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The two most pressing questions on investors’ minds are: have we seen the bottom yet, and where is the market heading in the next 12 months? The answer to the first question was covered in my last article, Are we there yet?, and in this webinar.
So how can you make the most of future sharemarket opportunities?
1. Don’t use dollar-cost averaging
According to professionals, dollar cost averaging can reduce the risk of investing in volatile markets and help to avoid the so-called pitfalls associated with “timing” your entry into and out of the market. In my opinion this strategy is flawed because investors subject themselves to higher risks when investing in assets that are falling in value – which has certainly been the case over the past few years.
2. Don’t buy cheap small-caps
Many investors tend to buy a share simply because they perceive it as cheap. To some, “cheap” implies getting a bargain, which may be the case down at your local supermarket but this mindset is not the best strategy to adopt in the sharemarket. You want to buy quality, not quantity, because this is where you generally get the greatest gains.
3. Don’t buy and hold
Time in the market is probably the most perpetuated myth in the financial industry. But to accept that time in the market is more important than timing the market is probably the greatest downfall of anyone wanting to beat the market average.
4. Don’t overuse leverage
Many investors get attracted by the hype and supposed quick returns that leveraging provides, however, reality has consistently bitten these people in both bull and bear markets. It is important to understand that leveraging not only magnifies gains – it also magnifies losses. Here the uneducated get eaten by the educated.
5. Don’t be affected by herd mentality
Investors react to market conditions, purchasing shares en masse when markets are rising and selling en masse when markets are falling. But in my experience it is far better to take a contrarian view to investing in the sharemarket. This is supported by Warren Buffett, who once said it is better to be fearful when others are greedy and greedy when others are fearful. In reality, most investors are fearful and greedy at the same time, which results in an inability to profit from market fluctuations.
6. Use stop-losses to protect capital
Successfully investing in the sharemarket is not about how much you make. Rather, it is 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 security to preserve capital if a recently entered trade turns against you, or to protect the profits of a winning trade. If you think about it, this rule alone would have saved investors from losing many thousands in the GFC.
7. Buy only top-quality stocks
The top 100 shares on the Australian market achieved this status for one reason: they are the best-performing shares in the market, so it makes sense to stick with a good thing.
8. 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 $1,000 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, as they both represent the same amount of risk.
9. Diversify – but not too much
While it is true that diversification reduces risk, a portfolio of shares that is over-diversified (for example, more than 12 stocks) is exposed almost exclusively to market risk, which cannot be eliminated by diversification. A portfolio that is over-diversified generally mirrors the market, which in the past five years has meant losses of 50% or more for some investors.
10. Educate yourself
Ignorance can be very expensive! Many people 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.
From experience, I can honestly say that if you follow these rules you will be able to manage your risk, and be far more profitable.
More do’s and don’ts when investing in the sharemarket are featured in Dale’s book, How to Beat The Managed Funds by 20%.