Money management is one of the most important – yet overlooked – strategies for reaching your investment goals.
Most stock gurus only provide an exciting new recommendation… never an entrance or exit strategy. And these strategies could mean the difference between a small loss and a total wipeout.
So for starters, here are the three fundamental things you must do:
No. 1: Place a stop loss on all of your positions
A stop loss is designed to limit your loss on a stock. For example, if you buy XYZ stock for $10 and set a 25% stop loss, your downside is $2.50 (25% of $10 = $2.50). So if the stock falls to $7.50 ($10-$2.50), you will sell your position.
Here’s why this rule is important…
In 2008, the markets suffered one of the worst downturns since the Great Depression. The S&P 500 Index fell 38.5%. And investors watched their hard-earned retirement money disappear in a matter of months.
If you placed a 25% stop loss on your positions in 2008, you would have sold well before the lows in March. You would have saved about 13% when comparing your losses to the S&P 500.
And if you were heavily invested in small-cap stocks, a stop loss would have prevented catastrophe…
During the collapse of 2008, small-cap stocks were hit hard. Companies like Sirius Satellite and Level 3 Communications lost more than 90% of their value.
These stocks had huge growth potential but were loaded with debt. When the credit markets froze, few companies were able to borrow. These debt-laden companies could not raise enough cash to fund operations, and their stock prices quickly headed south.
Placing a stop loss on your positions would have saved you from a near wipeout.
There’s more to the story…
At the market lows in March 2008, more than 20% of the S&P 500 traded for less than $10 a share. This was the largest percentage I’ve seen in more than 20 years of researching low-priced stocks. (The percentage usually hovers around 5%.)
If you use stop losses, you preserve your capital for another day.
In March 2009, you could have put the cash you saved to work in one of the greatest market runs in a generation…
Imagine having cash on the sidelines to invest in companies like Ashland, Starbucks, eBay, or Bank of America.
These stocks traded in the single digits in early 2009… and are trading at much higher levels today.
Limiting your losses will keep you in the game.
Rule No. 2: Don’t jump too quickly… Wait for the right price
From my experience, investors ignore this rule the most.
Especially in the small to mid-cap space…
They often approach these investments with the same methodologies used to invest in today’s giant S&P 500 companies.
A standard small-cap company, for example, will have a market cap of less than $1 billion…
To put that in perspective, in March 2017, Johnson & Johnson had a market cap of $337 billion.
Which means, a small-cap company with a market value of $200 million is less than one-tenth of one percent the size of Johnson & Johnson.
And because these companies are so small, their trading liquidity runs thin…
The Apple’s, Johnson & Johnson’s, or Microsoft’s in today’s market trade north of twenty million shares on a single trading session. Small caps, on the other hand, can sometimes trade less than a thousand shares a day.
My point: A large portion of buying or selling in a short period of time will cause small-cap shares to swing fiercely.
One-day moves of 10%… 20%… and 35% are common. And can bite investors in the back when they’re not looking.
One day, the share price of a financially stable and good company can be trading at $1.90. The next day, after the slightest news, insider selloff, or sell rating, it can fall 20% to $1.50.
So when I find a company with massive growth potential, I don’t jump into the market and buy immediately, at any price.
Instead, I play the waiting game.
Even if it takes weeks of waiting, so be it. I “shadow” the asset… and wait for the pullback I want.
Buying a stock for too much money will only do two things: Reduce your potential upside and increase your risk.
By simply waiting for the right price, your returns are hugely amplified.
For instance, let’s say a stock you want is trading at $1 a share. If you buy it then, and the price jumps to $4 a share, you’ll make 300%.
But if you were patient, and “shadowed” the asset until the market pulled the asset back 25% to a bargain entry point of $0.75, you would pocket 433%.
Rule No. 3: Diversify your portfolio
Diversification is buying a selection of different securities to reduce risk.
This is probably the most talked about rule in investing. I’m sure you heard it over 100 times throughout your investing career.
Yet, this is the rule investors ignore the most.
What is diversification?
Let’s say you have $10,000 in your account…
Instead of investing the whole $10,000 in one stock, you’d buy five stocks with $2,000 in each, or 10 stocks with $1,000 in each.
Sure, if the one stock you buy for $10,000 goes higher, you’ll make a killing. But let’s look at the other side of the equation…
Las Vegas Sands was trading at $115 in 2007. The gaming resorts company was about to open a new casino in Macau. Macau,17 miles west of Hong Kong, had just surpassed Las Vegas in total gaming revenue.
Las Vegas Sands’ market cap was $43 billion and most analysts had a buy rating on the stock. But in 2008, the economy fell into recession.
The real estate market collapsed and few banks were offering credit. By 2009, Las Vegas Sands was close to filing for bankruptcy, with its stock price collapsing to $1.38.
Its market cap fell to $3 billion.
If Las Vegas Sands was the only company in your portfolio, you would have lost more than 80%. That kind of ground is almost impossible to make up.
Even the best analysts will have a few losers in their portfolio – including Warren Buffett, Carl Icahn, and Bill Miller.
If you invested all of your money into one of their losing positions, you would have lost out on life-changing gains… since these legends significantly outperformed the market over the past few decades.
That’s why it’s important to diversify.
I suggest buying each position with an equal, small investment. Diversifying will limit your downside. And it will allow you to profit on any new ideas.
If you want to beat the market year after year, stick to the three rules above:
- Use a stop loss
- Wait for the right price before entering a position
These simple rules helped me outperform the market for over 20 years.