give yourself some time to become familiar with how the stock trades.

You will find that your view of the stock will change tremendously once you own some shares for a while. Your emotions will come into play, and your objectivity will be compromised to some degree. One of the major benefits of this two-step approach is that it helps to break the emotional attachment that is developed when someone researches and finds a good stock. As someone learns more about a stock, there is a natural inclination to become emotionally invested in it, and that impairs your judgment when trading it.

Trade Management

The trade management dynamic needs to be separated from the stock selection decision. In the trade management step, the focus is on price action and potential catalysts. How do you adjust position size as the level of risk increases and decreases?

I am constantly looking for new stock ideas and maintain a long list of ideas. That list has to be renewed all the time to look for optimal entry points. Once I buy the stock, then it is all about trade management.

Try thinking about investments as a two-step process and see if it helps you produce better results.

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