DEVELOPING AN INVESTMENT STRATEGY
Developing an investment strategy is one of the most important steps to becoming a successful stock market investor. Contrary to common belief, this process doesn’t require any specific knowledge or skills, but rather an understanding of oneself. This process is usually a very simple one, the difficult part comes with actually sticking to the strategy. The vast majority of mistakes made by investors occur when there is a deviation from the strategy. The following is a list of points that should be looked at when developing an investment strategy;
Clear definition of investment goals:
Whether you are buying stocks to hold for the long term or whether you are trading every day, every investment decision you make should in some way be designed to achieve at least one of your investment goals. When setting your investment goals, ask yourself questions such as; “What is my objective for investing in the market? What are my financial goals from these investments? Do I want income specifically, or am I focused more on capital growth?”
Developing your investor profile:
Once your investment goals have been determined, the next step is to work out your investor profile. Developing your investor profile will establish what type of investor you are and help you choose the types of investments that suit you. An investor profile usually focuses on two main variables… time horizon and risk. Ask yourself questions such as, “How long do I intend to be invested in the market for? Am I a long term or short term investor? What sort of income am I looking for over this invested period? “What is my attitude towards risk? Am I a high risk investor or do I have no tolerance for risk at all?”
Investing vs. speculating
Part of developing your investment strategy is to decide whether or not you are an investor or a speculator. Investors tend to have a longer term outlook, while speculators tend to be much shorter term. Investors buy stocks based on fundamental analysis… i.e. looking at the financial position of the business and trying to forecast where the company will be in two, three and four years down the track. A stock is bought when the share price is cheap, or does not reflect the value of the business going forward. Over time, if the forecasts are correct, then the share price will catch up to the value and a profit is made. Because this longer term view is taken, an investor should not be concerned by day-to-day movements in the share price, but rather things that will affect the earnings for that business.
Speculating, on the other hand, is more focused on share price movements as opposed to the financial analysis of the company itself. Often stocks will be held for less than a day, in some cases less than an hour. Speculators look more at price movements and use tools such as charts to try and forecast where and when a share price is going to move.
Capital allocation refers to the amount of money you choose to put in each individual investment. It is an effective way of managing risk. Most believe the only way of managing risk is through diversifying your portfolio, however, allocating capital efficiently will also minimise your risk. Every investment has a certain amount of risk already attached to it, so if you have a low tolerance for risk, then you would only have a small amount of capital in the higher risk investments. For example, if in a $100,000 portfolio, a high risk investment has a weighting of 3% and that share price halves, then the portfolio will only be down 1.5%. Whereas, if the high risk stock has a weighting of 20% and the share price halves, then the entire portfolio is down 10%.
For this reason, careful consideration should be given to how much is invested in each particular stock.
Diversifying your investments:
The second way of managing risk is through diversification. Diversification simply means owning a broader range of stocks as opposed to holding just one or two. If you hold a variety of stocks, it is unlikely that they will all move in the same direction, therefore if one or two of your investments do move in the wrong direction, the losses will be offset by the gains made on your other investments. This works in both directions in a diversified portfolio, however, with the gains made in your profitable investments also being offset by losses made in others. There is no correct number of stocks that one should have in a portfolio… it will be determined by your risk profile and capital allocation decisions.