Five Investor Tools to Turn Choppy Stock Markets to Your Advantage
InvestorEducation / Learning to Invest May 10, 2014 - 11:10 AM GMTBy: Money_Morning
Back in the late 1990s, my wife was expecting our second daughter and we were really anxious to buy a home.
But the real estate market was soaring … prices were insane.
I can’t tell you how many times we lost out on a house we really liked because some other buyer was willing to pay 25% or more above the asking price – or was an “all-cash” buyer.
I never play that game – and never pay more than list.
Although real estate agents urged me to “look at the market” and “play the game” to get into a house, I refused. Overpaying, I knew, might work in the moment. But when the market got back to normal, I’d be left owning a house that was worth less than I paid for it.
You just can’t make money that way.
As it turns out, we ended up buying a great house for thousands under the asking price. Not only that, but the agents cut their commissions to make the deal and actually paid us cash to move in.
I’m telling you this tale for a reason.
My story underscores the importance of managing risk in a turbulent market.
And what’s true of real estate is just as true for stocks, including tech stocks. At their core, houses and tech stocks are both financial assets. Managed recklessly, they can drive you into the poor house.
But managed skillfully, they can make you rich.
During my 30 years as an investor, I’ve developed five tools for turbulent markets. Through the years, they’ve always turned the table to my advantage.
And today I want to share them with you.
With the Nasdaq Composite Index – and tech stocks in general – going through a turbulent stretch of their own, these five rules will help keep you from making mistakes.
My five rules will help you navigate the choppy markets we’re seeing right now. And, in the long run, they will help make you wealthy.
Choppy Market Tool No. 1: Make Lowball Offers
I understand why many investors are confused these days. After all, the markets are all over the place.
But don’t worry: These rules are a set of tools that, used correctly, will put your mind at ease in any kind of market. And, in the long run, they’ll help get you to the “Winner’s Circle” so you can profit.
By making crazy low offers in a torrid real estate market, I bought a home with built-in profits. It’s a time-honored investment principle: Make your money when you buy, not when you sell.
With stocks, it’s easy to make lowball orders. These are called “limit” orders, meaning you only buy when the stock hits your chosen personal target price.
Let’s say momentum investors have piled into XYZ Software Corp., causing it to double in a short amount of time. Now, it’s sold off a bit, and is locked in a directionless, “sideways” market.
You want to buy the stock for the long haul: It has great financials, strong management, excellent products, and a strategically sound position in a growing market.
Suppose XYZ had a recent high of $100 and then dropped to $75. A lowball limit order of, say, $60 (a 20% discount) will protect your risk of losses and greatly boost your long-term gains.
Remember to stay focused and disciplined. If your research has yielded a price that makes sense, stick to it. You can set it up so the lowball limit order automatically expires in 60 days, which is called “good till canceled.”
If the order doesn’t fill, don’t worry about it. You’ll have plenty more opportunities in the future.
Choppy Market Tool No. 2: Buy “Test Shares”
Buying test shares is a powerful way to turn the investing odds in your favor. And it works in any kind of market.
The idea is to conduct a personal “reality check” for any particular stock. Think of it as dipping your toe in the pool instead of jumping right in.
I recommend this method so you don’t wind up sitting on the sidelines only to watch a desired stock run up before you have a chance to act.
For instance, let’s say XYZ Software is reporting earnings in two weeks. If the company beats estimates, the stock will soar. If it misses, the stock could get crushed.
Buying a few test shares is a great way to establish a position. As the term implies, you would buy only about 5% to 10% of your usual position on XYZ, using it as your initial entry point.
That way if it tanks, you won’t get killed. You’ve only devoted a small amount of your risk capital to this investment.
Look at this way. A 20% loss on a $1,000 entry is one-tenth the damage to your portfolio as the same loss on a $10,000 position.
This is one of those times where we want to wear both a belt and suspenders: We also protect our test-share position with a hard stop-loss.
Choppy Market Tool No. 3: Limit Your Exposure
And that brings us around to another important tactic. The rockier the markets, the more we want to limit our exposure.
A good way to stay in the market and limit your risk of loss is simply to make smaller entries. Look at it this way: If “test shares” are the equivalent of toe-dipping, exposure limits could be viewed as the equivalent of wading into the pool up to your waist.
Neither approach lets you get in over your head.
Let’s again assume the standard position for you is the $10,000 we discussed in the example of XYZ Software. To limit your exposure – and “wade into” the position – cut that buy in half.
In a particularly worrisome market, you can even combine the test-share and exposure-limit strategies. Start by purchasing your test-share block, re-evaluate both the stock and the market, and then purchase the remaining shares required to establish the smaller-than-usual “exposure limit” position.
This is a savvy, emotionally reassuring one-two punch that will help protect your portfolio from a knockout blow.
And such deals are even more powerful when you also use stop-losses to protect your hard-earned capital. Remember that you should almost always use “stops” to limit losses and protect profits.
Choppy Market Tool No. 4: Play “Moneyball”
In a whipsaw trading environment, consider following what I call the “Moneyball Method” of investing. Because I’m a fan of the Oakland A’s, this is an easy one for me to remember.
I named this method after the book and movie “Moneyball” about the A’s success in the early 2000s on a shoestring budget.
A key part of the team’s strategy was to focus on a metric known as “on-base percentage” – a measure of how good a batter was at getting men on base. The A’s won by letting the other teams swing for the fences while they focused on base hits, walks, and other means of getting the maximum number of folks on base. The team’s rationale: The more times our batters get on base, the more runs we’ll score – and the more games we’ll win.
The A’s have it right: It’s all about winning.
So let’s translate that into tech investing. As much as we like to focus on growth companies for their swing-for-the-fences gains, in choppy markets you need to look at getting the equivalent of walks, singles, and doubles – in order to “score” as much as possible.
So, in a bad market, when find yourself nabbing gains of 50% on a stock in a very short stretch, lock in at least some of the profit – before a whipsaw market reversal takes it away.
Once again, let’s say you invested $10,000 in XYZ Software Corp. After the stock advances, you want to protect profits against sudden reversals by taking gains off the table.
For each investor, the profit figure will vary. But I think in current choppy conditions, the average investor should take some profits by selling half the position when a stock is up 50% or so.
After that, you can protect profits even further by making sure you have a trailing stop. Let’s say you bought 100 shares of XYZ Software at $50 and it rallies up to $75.
In this case, you would sell half for profits of $2,500. Then, you can further protect yourself by putting in a trailing stop of around 20%.
With XYZ, that would mean selling the other half at $60 a share ($75 − 20% = $60). That gives you blended gains of 30% no matter what happens.
Even if you decided to give the stock plenty of room to run but automatically sold the remaining half at your entry price, you would still have weighted gains of 25%.
And in an especially choppy market, you might want to consider taking profits when you have very quick gains of as little as 20% to 40%.
Choppy Market Tool No. 5: Always Have Some Cash on Hand
An effective strategy that many investors forget is the importance of keeping a cash reserve.
Instead of thinking of cash as staying out, consider it as actually taking a position in the market. When there are a lot of bargains out there, the last thing you want to do is run out of money.
When that happens, not only do you miss some great opportunities, but being cash poor can make you indecisive and set you up for further losses.
Let’s say you’ve invested your entire cash pool in the market, and then the market starts to drop. Without extra funds, you can’t take advantage of great stocks that are “going on sale.”
If your ATM is empty, the only way you can increase your position in XYZ Software while it’s down 15% is to sell another stock. That may sound easy – but it’s not.
In a choppy market, cash-poor investors tend to freeze. So, when everyone else is confused or panicked, you can be bold and pick up tech leaders at a huge discount – as long as you have cash.
Combine these five rules, and you have yourself a powerful tool kit for uncertain markets. After all, our goal here at Strategic Tech Investor is to help you make money consistently.
Times like these are when it pays to remember this rule for creating lasting wealth: Separate the Signal From the Noise.
No doubt, the noise is high now because there is a lot conflicting economic news. In fact, in an upcoming conversation I’m going to talk with you about how to analyze that news to become a better investor.
And with the tips we’ve discussed today, you’ll be able to do just that by earning stock profits no matter what the market is doing.
[Editor's Note]: Michael’s latest research has just been released. It centers around a guy named J.B. Straubel, easily the world’s wealthiest and most brilliant tech innovators that most people have never heard of. Yet that’s about to change in a big way. Go here to see Michael’s full story.
Source : http://strategictechinvestor.com/2014/05/five-tools-to-turn-choppy-markets-to-your-advantage/
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