Iron Rules for Stock Market Investing

When it comes to investing one should target to increase the probability of success. The market is unpredictable on a short-term basis, but there are some long-term rules investors can follow to increase the profitability.

Iron Rules:

1. Follow the trend: if the trend is up – Buy!

• If the stock keeps going up – buy. Reasons for it are of secondary importance. PE ratios, economic sentiment, bad CEO news do not matter.
• Stock Markets in most countries trend up overtime. Once exception has been Japan, where the trend can be interpreted as down or sideways.
• If the trend is up simply buy. There is simply no good reason that I found to purchase a stock in a downtrend. I always always lost money no matter how good my reasons were.

2. If the trend is down: Do Not Buy

• If the stock or a given market keeps falling do not buy
• Reasons for a downtrend are of secondary importance. People are selling for a reason, and although you may not be aware of their reasons, the reasons themselves are not that important.
• If the trend is down – do not buy. Move to another security or ETF

3. High Dividend Yields and Low PE ratios are warning signs of a company that is about to disappear. Avoid high yielding and Low PE Ratio companies

• Low PE ratios are irrelevant in a downtrend and are not a good reason to buy a securities. This is simply because price leads earnings. Insiders and investors are selling because they see future earnings going lower. This is a PE Ratio trap
• Same applies to Dividend Yields. High dividend yields are a negative signal. Oftentimes, high dividends are cut and price declines even further.
• From my personal experience:
  • Purchased Yellow Pages, Second Cup, and Cominar Real Estate because of high dividend yield (i.e. 10%). My thinking was that I was purchasing an income making portfolio. However, what I was buying was pure crap. All these companies declined even further, and some completely disappeared. In some cases, I was able to get out of a trade clean before the absolute reckoning.
  • These companies had a very low PE ratio and high dividend yields, and thought I was getting a deal, but I was very very wrong.

4. Stock Market Drawdowns are opportunities: Buy When the stock market declines 50%+ or rebalance your portfolio to strategic asset allocation (Contrarian / Rebalance Trade)

• Investors should always follow their asset allocation and consult with their investment advisor
• However, in my personal experience, when a stock market declines and I have some spare cash sitting around – rebalance the portfolio (i.e in this case rebalance to your strategic asset allocation) or invest your spare cash based on your strategic asset allocation (i.e. 60% stock / 40% bonds)
• I have been an investor since 2007. In 2008, the whole stock market declined 50% and there was a lot of fear. People were selling their positions. However, it was time to buy.
• Stock market declines are a blessings in disguise. I can buy the whole market at 50% discount? Yes please.
• This rules does not apply to individual stocks. If the market is healthy and a company declines 50%, it is likely going lower because there are issues with that particular company. In any case, we don’t know the future with a particular stock and neither with a stock market
• However, a stock market is a diversified portfolio of 500 securities. It is unlikely that all of them disappear.
• How often do these opportunities present themselves?
  • Since 1923 40% drawdown occurred only 6 times. Be greedy when everyone is fearful, and be fearful when everyone is greedy.

Credit: A Wealth Of Common Sense

5. Stock are a long-term investment: the longer you hold the less is your risk

• Stocks are a long-terms investment (in my opinion a minimum of 10 years).
• If you are investing for a shorter term your allocation to stocks should be lower.
• Your total return becomes more stable if your holding period increases. Fidelity has a great tool that demonstrates this concept.

• The tool also demonstrates that in a given holding period you can loose money (even though it is a 10 year horizon, yes, you can still loose money)
  • However, you can minimize the probability of loss by investing in different 10 year periods (i.e. every year)
  • Investing in different/uncorrelated markets

6. Trend reversing trades are rare

• You must have a very very ….. very good reason to buy in a down-trending market.
• The only market that I have been successful in was commodities.
  • For example, I bought silver because the silver/gold ratio was at all time high (120 ounces of silver to purchase one ounce of gold). The ratios was an absolutely extreme level, and has started to reverse before I entered into a silver position
• I have not been successful in other markets, and do not have good experience trading against the trend. I generally tend to loose money.

6. Stay Invested in the Stock Market or other Risky Investments Based on Your Asset Allocation

• It is important to stay invested based on your strategic asset allocation, which is unique to each investor
• For example, missing a few positive return days (i.e. not being in stocks on those days) would have a significant negative impact on your portfolio.
• Fidelity has another good tool to demonstrate this concept. If you missed 20 best days since 2002, your portfolio value would be between $12K (missed days scenario) and $33K (fully invested scenario)