1) Look at the fundamentals.
Even if you are a short-term trader and following a technical analysis approach, having a good grasp of the company you are investing in can help limit the possibility of financial loss and save you from the unnecessary trauma of trying to catch a falling knife. We typically recommend that investors stick to companies that have a clear and uncomplicated strategy, a solid management team, positive cash flows, low levels of debt, and growing revenues.
Not considering the fundamentals of a company may leave you feeling out of control and like you need to rely on luck to show a return. It feels infinitely better to know that the company you are investing in is in safe hands and financially sound. Having identified a company or a few companies you feel comfortable with, the next consideration needs to be whether the stock fits into your portfolio and how big your position size will be.
2) Consider the appropriate exposure.
While you will have some companies in your portfolio that move together and operate in the same industries, typically you want to add stocks to your portfolio that do not necessarily move in a similar way to the rest of your portfolio. Another consideration will be position size, which will be a function of your total portfolio size, your portfolio composition, the size of the company and how confident you are in your selection. We would typically allocate at least 2% to a stock and up to 10% to a specific name if we are confident in the investment case, if it adds diversification benefit, and if the company itself is large.
Now that you have picked your company and determined how much money you will be investing in the stock, it is important to consider whether the current share price is an appropriate entry level. There are times when good companies are overvalued, which will translate into them being an underperforming investment, particularly if your holding period is shorter.
3) Decide on an appropriate entry level.
Investors can use technical analysis or charting techniques to determine their entry level or look at fundamental valuations - relative valuations, like price/earnings ratios are simple to calculate and easy to understand. We like using a combination of technical and fundamental analysis in determining entry levels - shares must have some level of technical support, indications of positive momentum in the share price, and should trade at reasonable multiples (lower than its own average or at a smaller premium/bigger discount to peers than what is usual for the stock). If the stock looks expensive on the fundamentals or weak on the technicals rather keep it on your watchlist - but based on your research, you will have a level in mind where you can reconsider the investment.
Knowing when to sell is just as important as knowing what and when to buy. It is particularly important to have a solid exit strategy because this is usually where your inherent human bias begins to have a negative impact on our investment behaviour. Biases like confirmation bias, mental accounting, loss aversion and regret aversion (FOMO) may result in you hanging on to your positions too long.
4) Finalise your exit strategy.
Before making a trade you should know how long you are looking to hold the investment - short term or long term? You should also have a target price or valuation in mind where you would consider selling the share. When you are making short-term calls it is vital to also have a stop-loss in place. The market moves quickly and if the bottom falls out of a share price (be it technical or fundamental) it could take a very long time for you to recoup your losses.
Finally, you are ready to trade - now for the execution. You need to understand a few key trading terms to make sure you execute your trade as efficiently as possible. In cases where, for example, you are trading in an illiquid stock, you will want to execute differently to when you are buying a big company that is traded in high volume.
5) Learn the mambo jumbo. The most important terms to understand are:
Executing effectively can have a positive impact on your investment outcome - particularly when you are looking at smaller companies or intending to make 'cheeky' offers in a company that seems overvalued.
Building a share portfolio can be both a fun and financially rewarding experience. It should not feel like you are gambling or wasting your hard-earned cash. Sticking to the basics and not getting carried away with a specific fad or trend will aid you in making better decisions and trading more effectively and efficiently. Sticking to the five principals above will help you avoid some of the major trading pitfalls including emotional buying, staying in a bad investment for too long, and making mistakes on execution and investment size.
