An investment strategy aims to guide safe and effective trading decisions. Without an established strategy, investors are more likely to overtrade, let emotions get the better of them, or inadvertently change their risk profiles. Any of those outcomes may limit long-term growth potential.
Whether your goal is to generate profits or income, having a sharp focus gives you the best chance of success in the stock market. Fortunately, you don’t have to be an investing genius to create a strategy that works for you.
You can develop a solid, customized investment framework in three steps.
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Risk tolerance describes how much volatility you will accept within your investment portfolio. Your risk appetite or aversion should influence all aspects of your investment strategy.
Also keep in mind that risk and reward go together in investing. Higher risk assets have higher growth potential and lower risk assets have lower growth potential. The relative risk and reward of investing in stocks versus cash demonstrates this.
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Since risk tolerance is a fundamental element of your strategy, it is advisable to define it in writing. With that documentation, it should be easier to review and validate your approach periodically. If your risk appetite hasn’t changed, your strategy is probably still the right one. Or, if your defined risk tolerance no longer suits you, it’s probably time to review your strategy.
The easiest way to clarify your risk tolerance is to consider portfolio downturn scenarios. Could you withstand a 10% drop in your investment account? What about 50%?
Your maximum capacity for unrealized losses can indicate where you are on the risk tolerance spectrum. You incur an unrealized loss when a stock you own loses value. Losses are realized only when you sell a stock for less than what you paid for it.
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An example of what your risk tolerance spectrum might look like:
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If 10% is your limit, you are risk averse.
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If you can accept declines in the 20% range, you have a moderate risk appetite.
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If you can accept drops of 30% or more, you are risk tolerant.
With a higher risk tolerance, you can comfortably own stocks that have higher growth potential—stocks like Nvidia, for example. Ayako Yoshioka, director of portfolio consulting at independent asset manager Wealth Enhancement Group, notes that Nvidia (NVDA) stock has gone through multiple periods where it has fallen more than 50%. Therefore, the stock provides a useful thought experiment for investors. If a stock you own lost half its value, would you panic and sell or would you be willing to wait for a recovery?
Asset allocation is the composition of your portfolio between different types of assets. Setting asset allocation goals helps you manage risk to your tolerance.
For example, conservative investors might aim for 50% exposure to stocks and 50% to bonds. In this combination, stocks offer growth potential along with volatility. Bonds provide stability in redemption value and income.
A portfolio with a higher percentage of stocks could generate higher returns but with more risk. That’s why aggressive investors who can handle risk prefer higher exposure to stocks, up to 90%.
You can also divide your exposure to specific stocks into smaller categories, such as growth stocks, value stocks, small-, mid-, and large-cap stocks, and international stocks.
You can also limit your relative exposure to a single stock. This is particularly important for volatile growth stocks, which can change price quickly and dramatically. Keeping each stock at, say, 5% or less of your portfolio prevents you from becoming too dependent on any given position.
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Your allocation objectives guide your initial portfolio construction and ongoing trading decisions. For example:
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As the price of a stock appreciates, the holding value of that position becomes a larger percentage of your portfolio. The position could eventually exceed your exposure limit to a single stock. That would be a signal to sell some of your shares to reduce your exposure and make a profit.
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A drop in price could leave you room to increase your position. If you still think the stock has upside when that happens, it may be time to buy.
Michael Kodari, CEO of wealth manager KOSEC Securities, recommends setting target buy and sell prices to manage risk.
Target purchase prices may be based on formal or informal estimates of the company’s intrinsic value. Formal methods for establishing value include the dividend discount method (DDM) and discounted free cash flow (DCF) analysis.
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DDM quantifies the value of a company by estimating future dividends and adjusting those earnings to the present value. The DCF follows similar logic, but discounts the company’s projected free cash flow instead of dividends. Informal methods of establishing value include historical and peer comparisons.
Keep in mind that many investors set the desired purchase price below their value estimate. This provides a margin of safety against further declines in the share price.
Setting target sales prices can be easier. You can base them on percentages of unrealized gains or on any price that causes the stock to exceed its allocation targets. For example, you may want to profit when the stock price rises 20% above your purchase price.
Other data points that can inform your triggers include:
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Relative Strength Index (RSI). RSI is a momentum indicator that measures the speed and size of recent changes in stock price. An RSI of 70 or higher indicates that the stock could be overbought and ready for a price correction. An RSI of 30 or less implies the stock is oversold, which can create a bargain price.
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Valuation ratios. Price-to-sales and price-to-earnings ratios quantify how expensive a stock is relative to its revenue and earnings, respectively. These ratios are more significant compared to peers and the company’s historical values.
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Analyst ratings and price targets. Analysts have deep knowledge of the companies they cover. They’re not foolproof, but analysts can quickly identify how recent events affect a stock’s prospects. If you’re questioning a stock’s prospects, try reviewing what analysts have to say as a starting point.
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A sound investing strategy can transform your investing from a guess to a productive methodology. Use it to inform your decision making, especially in headline-grabbing stocks like Nvidia or Tesla (TSLA), to find a safer path to wealth creation.