What separates successful investors from the vast majority who can’t even match market returns?
I’ve spent a lot of time looking into this. While successful stock market investors use a variety of tactics, follow differing market philosophies, and have varying temperaments, one thing remains the same: they stick to a defined set of rules.
Having the ability to develop consistent and unwavering investing rules in the face of adversity is the key to stock market success. Most investors don’t approach the stock market in a systematic rule-based way. They make investing decisions based on emotion, fear, and greed.
This is particularly true during losing streaks. Every investor, regardless of skill level, experiences losing periods. What separates successful investors is that they stick to their rules despite strong urges to deviate and shoot for short-term gains.
Despite differences in specific methodologies, there are overriding themes that every single winning stock market investor follows. I have distilled the basis of every winning investor’s plan into five easy to understand rules.
Almost All Successful Investors Do These 5 Things
Diversifying across multiple assets, from stocks in different sectors to other types of securities, dramatically reduces your chances of catastrophic loss. Also, the higher your diversification across sectors, geography, and companies, the higher your chance of catching monster gains.
If you don’t have enough capital to build a truly diversified portfolio, start by investing in exchange-traded funds (ETFs). ETFs provide ready-made diversification within a sector or geographical location without the costs and effort of designing your own portfolio.
2. Always Use Limit Orders, Never Market Orders
While experienced, skilled investors can deviate from this rule in fast-moving markets, using limit orders is a must for the vast majority of us. Using limit orders allows you to control the exact price that you enter a stock. While we cannot control the market or stock price, we can control the purchase price. Market orders are often executed at a less-than-ideal price, setting the trade up for failure from the start.
3. Avoid Entering The Market All At Once
The famed stock market investor Jessie Livermore lived and died by this rule. Should a stock drop after your first entry, buying again at lower prices results in dollar-cost averaging, which lowers the overall cost of the investment. In other words, it brings your break-even price lower should your initial entry not be an immediate winner.
Conversely, should the market move favorably in your direction after the initial entry, entering in stages as it climbs higher can be thought of “testing the market” rather than risking your entire investment on a potentially losing stock.
4. Use Stop-Loss Orders
The best investors always cut their losses and let winners run. Using stop-loss orders is the simplest way to keep losing trades under control. They help to eliminate the fear of investing by setting a maximum loss level for every position.
The loss level itself is a personal decision. Some investors utilize a percentage of their portfolio value they are willing to risk in any single stock. Others fine-tune the stop-loss level based on the inherent volatility of the stock itself. The more volatility expected, the further the stop-loss is set away from the entry point.
One way I set stop-loss orders in the stock market is via the indicator known as Average True Range (ATR). ATR reveals how far, on average, a stock moves during a specific period. Utilizing ATR enables me to understand how far the stock should move during the time frame selected. Setting a stop-loss order outside of this expected volatility band keeps the trade alive until an out-of-the-ordinary drop occurs.
5. Be Patient
This is perhaps the most important rule of all. Impatience is the number-one portfolio killer. The stock market is not a get rich quick scheme — it takes a long time to build wealth this way. While you can get lucky by investing in a hot stock or just starting investing on the brink of a massive bull market, the majority of time stocks move slowly and steadily. Patience enables you to take advantage of the natural upward drift of the stock market while riding the short-term bumps.
Risks To Consider: The above rules are not set in stone. Since the stock market is a dynamic system, there are exceptions to every rule. However, sticking with a defined plan is far better than making random trades based on emotion.
Action To Take: Write down and refine your personal investing rules to make them easier to follow in the heat of making decisions. If you are computer savvy, consider automating your rules to guarantee adherence regardless of your emotional state.
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