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Many long-held beliefs about share investing are seemingly not working and investors have had to endure one of the biggest rollercoaster rides the sharemarket has ever seen. But share investing can still be a source of significant wealth creation if you follow these rules, reports Wealth Within's DALE GILLHAM.
By Dale Gillham, Wealth Within
The global financial crisis of 2008 and recent sharemarket woes have left many investors wondering what they need to do to be successful.
In this article, I discuss 10 things you need to do to be successful in the sharemarket, and bust some myths that I am sure many believe to be true.
Before I do, there's one thing I know for sure has not changed: the Three Laws of Wealth Creation I talk about in my book. They are 1) spend less than you earn; 2) invest wisely; and 3) leave it alone so it can grow - let the law of compounding work for you.
The 10 points below are in no particular order because all are important, and some are discussed in more detail in my book, How To Beat The Managed Funds By 20%.
1) Learn to 'read' the market
Any great football champion will tell you that the key to their success is learning how to "read" the game - knowing with a high degree of accuracy what their team-mates and opposition are likely to do before they do it, and using that to be in the right place at the right time. The same can be said about the sharemarket. The market is a living, breathing organism that is constantly changing, and over recent times this has caught out a number of traders and investors. Consequently, the majority mistakenly believe that now is the time to run for cover and put their head in the sand. They believe it is all too complex, and they lack the knowledge to invest properly, which leads to poor decision-making based on fear and greed.
Learning to read the market is not hard and mysterious, and those with the right knowledge and experience are adapting to market conditions, which for them present opportunities rather than threats.
2) Buy and hold is not the answer
Investors generally live by the strategy that "buy and hold" is the best way to achieve superior market gains, yet most adopting this approach over the past decade would have seen poor returns and portfolio values drop by 50 per cent or more during the GFC. Making matters worse, a 50 per cent loss means a portfolio has to rise by 100 per cent to attain pre-GFC market value.
In essence, using a "buy and hold" approach will see gains made during bullish periods decimated when the bears take control. On the other hand, an active approach allows you to participate in the majority of a bullish run and sit on the sidelines to avoid the worst if the market turns bearish. Using a simple capital preservation technique, such as a stop-loss (a pre-determined point at which you sell; see point 6 below), will achieve superior returns because the portfolio will not suffer large losses and returns are compounded much faster than by holding on to falling shares and hoping for the best.
3) Have a plan
Did you know that the logical part of your brain is much smaller than the emotional side? To make smart decisions about your finances, it stands to reason that you need logic to dominate, yet the opposite is normally the case once fear or greed set in. This is the main reason that otherwise intelligent people chase get-rich-quick fantasies (through greed) or hang on to shares that have lost significant value (through fear of loss): they are following emotion-driven financial decisions.
In recent months and during the GFC we have seen what fear can do to financial markets the world over. The way to avoid this is to have a solid plan in place as to how you will, and most importantly will not, invest your wealth (Law No. 2), and stick to your plan (Law No. 3).
4) Cheap doesn't mean a bargain
There is talk around at the moment from many in the industry that shares are cheap and the time is ripe to "buy up big on some bargains". In theory this may be true and BHP Billiton shares might look appealing at around $40, but how do you know it won't fall further? Many investors in the past bought into shares such as Babcock and Brown, HIH, Onetel, ABC Learning Centres and many others on the premise that they were cheap, only to lose more money.
Just because a share seems cheap or pays a high dividend because it has fallen hard, does not make it a good investment. The financial industry has stood firm by the myth that "time in the market" is king, but the GFC and current volatility have exposed flaws in this theory. If you know how to time the market, or more specifically how and when to enter a share and get out before the longer-term direction changes, you will be far ahead of the pack.
5) Don't follow the herd
Many investors react to market conditions by purchasing shares en masse when markets are rising and selling en masse when markets are falling; the old adage that investors buy at the top and sell at the bottom rings true. In my experience it is wise to take a contrarian view to investing, which is supported by Warren Buffett, who once said: "It is better to be fearful when others are greedy and greedy when others are fearful."
6) Use stop-losses to protect capital
Successfully investing in the sharemarket is not about how much you make but rather about how much you do not lose. In other words, it is about minimising risk, not maximising profits. A stop-loss is simply a price point where you sell a share to preserve capital if the trade turns against you. I suggest exiting at 15 per cent below your buy price. When you learn how, you can also use stop-losses to protect profits. Simply using a stop-loss would have saved investors from losing thousands over the past few years, and if I had to rank the importance of these 10 points then this would be number one by a long way.
7) Always manage your risk
The amount we invest in the sharemarket tends to change our perception of the risk we are taking and the research required to manage that risk. Usually this is because it is much easier to swallow a $1000 mistake than a $500,000 mistake. But let me assure you, the process you take to invest $500,000 or $1000 should be exactly the same.
8) Educate yourself
Ignorance can be very expensive. Many who told me in the bull market that they did not need, or could not afford, to learn have now suffered losses many times greater than if they had gained a solid education. When it comes to the sharemarket, your first investment should always be to educate yourself. Ask yourself, would someone else give you their money to manage?
9) Don't over-diversify
We have all heard the saying, 'don't put all your eggs in one basket' and there is good reason not to. It makes sense to spread your investments across different asset classes. However, when diversifying within an asset class, we find that people mistakenly hold too many shares in their portfolios.
An over-diversified portfolio tends to have one-third of the shares rising, while the other two-thirds are either travelling sideways or down. We only want to hold on to those that are rising, so it makes sense to get rid of those not performing by following point 6 above. My research and conclusions formed by others proves that it is wise to restrict a portfolio to between five and 12 different shares on average. The benefits are that it is much easier to select a small number of rising shares, the portfolio is much easier to manage, and to top it off you will save money on transaction fees. All of that helps you make more money.
10) The holy grail
Many investors search for the fabled holy grail of investing, the system or fund manager that will be able to turn them into millionaires overnight. They chase high returns but when things do not go as expected they blame others, because they have not taken responsibility to properly understand what they have invested in.
Storm Financial is a prime example of investors chasing the holy grail of high returns. It simply does not exist and never will, and such investors and traders should take heed of the old adage that slow and steady wins the race. The three "P's" to successful investing and trading are that it takes Patience, Planning and Persistence. In my experience, anyone thinking they will make big money quickly is on the fast track to going broke.
About the author
Dale Gillham is author of How to Beat the Managed Funds by 20%, and Director/Chief Analyst of Wealth Within.
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