On Saturday, I shared with you the first three of my five simple investing rules that can dramatically boost your performance and potentially beat the stock market by following five simple rules. They were:
- Rule #1 – Set Goals and Monitor Your Progress
- Rule #2 – Concentrate Your Assets
- Rule #3 – Structure Your Portfolio and Rebalance at Least Yearly
I’m going to go through the last two today. Taken together, they’ll make you a much better investor – wherever you choose to put your money.
Rule #4 – Use Trailing Stops to Limit Risk
Think of it as a plumber would. Big losses – like water in your living room from a broken pipe – are expensive and tough to recover from. They can set you back years, which is why it’s best not to incur them in the first place.
Instead, do what the world’s most successful investors do. Focus the majority of your efforts on avoiding losses in the first place.
Success here will really make a difference, especially when you consider that most investors have been halved twice in the last decade – once from 2000-2003 and again from 2007-2009.
The simplest way to avoid catastrophic losses is through the use of protective or “trailing” stops.
These work in one of two ways. You can set them at a certain percentage below your purchase price when you first buy a stock or other security. Or you can set them at an absolute dollar amount below your purchase price.
And if that stock starts to run, you can “slide” your stop up and keep it at a certain percentage below the current price.
In either case, the “stop” establishes a certain price at which you will exit the position – automatically and with no questions asked.
For instance, I favor a 25% trailing stop. This means if I buy shares in “XYZ Corp.,” and XYZ falls 25% from my initial purchase price, I’m out – no emotion and no potential for vacillating with indecision as the loss widens.
Similarly, if I’ve owned XYZ for years, and it’s risen tremendously, I’ll move my trailing stop up in lockstep. That way, I’ll keep at least some of those profits should the stock ever fall more than 25% from its successfully higher peaks.
With today’s technology, there’s simply no excuse for not employing trailing stops as a means of protecting your savings. Almost every broker now offers software or the online capability to easily establish and monitor your investments, including the use of trailing stops.
Rule #5 – Don’t Chase the Train If It’s Already Left the Station
Most investors have an uncanny knack for doing exactly the wrong thing at precisely the worst possible moment – meaning they buy or sell at times that inflict the greatest amount of financial damage on themselves.
That’s why it’s well documented that investors sell at market bottoms and buy when things have already run up (and are ready to reverse).
Given human nature, that’s completely normal.
But it doesn’t mean you can’t avoid such emotional pitfalls in your own investing.
That’s especially true now, when many investors are trying to make up lost ground by piling in at a time when the U.S. Federal Reserve has its foot on the gas in a well-intentioned, but ultimately misguided, effort to reinflate the markets and stimulate our economy.
The way I see it, piling into stocks in a wholesale fashion right now is like running down the platform in an attempt to catch a train that left the station in March 2009 – after the market has gained 95% (as measured by the S&P 500.) If you do that, the odds are strong that you’ll trip and fall – right off the platform and onto the tracks.
I think it’s far better to buy your ticket and then calmly walk for the train that you know is waiting.
All investments contain risk. But by following the five simple rules I’ve just outlined you can go a long way to ensuring a healthier, more profitable portfolio that’s capable of generating market-beating returns.