An investment strategy aims to make confident, effective trading decisions. Without a strategy, investors are more likely to over-trade, let emotions get the better of them, or unintentionally change their risk profile. Either of these outcomes could limit long-term growth potential.
Whether your goal is to generate profits or income, a defined approach offers the best chance of success in the stock market. Fortunately, you don’t have to be an investment expert to create a strategy that works for you.
You can develop a solid, personalized investment framework in three steps.
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Risk tolerance describes how much volatility you accept within your investment portfolio. Your appetite or aversion to risk should influence every aspect of your investment strategy.
Also keep in mind that risk and reward work together when investing. Higher risk assets have greater growth potential, and lower risk assets have lower growth potential. The relative risk and reward of investing in stocks versus cash demonstrate this.
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Because risk tolerance is a fundamental part of your strategy, it is wise to put it in writing. With that documentation, it should be easier to periodically review and validate your approach. If your risk appetite hasn’t changed, your strategy is probably still valid. Or, if your defined risk tolerance no longer suits you, it’s probably time for a strategy overhaul.
The easiest way to clarify your risk tolerance is to consider portfolio decline scenarios. Can you handle a 10% dip in your investment account? What about 50%?
Your maximum capacity for unrealized losses can indicate where you fall on the risk tolerance spectrum. You suffer an unrealized loss when a stock you own declines in value. Losses are only realized if you sell a stock for less than 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 dips near 20%, you have a moderate risk appetite.
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If you can accept dips of 30% or more, you are risk tolerant.
With a higher risk tolerance, you can comfortably own stocks that have greater growth potential, for example stocks like Nvidia. Ayako Yoshioka, portfolio advisory director at independent asset manager Wealth Enhancement Group, notes that Nvidia (NVDA) stock has gone through several periods where it fell more than 50%. The stock therefore offers a useful thought experiment for investors. If a stock you own lost half its value, would you panic and sell or be willing to wait for a recovery?
Asset allocation is the composition of your portfolio across different types of assets. Setting asset allocation targets allows you to manage risk based on your tolerance.
For example, conservative investors can target an exposure of 50% to stocks and 50% to bonds. In this mix, the shares offer growth potential and volatility. The bonds provide stability in redemption value and income.
A portfolio with a higher equity percentage can yield greater profits, but with more risk. That is why aggressive investors who can handle risk prefer heavier equity exposure, up to 90%.
You can also break down your target equity exposure into smaller categories, such as growth stocks, value stocks, small caps, mid-caps, large caps and international stocks.
You can also limit your relative exposure to a single stock. This is especially important for volatile growth stocks, which can reprice quickly and dramatically. By keeping each share at, for example, 5% or less of your portfolio, you prevent yourself from becoming too dependent on one particular position.
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Your allocation objectives will determine your initial portfolio construction and your subsequent trading decisions. For example:
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As a stock price rises, the holding value of that position becomes a larger percentage of your portfolio. The position could ultimately exceed your exposure limit for one stock. That would be a signal to sell some of your shares to reduce your exposure and take profits.
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A price drop can give you room to increase your position. If you still believe the stock has upside if that happens, it might be time to buy.
Michael Kodari, CEO of asset manager KOSEC Securities, recommends setting target buying and selling prices to manage risk.
Target purchase prices can be based on formal or informal estimates of the company’s intrinsic value. Formal methods for determining value include the dividend discount method (DDM) and discounted free cash flow (DCF) analysis.
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DDM quantifies a company’s value by estimating future dividends and adjusting those earnings to the current value. DCF follows a similar logic, but ignores the company’s expected free cash flow in lieu of dividends. Informal methods of establishing value include peer and historical comparisons.
Note that many investors set their desired purchase price lower than their value estimate. This provides a margin of safety against further declines in stock prices.
Setting target sales prices can be easier. You can base this on unrealized profit percentages or on whatever price would cause the stock to exceed your allocation targets. For example, you may want to take profits 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 magnitude of recent stock price changes. An RSI of 70 or higher indicates that the stock may be overbought and ready for a price correction. An RSI of 30 or less means 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 the stock is relative to its sales and earnings, respectively. These ratios are most meaningful when compared to industry peers and the company’s historical values.
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Analyst ratings and price targets. Analysts have in-depth knowledge of the companies they follow. They’re not infallible, but analysts can quickly identify how recent developments are affecting a stock’s prospects. If you’re questioning a stock’s prospects, try seeing what analysts have to say as a starting point.
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A solid investment strategy can transform your investing from guesswork to a productive methodology. Use it to inform your decision-making – especially for headline-grabbing stocks like Nvidia or Tesla (TSLA) – for a surer path to wealth creation.
