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Stock Selection – Tools And Rules

At least ten hands shoot into the air as the discussion turns to stock selection. The speaker smiles, responds to each, and observes: "You really need to know the depth of the water, its temperature, tides, and currents before you dive into the river --- and then, what kind of predators are in there?"

Flying low over coastal South Carolina, I'm probably the only person on the plane who sees the meandering rivers and tidal creeks as a history of stock market cycles. How does one navigate these complex connections without getting lost, running aground, or being attacked by alligators?

How does one select equity securities in a manner that consistently avoids the risks of volatile markets, fickle investors, abusive regulators, regressive tax codes, and brainwashed investment gurus? Along with self-confidence and experience, it takes some management skills that most investors fail to sharpen before they launch their boat --- planning, organizing, and controlling.

Here's an overview, and it is expected to provide structure and provoke thinking while skimming over most of the detail and explanation that can be found in the "Brainwashing" book.

The investment planning stage is too often ignored by the young and the new, and too often over cooked by the older and beaten up. Most of the confused indecisiveness is due to constant media hype and an endless bombardment of data, news, software solutions, electronic tools, and expert opinions. But most actual investment errors are caused by invalid expectations, fear, greed, and lack of discipline.

Markets have been and always will be volatile while tracking higher and lower, predictably and unpredictably at the same time. If you can't embrace the market cycle and use it to your advantage, you will have trouble becoming a successful equity investor.

Planning involves two basic determinations: Can I afford to take the risks associated with investing in the stock market? Am I preparing effectively to meet my retirement income needs from the income bucket of my portfolio? Clearly, if you do not hold any securities whose primary purpose is income generation, you are overlooking a key element of portfolio development, and need to plan better.

Another "planning" necessity is defining and identifying a risk-minimizing equity selection universe. First of all, market price volatility is not a risk element --- it is the very nature of equities. The real risk is the actual financial demise of the company you are partnering up with when you buy its common shares. Clearly, the fundamental quality of the companies you buy is an important consideration.

Investment Grade Value Stocks (you need to google this one) come to mind as a kind of pre-screened, or cookie-cutter, collection of the best American multi-national companies. Well known foreign company ADRs can be examined internally for fundamental quality as well. Unfortunately for the lazy, there are no mutual funds comprised solely of IGVSs --- and Market Cycle Investment Management "mirror portfolios" are yet a glimmer in an old man's eye.

An overpriced, highest quality in the world, selection universe provides little investment opportunity --- because? Because the "traders" are correct. The only reason to buy a stock is to sell it (as soon as possible in my book) for a reasonable profit. The higher prices are, the less likely it is that additional gains will come along quickly, and just what is a "reasonable profit"?

Managing your investment portfolio requires that you rein in your emotions with rules for both buying and selling. Operational simplicity is essential. Disciplined compliance with the rules you establish is less simple and a whole lot more essential. In order to succeed, you need to identify and immediately quash anything that looks, sounds, tastes, or smells like hindsight.

In equity investing/trading (one and the same), a lower market price is an opportunity for buying and a higher price an opportunity for profit taking. The number of individual issues within the equity bucket of a portfolio should rise during falling markets because more stock prices are entering an acceptable "lower-price" buying zone.

The objective of the exercise is to have cash available for buying during every downturn --- can't happen unless you have the courage to take profits when prices are rising. Yes, you are expected to feel stupid in both exercises. When you feel like you "sold too soon", the bubble buster is just around the corner. When you know you re-entered the market too early, the rally is just over the horizon.

The fact that your holdings move (forgive the use of this emotionally charged, designed to make you lose money unnecessarily, buzz word) "underwater" while the stock market corrects is irrelevant so long as they retain their quality, profitability, dividend payout, etc. You need tools that allow you to make this determination --- the S & P monthly stock guide comes to mind.

The controlling process of investment management makes you consider the declining market-value inevitability upon your initial investment in any security. The organizing element keeps you diversified by security and by sector --- all the diversification you really need with IGVSs, which are generally multinational entities.

Buying rules should be somewhat complex so you don't just go out and buy everything --- always a mistake. With some experience, you'll find no need to buy anything until it's down at least 20% from its 52-week high. Note that at this purchase price, the market value can rise 10% without establishing a new 52-week high --- very important psychologically.

Selling rules should be ridiculously simple, written in stone, unquestionable by anyone, and understood by your financial professional --- if not by the SEC (call me if you really want a good laugh/cry about regulators).

Ten per cent is a reasonable profit level; even less is fine if buying opportunities are plentiful.

No equity investor (trader, speculator, whatever) should ever allow a reasonable profit to go unrealized. No intelligent body of human beings should allow their elected representatives to perpetuate a tax code that encourages loss taking more than it does profit taking, or that considers investment income of all kinds "unearned", ugly even.