Four Stages of a Successful Investor – Stage 3: Stock Investors

Continued from yesterday’s stage two post.

Stage Three – Stock Investors

Whether it’s after a few months or a few years, successful investors often grow tired of the evils of mutual funds and move towards making their own individual investments.  They might have gotten a taste of the better gains through ETFs and now want to see what they can do with individual stocks.  They might have only been parking their money in mutual funds while they studied stocks, saved and eventually built up enough cash to make individual stocks worthwhile.  However they got here, these stage three investors are likely to understand that over-diversification will hamper your returns.  That’s what index funds are for, striving for average.

By stage three, a successful investor has enough money to invest in at least five stocks without using margin.  An old myth still exists for some that stock purchases must be made in lots of 100 shares.  I’m not sure how that theory got started, but it is no longer true.  My only guess is that there was less liquidity in the market before electronic trading became the norm and to simplify trades brokerage houses pushed investors to trade in larger lots with 100 as the common denominator.  These days we can trade on line and are charged the same commission for 25 shares as for 500 or more shares.  This change opened the door for smaller investors to get started investing in any stock they wanted without having to worry if they could afford 100 shares of the stock in one transaction.  Clearly the advantage to trading in larger lots includes spreading out the commissions over a greater number of shares so the cost per share is less.

Stage three investors understand that diversifcation has its pros and cons.  Downside risk decreases as the number of sectors and industries increases.  The point of diminishing returns enters the equation somewhere between 10-15 stocks.  At that point, each individual stock that goes up has too small of an influence on the total portfolio.  On the other side, an investor who has too few stocks can be devistated by one bad investment.  The sweet spot is between eight and 12 stocks.  As an example of my point, consider if you have 10 stocks and you have the same amount invested in each.  If one goes bankrupt and the others stay even then you only lose 10% of your portfolio balance.  That’s pretty good considering you picked a complete loser of a stock and didn’t sell the whole way down.  If one doubles and the others stay even you still make a 10% gain.  That’s quite good considering that you are hitting a .100 batting average and struck out on the nine other trades.  Peter Lynch thought that out of every five stocks he bought, one would not do well, three would be mediocre and one would take off.  The key is to let the good one run free and cut your losses on the one performing poorly.

During stage three successful investors hone stock picking skills.  The causes behind what makes a stock price move start making sense whether it’s through macro economic factors, individual fundamental analysis or technical analysis on an equity or even a combination of both approaches.  Learning these skills well takes a lot of reading and learning through real time experience.  The time a successful investor takes to analyze a stock decreases dramatically as experience builds.  Since each stock trading decision takes less time with more experience, faster analysis means more choices for investments.  In other words if you only have one hour per day to research stock picks and when you started investing you needed that full hour to decide on one stock, when you have more experience you might be able to make a decision on 6 stocks in that same hour.  This leads to better stock picks as you can pick the best one or two of those six stocks researched to invest.

In layman’s terms, fundamental analysis can be related to why a farmer is willing to pay more per pound for a calf than a cow.  If this sounds like an odd comparison, consider the future output of a calf versus a cow that might have already had her best production years behind her.  A calf has more physical growth (think revenue increases) and more years left in producing new calves (think divdends).  The term “cash-cow” didn’t become a standard business term without reason.  My Mom grew up on a small farm we still own where we raise cattle although we don’t live down there.  Being raised with such a basic understanding of how important growth and dividends are in valuing an asset helped shape my understanding of the value of companies.

Charting can be more complicated with the scores of different theories out there.  I keep my charts simple and focus on trend lines.  Stocks tend to move in a generalized direction and move up and down around those lines based on other investors’ emotions.  If no other macro economic factors (such as 9/11, Huricane Katrina, a Fed rate cut/increase, etc) and no stock specific factors (such as earnings being better or worse than expected, customer goes bankrupt, customer says business is better than expected, etc) have occured then the stock can be a good buying opportunity when it comes below the average straight trend line or to the lower part of a trading channel.

This is the stage where investors might stop reading “Money” magazine which caters to stage two investors and move towards rags like “Barron’s” and “Investor’s Business Daily” for more individual stock ideas written at a higher level of understanding.  “Barron’s” is a weekly newspaper and “IBD” is daily Monday through Friday.  The “Wall Street Journal” is also daily Monday through Friday and offers great in depth articles on the markets.

An investor’s personality type emerges in stage three.  Some investors like to buy and hold the same stock for years as they wait out rough periods while others will see the benefits of continuously analyzing their holdings and selling stocks when they have earned the return they wanted from it and then move on to another that has greater potential.  Successful investors learn to keep emotions out of their trading model.

If you are not reading this post on www.mytradersjournal.com you are reading it from a site that has plagiarized it.  I’ve had to add this notice to the end of every post with the growing number of scum out there who steal posts and don’t credit the authors.

Click here to read my stage four description.