You need this chapter for two essential reasons. First, we want you to be very careful with your capital. We strongly recommend you put only 18-20 percent of your capital into short-term trading and the other 80 percent into sound, long-term investments. Second, before investing whatever part of your money you decide to put into long-term investing, you should be aware of some of the various strategies for that kind of portfolio. You will find some of those various styles and strategies here, in a shortened form. As you will see, many investment principles can be used or modified so you can use them in your short-term trading strategies as well.
As you probably know, when it comes to stock investing, there’s no shortage of methods, strategies, plans, and theories to make money. Some strategies are untested; some are proven. None of them are absolute or work all of the time. What you will find here are many of the best known and most effective stock investment theories. These are the fundamentals you need to know before you go any further. This is just the beginning.
The following are some basic concepts that you should know and keep in mind at all times.
Diversification
Your portfolio can be severely damaged if you put all your eggs in one basket. It is a cliché, but it is true. If your money is all in one sector, or heavily concentrated in only one or two stocks, and that part of the market collapses, then so does your money. Make sure you invest in a mix of different kinds of companies. Even in the best of markets, not all stocks go up at the same time, and some can even head downward while most stocks are skyrocketing. If you have too many stocks in one or two sectors, such as banking, raw materials or energy – or if you have your money in only one or two stocks – and that sector or those few stocks nosedive, your portfolio will, too. Sure, if that sector skyrockets, your portfolio looks great. The best offense, however, is a good defense. Make sure you are diversified so you don’t lose too much when, not if but when, the market or some of its sectors take a nasty downturn.
You must have a plan when to sell. Nothing goes up forever. Determine under what circumstances you will sell and stick to your plan. Be disciplined. For most investors, selling is a lot harder than buying, and for a lot of reasons. If you’ve lost a lot of money, the temptation is to stay with the stock and hope it comes back. If the stock has gone up a lot, the temptation is to stay with it and hope it will go up even more. Sometimes you will sell the stock and it will continue to go up a little, then anxiously you will buy it back just in time for it to fall and take all the profits you just made. Obviously, these actions are classic signs of Fear and Greed. If you plan ahead and know when you will sell and ruthlessly apply that discipline, you will save yourself a lot of pain – and will make yourself more money by getting out of a stock when the time is right for you.
Understand Fundamental Analysis and specifically know about a stock’s beta coefficient. The beta coefficient is a measure of how volatile a stock is compared to the market. Usually, the stock is compared to the ALSI index (ALSI 40). If a stock has a beta of 1.0, then it rises and falls exactly as much as the market does. If the beta is higher than 1.0, then it has wider swings, up and down, than the general market. If a stock’s beta is lower than 1.0, its ups and downs are less than the market’s general rise and fall. A high or low beta is neither good nor bad. It is simply a way of measuring how risky an investment the stock is. When you buy a stock, you have to factor in your ability to handle risk, and beta helps you determine whether a stock is too risky, too conservative, or about right for your own risk tolerance level.