1) Thou art not God and are fallible.
Warrant Buffet makes bad trades and you will, too. Get over it.
Whether a bad trade becomes a very minor nuisance or a disaster just depends on one very simple rule: SELL YOUR DOGS!!!!
The definition of a dog is very simple. When a stock closes below 7.5% of the initial purchase price, sell. Under no circumstances must this rule ever be broken. Even if CNN reports it’s raining diamonds in the company’s parking lot right before you sell just sell, sell, sell.
Forget your ego, never double down, never wait for a turnaround, don’t wait to make your money back, don’t try to figure out what happened, don’t be a doe in the headlights, just take the 7.5% loss and move on. It’s that simple.
Delete from your brain the idiotic and dangerous axiom that you only lose money if you sell. That’s complete and utter nonsense that will destroy you. Don’t fall in love with a stock; love the game and sell your dogs.
2) Thou shalt not adulterate thy portfolio.
Pick only the best undervalued growth companies in an industry (seldom the biggest) in terms of comparative fundamentals (net profit margins, sales growth, earnings growth, dividend growth, ROE, excellent management, low PEG ratios, exceptional products and services, rock solid balance sheets and earning statements). Don’t buy second-rate unproven companies with inferior products or services, regardless of being “undervalued”. Second-rate companies are “undervalued” for a reason: they are second rate.
Only pick stocks that have a story about them. (i.e. The company has the lowest production costs in the industry with expanding international and domestic sales and new cutting edge products in the pipeline. They will exceed the industry growth rate because….)
If the story changes for the worse, sell.
One of the best tools to evaluate undervalued stocks is by using the sum of present values. This computation simply determines the present intrinsic value of a stock based on its current earnings and projected long-term EPS growth rate; the two most important variables of any stock.
An excellent PV calculator can be found on smartmoney.com called the price check calculator:
http://www.smartmoney.com/pricecheck/index.cfm?story=worksheet&nav=dropTab
Please remember that there is no magic bullet in trading. Always remember that “constants” never are and “variables” always do….
There are always, and I mean always, reasons why a stock is undervalued. The key to making money in the market is finding out what these reasons are. Once you determine what these reasons are, the art and science is to determine:
a) Are these real or perceived problems?
b) If they are real, how are the problems being addressed?
c) When will the solutions to the problems most likely take effect?
d) What will be the net effect of the solutions to earnings?
If you can’t answer these questions, don’t buy the stock. (See commandment III).
Always take the worst-case scenario when calculating the net effects of solutions to addressed problems. Best case takes care of itself and given Murphy’s Law, even your “worst-case” scenario could end up being wildly optimistic.
With few exceptions you’ll, on average, make more money buying small to medium capitalized companies than large capitalized companies. Go with the odds. Historically, you’ll make annual returns of close to twice that of the DOW.
3) Thou shalt not gamble.
Never buy: penny stocks, falling knives, companies with major unresolved problems (scandals, legal problems, large pending lawsuits, stocks with unproven or long-term falling sales, overvalued stocks with crazy PEG ratios, etc.) and especially don’t buy companies with cash flow problems.
Never invest in a company if its EPS (earnings per share) appreciation is pending a resolution that could go either way. Remember Murphy’s Law and always sell your dogs!
4) Thou shalt not be ignorant.
If you are a novice, never and I mean never invest real money until you know what you are doing. Practice making various portfolio simulations on Internet sites such as smartmoney.com, etc., until you can consistently make an annualized 15% return (The S&P 500 historical average is about 10% per annum). Read numerous books on stock trading and understand how to read and interpret: earnings statements, balance sheets and know how to value stocks.
There is a lot of tutorial information on smartmoney.com that will teach you all the fundamentals you need to get started.
If you are an experienced trader, never stop learning. Learn more complex things like stock options, shorting stocks, hedging, technical analysis, derivatives, etc. by continuously reading books, surfing the net and getting involved with on-line investment chat rooms.
Never become complacent with your knowledge. You can always learn more.
5) Thou shalt not be a swine.
The old saying, “Bulls and bears make money but swine get slaughtered.” is very true. Make your money by buying “too” late and selling “too” early. Let the swine try to guess the bottom 10% and the top 10% and learn to enjoy the 80% lower-risk middle ground.
Never buy falling knifes and set entrance and exit points for every stock you own. When a stock meets your targets, sell and move on. Don’t fall in love with a stock. Take your profits and move on to the next one.
6) Thou shalt not hold more than 3 stocks
Holding more than three stocks greatly lowers long-term returns. It’s impossible to conduct proper DD and monitor too many stocks. Holding just three stocks forces detailed comparative analysis to determine which three stocks make it in your portfolio.
Never, and I mean never put all your eggs in one basket, but do put them in just a FEW baskets.
Never forget the first commandment.
7) Thou shalt not covet thy neighbor’s portfolio
Don’t worry what hot stock jumped 30% in one day or what your uncle Bob says is the next “sure thing”. Have confidence in your portfolio, but sell your dogs. Undervalued medium-cap growth stocks with stories behind them will almost always win in the long run.
8) Thou shalt not invest more than you can afford to lose
Never borrow money to invest in the stock market. Start off slow if you need to and add funds to your portfolio as nonessential income becomes available. Compounded gains grow to incredible levels over time so there is no need to dig a hole of debt.
Trading on margin is fine, but be sure that you have sufficient nonessential funds to back it up in the event of a margin call. Margin calls should never be a problem if you follow the first commandment.
9) Thou shall start investing as soon as possible.
After you learn the basics and have practiced building simulated portfolios on smatmoney.com AND are beating the S&P 500 in your simulations then start as soon as possible.. Just do it. Don’t procrastinate. Start off small but get started. Compounded gains grow at incredible rates. As you become more proficient and gain confidence, add more to your account.
Starting with just $10,000 and adding 3,650/year (just $10/day) at 15% compounded gains for 30 years will grow to over $2,500,000. If you took that same money and stuck it under your mattress, it would only amount to only $119,500….
http://www.moneychimp.com/calculator/compound_interest_calculator.htm
10)Thou shalt trade by set rules
There are basically two types of traders: value and momentum investors. Both types make money, but you need to determine what system works best for you and stick with it.
Stay focused on just one strategy, stick with it and become an expert. Don’t mix stocks of different strategies in your portfolio. They require different disciplines and you’ll lose focus.
Always trade with what’s between ears and not what’s between your legs. Don’t become emotional and don’t trade too often, but never forget the 1st commandment: SELL YOUR DOGS!!
Decide on WHAT to buy using Fundamental Analysis (FA), and decide WHEN to buy on Technical Analysis (TA). Not the other way around. If you’re just starting, don’t try acting on Technical Analysis until you have a lot of experience. TA is, by definition, is, well, technical and takes a lot of hard study, practice and discipline to use it correctly.
There was some very interesting research done at the University of Chicago, which found a phenomenon they ended up calling, the house-money effect, which seems to be hard wired into the human brain. Simply put, humans are predisposed to sell winners and hold losers. The complete opposite of what you need to do to make money.
I guess it all boils down to this axiom a very smart trader once said, “The market is driven by fear and greed. The problem with most people is that they are greedy when they should be fearful and are fearful when they should be greedy.”
Buy low, sell high. It sounds so simple in theory but it takes real discipline to actually do it.
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