The aim of an investment strategy is to guide confident and effective trading decisions. Without a strategy in place, investors are more likely to overtrade, let emotions take over, or inadvertently change their risk profiles. Any of those outcomes can limit long-term growth potential.
Whether your objective is to generate earnings or income, having a defined approach gives the best chance of success in the stock market. Fortunately, you don't have to be an investment whiz 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 the amount of volatility you will accept in your investment portfolio. Your appetite for, or aversion to, risk should influence every aspect of your investment strategy.
Note, too, that risk and reward work together in investing. Higher risk assets have more growth potential, and lower risk assets have less growth potential. The relative risk and reward of investing in stocks versus cash illustrates this.
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As risk tolerance is a fundamental element of your strategy, it is wise to define it in writing. With that documentation, it should be easier to review and validate your approach from time to time. If your risk appetite hasn't changed, chances are your strategy is still on point. Or, if your defined risk tolerance no longer suits you, it's probably time for a strategy overhaul.
The simplest way to explain your risk tolerance is to consider portfolio decline scenarios. Could you handle a 10% drop in your investment account? How about 50%?
Your maximum capacity for unrealized losses can indicate where you fall on the risk tolerance spectrum. You will incur an unrealized loss when a stock you own falls in value. Losses are only realized 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 your limit is 10%, you are risk averse.
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If you can accept dips in the 20% range, 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 own stocks with more growth potential – stocks like Nvidia, for example. Ayako Yoshioka, director of portfolio consulting at independent asset manager Wealth Enhancement Group, notes that Nvidia stock (NVDA) has gone through multiple periods where it has decreased by more than 50%. The stock, therefore, provides a useful thought experiment for investors. If a stock you own loses half its value, would you panic and sell or be content to wait for a recovery?
Asset allocation is the composition of your portfolio across different types of assets. Setting asset allocation targets helps you manage risk according to your tolerance.
For example, conservative investors might target 50% exposure to stocks and 50% exposure to bonds. In this mix, the stocks provide growth potential along with volatility. The bonds provide stability in terms of repayment value and income.
A portfolio with a higher percentage of stock could deliver greater returns but with greater risk. That's why aggressive investors who can handle risk prefer a heavier stock exposure, up to 90%.
You can also divide your targeted stock exposure into smaller categories, such as growth stocks, value stocks, small caps, mid caps, large caps, and international stocks.
You may also limit your relative exposure to any single stock. This is particularly important for volatile growing stocks, which can reproduce quickly and dramatically. Holding each stock to, say, 5% or less of your portfolio prevents you from becoming too dependent on any one position.
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Your allocation targets guide your initial portfolio construction and ongoing trading decisions. For example:
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As the stock price appreciates, the value of holding that position becomes a larger percentage of your portfolio. Ultimately, the position could exceed your single stock exposure cap. That would be a cue to sell some of your shares to reduce your exposure and take profits.
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A drop in price could leave room for you to increase your position. If you still believe 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 can be based on formal or informal estimates of the intrinsic value of the company. Formal methods of establishing value include the discounted dividend 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 that income to present value. DCF follows a similar logic but discounts the company's projected free cash flow rather than dividends. Informal methods for establishing value include peer and historical comparisons.
Note that many investors set their desired purchase price below their estimate of value. This provides a margin of safety against further declines in stock prices.
Setting target sales prices can be simpler. You can base these on unrealized earnings percentages or whatever price would cause the stock to exceed your allocation targets. For example, you may want to take a 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 magnitude of recent changes in stock prices. 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 suggests the stock is oversold, which can create a bargain price point.
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Valuation ratios. Price-to-sales and price-to-earnings ratios measure how expensive the stock is relative to its revenue and earnings, respectively. These ratios are most meaningful when compared to peers and the company's historical values.
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Analyst ratings and price targets. Analysts have detailed information about the companies they cover. They are not infallible, but analysts can quickly identify how recent developments affect a stock's outlook. If you're questioning a stock's outlook, try reviewing what analysts have to say as a starting point.
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A sound investment strategy can transform your investment from speculation to a productive methodology. Use it to base your decision – especially on headline-grabbing stocks like Nvidia or Tesla (TSLA) — for a surer path to wealth creation.