FIVE MINUTE INVESTING

Supercharge and Manage Your Portfolio in Five Minutes a Da

By Braden Glett, glett@yahoo.com
Copyright 1995 by Braden Glett
Noncommercial reproduction and use allowed as long as authorship is noted.
New Braden Glett!s new boo" builds on some o# the original ideas #rom this $%i&e
'inute (n&esting$ material, and has a whole lot more. )he boo" is scheduled #or
publication in *eptember +,,+. -ou can #ind out more at .ma/on0 Stock Market
Stratagem: Loss Control and Portfolio Management .
Clic" #or the printer1#riendly &ersion o# this chapter.
Disclai!er
*toc" mar"et in&esting is ris"y. -ou can lose all, or potentially more than all o# your
money gi&en certain mar"et conditions, using the techni2ues described in this boo".
*tatements contained herein are the author!s opinions, but may not re#lect reality.
3ence, the reader assumes all responsibility #or any trading or in&esting acti&ities
which he or she engages in.
Preface
)he (n&estment %.4 is delighted to host Five Minute Investing, a short boo" on an
in&estment strategy called the Reverse Scale Strategy. )he author, Braden Glett, has
"indly gi&en his permission to ma"e his wor" a&ailable here.
)he Reverse Scale Strategy is essentially a momentum in&estment strategy. .
momentum strategy, as the name implies, is one way o# hitching your wagon to a
rising mar"et. Braden e5plains how to buy stoc"s that are going up and how to sell
stoc"s that are #alling.
( would classi#y this strategy as most appropriate #or traders6 i.e., people who are
com#ortable with buying and selling securities on a #airly #re2uent basis. (n my
opinion, this is not the best starting place #or beginners. Beginners should read the
%.4 article with ad&ice #or them, and might want to browse the boo"shel# to #ind
help#ul guides on personal #inance.
Christopher 7ott, 8contact me9, :uly 199;
Introduction
(# you are li"e most persons these days, no one needs to remind you that we li&e in a
hectic society which stretches nearly e&eryone!s schedule to the brea"ing point. )his
is why ( ha&e written %i&e 'inute (n&esting. )his is a boo" designed to help busy
people per#orm consistently well with their stoc" in&estments. (t is #or the person who
wants to aggressi&ely manage his or her port#olio #or ma5imum growth, yet not ha&e
it consume their li#e with time1consuming analysis and worry.
%i&e 'inute (n&esting #ocuses on the two main aspects o# managing an aggressi&e
stoc" port#olio0 *toc" pic"ing and port#olio management. (n other words, what to buy,
when and how much to buy, and when to sell.

"ac#ground
(# you ha&e e&er tried to ma"e your own in&estment decisions o&er a period o# time,
chances are you spent most o# your time wondering what you should do ne5t. -ou
also e5perienced how time1consuming and distracting that can be. <nce you ha&e
studied and thoroughly comprehended the concepts in this boo", you should ne&er
again agoni/e o&er which stoc"s to buy, or how much to buy, or when to sell them.
=eace o# mind comes #rom ha&ing a plan that will ta"e care o# you no matter what
conditions pre&ail. .ny port#olio o# stoc"s can be managed e##ecti&ely and without
worry i# you care#ully #ollow the strategies laid out in this boo". .s power#ul as it is,
this strategy can truly be implemented in #i&e minutes a day or less. -ou need not
thin" about it beyond those #i&e minutes. .s you use and gain con#idence in %i&e
'inute (n&estor techni2ues, you will #ind that you thin" about your stoc" in&estments
only during those #i&e minutes, not worrying about them all day long as some people
do.
)he a&erage person thin"s that the "ey to success in the stoc" mar"et hinges on the
ability to pic" which stoc"s will do well. )his is only partially correct because e&en a
stoc" port#olio which is pac"ed with tomorrow!s winners can turn out to be a disaster,
i# managed incorrectly. (# there is only one thing that you retain #rom this boo", let it
be this0 strateg and advance planning are at least as i!portant as stoc#$pic#ing.
)he main premise o# %i&e 'inute (n&esting is that without a well1concei&ed plan, the
psychological ma"eup o# most indi&iduals will lead them to ma"e emotional, and
mostly bad, decisions. *o the emphasis in the boo" will be on ma"ing nearly no
subjective decisions. )his boo" gi&es the a&erage in&estor a plan to use #or managing
both the indi&idual stoc"s in his>her port#olio, and the port#olio as a whole. (t is the
best blend o# ris", reward, and time commitment o# any strategy ( ha&e seen or used.
?hile the sub@ect o# stoc"1pic"ing has been addressed in many writings, the one in
%i&e 'inute (n&esting re2uires little or no time in reading annual reports, #inancial
analysis, and the usual host o# acti&ities that most in&estors commonly associate with
pic"ing stoc"s. Because some o# the ideas are unorthodo5 and run counter to popular
belie#, it may ta"e some #aith on your part to accept them until you see that they wor"
under real1li#e mar"et conditions. ( ha&e de&oted the #irst #ew chapters o# this boo" to
addressing myths and misconceptions, because if ou are going to change our
invest!ent results% ou !ust first change our &a of thin#ing. )hese #irst
chapters lay the conceptual groundwor" #or the strategy and stoc"1pic"ing criteria
de&eloped later in the boo". =lease chec" at the door any preconcei&ed ideas about
how to be success#ul in the stoc" mar"et and try to "eep an open mind.
%i&e 'inute (n&esting re2uires a longer1term commitment to the stoc" mar"et. )his is
a boo" on stoc" trading, but not a boo" on short-term stoc" trading. )hat is, stoc"s are
e&entually sold but we attempt to hold onto a position #or as long as possible 1
hope#ully many years. 'ost boo"s tend to #ocus on either how to pic" stoc"s or how
to trade them once you!&e pic"ed them. <#ten, they are collections o# sub@ecti&e rules
o# thumb which re2uire years o# in&estment e5perience be#ore the techni2ues can be
applied with any degree o# con#idence. )his boo", on the other hand, will gi&e you a
simple, unambiguous method #or not only pic"ing winning stoc"s but also #or
managing your port#olio.
)he Reverse Scale Strategy 1 the port#olio management techni2ue which is de&eloped
in Chapter A 1 will wor" with &irtually any type o# stoc" port#olio, but it gi&es you
your ma5imum ad&antage when applied to growth stoc"s. Bsing the stoc"1pic"ing
approach suggested later in the boo" will result in your port#olio being pac"ed with
timely, high1potential stoc"s and these stoc"s can easily be selected in a hal#1hour or
less.
)he term $growth stoc"$ is sometimes ta"en to mean $stoc"s o# small companies,$ but
that is not what ( mean by the term. 'y de#inition o# a growth stoc" is a company that
is growing rapidly in mar"et &alue. )here ha&e been long periods o# time when the
return on larger companies has outstripped the returns on small companies. )here
ha&e also been many periods o# time when the opposite has been true. *o, both large
and small companies can be growth stoc"s in their season. ?hiche&er the case may be
at any gi&en time, the stoc"1pic"ing section o# %i&e 'inute (n&esting will lead you to
them.
%inally, in e&ery case ( ha&e tried to a&oid the use o# con#using #inancial and stoc"1
mar"et @argon commonly #ound in boo"s on this sub@ect. 'y personal #eeling is that
these types o# terms are not well understood by the public and ma"e the world o#
stoc" in&esting seem li"e alchemy. )he emphasis here is on "eeping things simple.
Because o# the simplicity o# this strategy, no computers are re2uired #or
implementation o# anything in this boo". This &ill not 'e the !ost complicated or
scholarl 'oo# on stoc# investing ou have ever read% 'ut it &ill 'e one of the
si!plest and !ost practical( *implest is best, especially i# simple wor"s. ?hy
complicate things unnecessarilyC
Su!!ar of o')ectives
)o summari/e, this boo" is designed to show you a plan #or in&esting that is simple
yet complete 1 one that ( ha&e used with a high degree o# success #or years. %i&e
'inute (n&esting will allow you to success#ully na&igate the two main chords o# stoc"
in&esting 1 stoc" selection and port#olio management, and also0
Bnderstand what you are doing and why you are doing it.
3a&e no need #or mar"et gurus, #ull1ser&ice stoc"bro"ers, newsletters,
ad&isors, and the li"e.
.&oid the most common mista"es and #allacies o# in&esting.
Be able to sleep at night, because your ris"s will be tailored to #it your le&el o#
ris" tolerance and con#idence le&el.
3a&e con#idence that you will ne&er enter into a trade without ha&ing an e5it
plan that co&ers e&ery possible outcome o# that trade.
Dnable a busy person to manage an aggressi&e stoc" port#olio in #i&e minutes
per day with the peace o# mind that comes #rom ha&ing a plan.
*hapter +, -eplacing .ur Stoc# Mar#et Mths
(n the (ntroduction to %i&e 'inute (n&esting, ( mentioned that the ideas and
approaches de&eloped in this boo" would be unorthodo5. (n this chapter, ( hope to
point out and correct a #ew o# the popular myths that abound in regard to stoc"
in&esting. )here are many more that e5ist, o# course, but (!&e attempted to identi#y and
address the most destructi&e ones. =lease study this chapter care#ully, and #eel #ree to
test any o# the assertions ( ma"e in the laboratory o# the mar"et. Eebun"ing these
myths and replacing them with concepts that are closer to the truth is #oundational to
understanding the rest o# the boo".
Mth /+, The stoc# !ar#et is a for! of ga!'ling
=erhaps at the heart o# many other stoc" mar"et myths is the idea that in&esting in
stoc"s is a #orm o# gambling. Femar"ably, ( recently heard someone who was
introduced as an $economist$ say as much on a national radio news broadcast .s o#
this writing 819959, some o# this myth has been dispelled by the relati&ely steady
returns en@oyed by in&estors is recent years, &ersus the up and down mar"ets
e5perienced during the 19A,s. *till, many #ol"s consider stoc" in&esting to be
#undamentally di##erent than in&esting in bonds, certi#icates o# deposit, and other
more1predictable in&estments.
)o understand why stoc" in&esting is inherently di##erent than gambling, #irst we need
to re&iew what common stoc"s are. (n the most basic terms, a share o# common stoc"
entitles the owner o# that share to a #raction o# what is le#t o&er a#ter all other
sta"eholders in a business ha&e been paid. *o, the #irm ta"es in re&enue #rom
customers in return #or the #irm!s product, and with that re&enue pays #or raw
materials, employee wages, energy, supplies, and pays interest on borrowed #unds.
?hate&er is le#t o&er, i# anything, belongs to the holders o# the #irm!s stoc", who are
essentially the owners o# the #irm. Eepending on business conditions and how well
the company is managed, the amount le#t o&er #or the shareholders can be &ery large,
&ery small, or e&en negati&e.
(t is ob&ious that the common shareholders see more &ariability 8ris"9 in what they
ta"e home than bondholders, raw material suppliers, employees or anyone else
in&ol&ed in the operation o# the #irm. )he common shareholder stands last in line to
be paid, and because o# this additional ris" the shareholder demands a higher e5pected
return than does the bondholder. (n the stoc" mar"et, in&estors are constantly trying to
assess what will be le#t o&er #or the shareholders both now and in the #uture. )his is
why stoc" prices #luctuate 1 because the outloo" #or business conditions are always
changing, and what will be le#t o&er #or the owners o# a particular #irm is always
changing too. But, one thing is #or sure0 common shareholders e5pect their returns to
be &olatile, but they also e5pect them to be positive and permanent o&er the long run 1
and higher than the return on bonds, treasury bills, or other less ris"y in&estments.
)hat is, the shareholders don!t e5pect to gi&e up all their gains 1 despite the
#luctuations in &alue, the returns at some point become permanent. %or as long as
common stoc"s ha&e e5isted 8hundreds o# years9, this e5pectation has been met0
*toc"s ha&e had their ups and downs, but ha&e trended steadily higher in &alue o&er
the years. .nd, they ha&e increased in &alue at a #aster pace, on a&erage, than dollars
in&ested in more predictable &ehicles such as bonds or treasury bills.
(t is this steady upward progression in the &alue o# stoc"s that sets them apart #rom
gambling in a ma@or way. -ou could buy a set o# stoc"s, and hold them #or the rest o#
your li#e. .lthough they would #luctuate in &alue o&er your li#etime, chances are they
would greatly increase in &alue during that period o# time. 3owe&er, no other person
would ha&e lost money simply because your port#olio o# stoc"s gained in &alue. )his
is not true with gambling. (n gambling, e&ery dollar won is a dollar lost by someone
else. (t must be this way because gambling produces nothing, creates nothing, and
there#ore can only return to a winner what it too" #rom a loser. )he &alue o# common
stoc"s increases without ta"ing wealth away #rom anyone6 in #act when the stoc"
prices increase, the amount o# aggregate wealth increases #or society as a whole. )his
is because common stoc"holders do produce something0 )hey postpone the
consumption o# goods 8ie, they sa&e some portion o# their income 9 in order to supply
the seed capital needed to buy production e2uipment and produce goods. )hey get the
ball rolling, so to spea", #or #irms wishing to produce goods.
3ere is another #act which highlights the &ast di##erences between gambling and stoc"
in&esting0 ?hen gambling, the longer you stay at the gaming tables, the more li"ely
you are to wal" away a loser. (n the stoc" mar"et, the longer you stay at it the better
chance you ha&e o# coming away a winner. (n #act, i# you buy and hold a well1
di&ersi#ied port#olio o# stoc"s, you are &irtually assured o# ma"ing money e&entually.
<# course, many people do lose money in stoc"s, but only because they #ritter their
capital away with e5cessi&e or ill1#ounded trading strategies.
D&ery stoc" in&estor needs to "now why in&esting and gambling are two totally
di##erent pursuits. <nce you reali/e this, it will gi&e you con#idence in pursuing a
long1term plan #or in&esting and will ma"e you less prone to the destructi&e #orces o#
#ear and greed.
*o, the two #acts to retain regarding myth G1 are as #ollows0
Ga!'ling transfers &ealth fro! a &inner to a loser 'ecause it produces nothing(
Investing increases overall &ealth 'ecause the capital invested in stoc#s provides
the initial funding for fir!s &hich e0ist for the purpose to producing goods and
services(
The value of stoc#s trends steadil up&ard over ti!e( The do not seesa& 'ac#
and forth in the sa!e range forever( In the aggregate% stoc# investors de!and
and receive a return that is substantial and permanent(
Mth /1, Stoc# Mar#et Predictions are the 2e to Successful Investing
<ne o# the greatest popular myths about in&esting in stoc"s is that in order to be
success#ul, you must be able to predict the stoc" mar"et!s mo&ements. ?hy do people
assume thisC %or some, it is because they do not understand that stoc"s gi&e a positi&e
and substantial return o&er time 1 they #alsely assume that stoc"s bounce around in the
same range #ore&er, and they there#ore conclude they must predict mo&ements in
order to be able to sell at the top o# the range and buy at the bottom o# the range. %or
others, the desire to predict is borne out o# human nature, which puts a premium on
certainty. ?e lo&e to "now what will happen in ad&ance. 3ence, it is usually assumed
by the beginning in&estor that to be success#ul, one must #irst become an e5pert at
#orecasting #uture mar"et trends. D5perienced in&estors "now, in #act, that nothing
could be #urther #rom the truth.
*ome icons o# ?all *treet lo&e to ad&ance the cause o# mar"et predicting, because
they are paid to predict these mo&ements. <thers simply humor their clients who are
loo"ing #or mar"et pro@ections because they "now that it is easier to gi&e them a
pro@ection than to try to correct the clients! thin"ing. %or instance, nearly e&ery retail
bro"erage #irm has a chie# economist or mar"et strategist whose main responsibility is
to predict the climate #or stoc"s. . large number o# boo"s, ad&isory ser&ices, and such
that are sold #ocus themsel&es almost e5clusi&ely on prediction o# how the stoc"
mar"et in general will per#orm in the #uture. But in truth the best !ay to make money
in the stock market is to avoid approaches that rely on market predictions" )his will
most li"ely seem an odd or e&en a absurd statement to some, perhaps most. -et, any
serious re&iew o# the results o# mar"et gurus o&er a long period o# time re&eals a trac"
record that is no better 8usually worse than9 a simple buy1and1hold strategy.
Eon!t misunderstand me0 )here is no doubt that i# a person could accurately predict
the short1term #luctuations o# the stoc" mar"et, that person could #ar e5ceed the return
o# someone who simply bought a bas"et o# stoc"s and sat on them. 3owe&er, the one
#atal problem with this is that there has ne&er been a single person who has #igured
out how to do it. Nearly all mar"et ad&isors claim to be able to call the mar"et!s e&ery
turn, but in #act e&ery credible study e&er done on the sub@ect has pro&en that these
claims are in&ariably #alse. By #ar, most mar"et prognosticators signi#icantly
underper#orm the mar"et, despite their uni&ersal claims to the contrary. Gi&en the
large number o# mar"et gurus that now e5ist, the laws o# statistics dictate that so!e o#
them !ust beat the mar"et, out o# pure luc" i# nothing else. 3owe&er, they lac" the
ability to repeat this per#ormance #rom one time period to another, and the group o#
mar"et beaters will usually be a di##erent group e&ery time period that is sampled. (#
you could predict which guru would be right #or the ne5t year, you would be in good
shape. But, o# course, it!s @ust as hard to predict which guru 8or which dart board9 will
be right #or the coming year as it is to accurately predict mar"et conditions. %inally,
e&en i# we are generous and assume that there is some mar"et #orecaster out there
who has the holy grail o# mar"et prediction, our chances o# being able to sort him out
#rom those who simply got luc"y are pretty slim.
.s o# this writing, the mar"et prognosticators who are most success#ul o&er the past
ten to #i#teen years are those who ha&e been perpetually bullish. .lthough we all get
bearish once in a while, we do best when we "eep our bearish #eelings #rom a##ecting
our actions. )here#ore, ( recommend that you #eel #ree to ha&e your opinions about
where the mar"et is heading, but always in&est as though the mar"et is going higher.
<&er the long run, you will be better o## than i# you had @umped in and out o# the
mar"et. <# course, you ha&e to e5ercise some caution in ha&ing an optimistic
&iewpoint6 the best policy is to only in&est money that you can a##ord to be patient
with i# the mar"et stalls or bac"trac"s. (# you ta"e out a huge mortgage on your home
with the e5pectation o# in&esting it #or a 2uic" payo##, you are tempting #ate and your
emotions o# #ear will almost certainly cause you to #ail.
(# results are any indication, the conclusion must be that mar"et #orecasting is prone to
#ailure. <ne o# the purposes o# this boo" is to #ree you #rom the compulsion we all
seem to ha&e to predict #uture mar"et trends.
3n alternative !indset to the prediction ga!e
(# we are not going to spend our energies wondering where the mar"et is going, then
how can we succeed in the stoc" mar"etC
)he "ey is to de&elop a method which will react to e&ents as they occur, and will
ensure that our returns are as good or better than the returns on the general mar"et,
whate&er those mar"et returns may be in the #uture. ?e can essentially ignore what
$the mar"et$ is doing 1 or especially what it is #orecasted to do in the #uture. ?e own
our particular set o# stoc"s, not $the mar"et.$ ?hat we really need is a method which
concentrates on how our stocks are actually doing, as opposed to how they will do in
the #uture. ?e own our port#olio o# stoc"s. )he Fe&erse *cale *trategy is such a
method and will be de&eloped later in this boo" once its theoretical underpinnings are
e5plained.
If ou )ust can4t help ourself(((
.s most in&estors e&entually learn, mar"et prognosticators are notoriously inaccurate.
(# you already "now the #utility o# mar"et #orecasting but #eel that you simply must
predict the mar"et, ( will re&eal at this time how ou can be as good as the best
mar"et gurus in predicting the mar"et0 ?hen you get up each and e&ery morning #or
the rest o# your li#e, ma"e this astonishing prediction0 $)he mar"et will be up today.$
(# you ma"e that your prediction e&ery single day you will be as accurate as some o#
the best people in the #ield o# economics, ha&ing achie&ed a long1run accuracy o#
about H,I. Eespite people!s #ears o# bear mar"ets, the mar"et spends most o# its time
ad&ancing, not declining.
In the long run% a good invest!ent strateg that doesn4t rel on prediction &ill
'eat a !ar#et forecasting strateg(
Mth /5, 6hat goes up !ust co!e do&n
)he statement $what goes up must come down$ is certainly true in the natural world,
and it!s o#ten assumed to be true in the world o# in&esting as well. ( will attempt to
con&ince you that this assumption will lead you to ma"e some pretty signi#icant
strategic errors in your in&esting.
(# you re#er to the conclusion #rom 'yth G1, you will see that in the aggregate, stoc"s
trend upward o&er time and at some point, they ad&ance to the point where they will
ne&er again return to their pre&ious le&els. .s we ha&e noted pre&iously, stoc"
in&estors demand a permanent return on their in&estments, @ust as in&estors in other
types o# assets demand a permanent return on theirs. . good high1pro#ile e5ample o#
this is the Eow :ones (ndustrial .&erage, which is now at about 5,,,,. (n the 19J,s, it
was around 5,. ( do not e5pect to e&er see it at 5, again. *o, #rom here the Eow may
di&e to J,,,, or it may continue ad&ancing, but there is a certain point below which it
will ne&er again dip. *o, certainly the gains en@oyed by shareholders up to Eow +,,,,
or so may be considered $permanent.$ .t some time in the #uture, the gains up to Eow
5,,,, will also become permanent as the mar"et will at some point dip to the 5,,,,
le&el #or the last time. Naturally, there is no way to tell when that will occur.
Certainly, some indi&idual stoc"s do go up rapidly, then gi&e bac" the entire gain @ust
as rapidly. .ll seasoned in&estors ha&e had this disappointing e5perience. 3owe&er
disappointing it may be to ha&e a good pro#it going and then see it e&aporate, do not
let this bitter e5perience lead you to belie&e in ta"ing pro#its too 2uic"ly. (# you do, it
will cost you the really big gains, in the long run.
(# you thin" about it, the #act that the entire stoc" mar"et marches higher, o#ten ne&er
to return, then there must o# necessity be some indi&idual stoc"s that also ad&ance
without returning to their pre&ious lower price le&els. (n #act, this is the case more
o#ten than not. D&en so, the a&erage person commonly e5presses the belie# that when
they ha&e a pro#it going they should ta"e the money and run 1 o#ten lea&ing a lot o#
money on the table when they do.
<# course, the grain o# truth in this myth is the #act that any stoc" trend consists o# a
series o# ad&ances and retreats, resulting in a net increase o&er time. *o i# you are
going to belie&e the statement $what goes up must come down,$ then "eep in mind
that it o#ten happens that a stoc" mo&es !ay !ay up, and then comes down @ust a
little. )hin" o# it this way0 (# a stoc" increases ten#old in &alue and then undergoes a
+,I correction, we are still ahead by eight#old.
Gi&en enough time, stoc"s o# indi&idual companies o#ten ma"e substantial price
progress o&er time, and sometimes with no ma@or pullbac"s in price. .s an e5ample,
#ollowing is a listing o# stoc"s whose prices increased remar"ably o&er a period o#
recent years0
Stoc# Price Move Ti!e Period Percentage Gain
%astenal KA>; to KJ; 19;A195 L,+L+I
7inear )echnology K+ 1>; to KJ; 19;9195 1,H;;I
:upiter National KJ 1>+ to K+A 199119J HA1I
'id1.tlantic 'edical *er&ices K+ J>; to K+A 199119L 1,,A;I
'icron )echnology KJ to K95 199+195 J,,HHI
)here are many, many others. <b&iously, these are the types o# stoc"s you want to
#ind and hold onto. -ou won!t #ind them o#ten, naturally, but e&entually you will #ind
them i# you use the stoc" selection criteria in Chapter L.
(t!s educational to note that all the abo&e listed stoc"s spent a lot o# time on the daily
new1highs list while they were increasing in &alue. )he ne&$highs list is published
daily in most #inancial newspapers. (t is a list o# stoc"s which traded abo&e their
pre&ious high price #or the past 5+ wee"s.
7inear )echnology, as an e5ample, hit a new 5+1wee" high on 1>J>9,, at K+ J>L. (t
topped out 8so #ar as o# this writing9 at KL5 5>; on 11>9>95. )here were 1,L91 trading
days between those two dates, during which 7inear )ech appeared on the new1highs
list 15A times, meaning it made it onto the new1highs list about once e&ery two wee"s,
on a&erage. Euring those 1,L91 trading days, 7inear )echnology did not appear on the
5+1wee"1lows list e&en once. -et, incredibly, many people go to the new1lows list
when prospecting #or stoc"s )hey ignore the new1highs list, assuming that the stoc"s
listed there are $too high.$ (n so doing, they decrease their chances o# #inding the ne5t
7inear )echnology #rom pretty good to almost none5istent.
7ust 'ecause a stoc# has had a large increase in price does not !ean it cannot
increase further( Stoc#s &hich are hitting ne& highs often continue !a#ing
additional ne& highs in price(
%ollowing is a chart o# 7inear )echnology!s price trend #rom 19;9 to 19950
?ith this chart in #ront o# you, it is an e5cellent time to rid yoursel# o# another popular
strategy o#ten heard on #inancial tal"shows and in in&estment newsletters, namely0
$Buy good stoc"s on pullbac"s.$ .s you can see #rom the chart o# 7inear )echnology,
many o# the best1per#orming stoc"s do not ha&e signi#icant pullbac"s while they are
increasing in &alue. *o, by waiting #or a good stoc" to pull bac", you will most li"ely
doom yoursel# to sitting on the sidelines while a stoc" ma"es a tremendous mo&e
upward, without you. ?hen it #inally does ha&e the pullbac" you!&e been waiting #or,
that may be the beginning o# the stoc"!s demise.
.nce a good perfor!ing stoc# has 'een identified% don4t &ait for a pull'ac# in
price 'efore ta#ing our position( In the long run% this &ill cost ou !ore in
profits than it saves in losses(
Mth /8, 6hat goes do&n !ust co!e 'ac# up9 or "u lo&% sell high(
)his myth is the granddaddy o# them all. (n the sub@ect o# in&esting, probably no more
destructi&e misconception has e&er been concei&ed than the idea o# buying low and
selling high. ?hate&er the reason #or its appeal and widespread popularity, no myth is
more per&asi&e among amateur in&estors. )he emotional appeal o# this myth leads
in&estors to commit many o# the most grie&ous errors listed in Chapter + on the most
common in&estor mista"es.
*toc"s ma"e all price mo&ements in trends. *ometimes these mo&ements are small,
sometimes huge. Gi&en enough time, most stoc"s e&entually ha&e some large price
trends which de&elop. .lthough most people "now this, #ew ta"e the time to reali/e
the implications o# it. .s will be co&ered later in this boo", one o# the most common
in&estor mista"es is to buy stoc"s that are $down$ in price. )he common assumption
is that i# a stoc" has gone #rom L, to 1,, it is somehow more li"ely to get to L, again
than is a stoc" that has gone #rom L to 1,. )hey are both at 1,, but the ma@ority o#
no&ice in&estors assume the stoc" that is $down$ in price will be a better bet than one
that is trending upward. )his is e5actly the opposite o# the truth
If ou are to succeed in the stoc# !ar#et% ou si!pl !ust eradicate fro! our
!ind the appeal of 'uing declining stoc#s:
)hin" about this0 (# a stoc" is destined to go #rom 5 to 1,,, it o# necessity must pass
through H, A, ;, 9, J,, 5,, ;, etc. to get there. (t does not ha&e to 8necessarily9 pass
through L, J, + or 1 on its way to 1,,. )his is why pic"ing stoc"s that are trending
upward in price gi&es you a better chance o# #inding timely, winning stoc"s than
buying stoc"s in a declining phase. ?hy then, do most beginning in&estors tend to
choose stoc"s that ha&e declined in price, rather than choose ones that are at all1time
highsC *imply put, because they $#eel$ sa#er buying a stoc" that once sold #or a higher
price. )his #alse sense o# security has led many in&estors to the poorhouse o&er the
years.
'ost in&estors will #ind it use#ul to study a long1term chart boo" in order to get a #eel
#or how stoc"s ma"e large price mo&es. *ome good re#erences #or doing this are
7ong1)erm Malues, published by ?illiam <!Neill and Co, and the Malue 7ine
(n&estment *ur&ey. .s you study these long1term charts, note @ust how many stoc"s
ha&e made J,,11,,,I mo&es. -ou will #ind that such mo&es are not at all
uncommon, and some o# them happen in an almost uninterrupted manner. *ometimes,
stoc"s will e&en ma"e more stunning mo&es o# +,,,1J,,,I o&er longer periods o#
time. (t is ine&itable that any stoc" in an uptrend will ha&e periods o# correction
8short1term pullbac"s in price9, but most o#ten there are some long trends where
pullbac"s do not e5ceed J,I o# the stoc"!s pea" price.
*tudy the price chart o# a stoc" that has had a large 8#our to ten1#old9 increase in price
and note care#ully @ust how many times this stoc" made a new all1time or at least a
5+1wee" price high. %rom this you should learn that so!eone &ho is afraid to 'u
;or hold onto< stoc#s !a#ing ne& highs &ould auto!aticall guarantee that the
&ill never reap the 'enefits of large price !oves( .nd yet, it is only by owning
these &ery strong stoc"s that the true pro#it potential o# stoc" in&esting is reali/ed. By
studying the way in which price trends occur, you will gi&e yoursel# con#idence to
hold onto your winners rather than succumbing to the temptation to sell your winners
to !loc" in! pro#its. )his is why trading strategy 8or the way you manage your stoc"
pic"s9 is @ust as important as which stoc"s you pic".
It is i!possi'le to reap 'ig profits fro! the stoc# !ar#et unless ou are &illing to
'u and hold onto stoc#s that are !a#ing ne& all$ti!e highs in price( Further%
stoc#s that are at ne& price highs tend to do 'etter than those !a#ing ne& price
lo&s(
Eventuall% everone finds stoc#s that &ill ulti!atel turn out to 'e 'ig &inners $
'ut not everone ends up profiting fro! the!( It is our trading strategy that &ill
deter!ine &hether or not ou reap the 'enefits of the &inners ou find(
Valuation !easures
(# you are to ma"e really big money in the stoc" mar"et, resign yoursel# to the #act
that @ust about e&erything you buy, i# you are buying stoc"s correctly, will seem too
high priced by @ust about any traditional measure o# &aluation. )his is because
traditional measures o# a stoc"!s &alue generally are o# little use#ulness in
circumstances where earnings are growing &ery 2uic"ly. Bse o# these measures as
stoc" selection criteria o#ten misleads in&estors into buying stoc"s that are declining
in price. %or instance, =rice>Darnings 8=>D9 ratios are a commonly misused measure o#
a stoc"!s attracti&eness as an in&estment. 'any in&estors try to buy stoc"s that are
selling #or &ery low =>D ratios, meaning that the stoc" is selling #or a low price
relati&e to the pre&ious year!s earnings. )hey belie&e that i# the stoc" is selling at a
low =>D ratio, then the stoc" must increase in &alue. )his approach to selecting stoc"s
is #lawed because it assumes all companies ha&e roughly the same #uture earnings
growth prospects. 3owe&er, the reality is that companies ha&e &astly di##erent
outloo"s #or growing earnings and that is why the mar"et rightly assigns a low =>D
ratio to some stoc"s and a high one to others. )here are companies which grow
earnings at + to JI per year #or years and years on end. )here are also companies
which grow earnings at +, to J,I per year o&er many years. (t is absurd to assume, as
proponents o# a low1=>D ratio strategy do, that a company which is positioned #or high
growth should be priced the same as a stodgy company in a shrin"ing industry.
.nother popular but #lawed concept which leads in&estors into buying stoc"s which
are declining is the practice o# purchasing stoc"s which are selling #or a low price
relati&e to $boo" &alue.$ Boo" &alue is calculated by ta"ing the &alue o# the assets
owned by the #irm and subtracting out any debts the #irm may ha&e. )here are three
problems associated with using this calculation as a in&estment screening parameter0
1. Boo" &alues as calculated by accountants o#ten bear no resemblance to the real
&alue o# assets on the balance sheet.
+. %irms which are selling #or a low price relati&e to boo" &alue are selling #or a
low price #or a &ery good reason0 these #irms in&ariably are earning a &ery low
return on their assets. .#ter all, the &alue o# a #irm!s assets really do not matter6
what matters most is what the #irm can earn on those assets #or their
shareholders. . person loo"ing #or low prices relati&e to boo" &alue #orgets
that most #irms which are earning substandard amounts on their assets
generally "eep on earning low rates o# return.
J. 'uch o# the earning power o# a #irm is determined not by physical or #inancial
assets, but instead by the abilities o# the people wor"ing #or the #irm 8human
capital9 and by the position o# the #irm in the mar"et it ser&es. Boo" &alues
capture none o# this and thus ignore completely the most critical assets which
a #irm possesses.
(t is best to a&oid stoc"s that are declining in price, e&en i# they ha&e #inancial
measures which appear to ma"e them good &alues.
Stoc#s that appear to 'e cheap ' financial !easures and are falling in price
tend to #eep falling% and &hat see!s too e0pensive and is rising in price tends to
#eep on rising(
*hapter 1, Things to 3void
Building upon the last chapter, we are now ready to e5plore and #ace the mista"es that
nearly e&ery beginning in&estor ma"es. Eo not s"ip o&er this or any other part o# the
boo" because you need to be aware o# these mista"es. <therwise, you may spend
years learning these lessons the hard way. =racticing these errors &ersus not practicing
them ma"es a &ery large di##erence in your rate o# return, not @ust a small di##erence.
Generally, in #act, it will ma"e the di##erence between a large positi&e rate o# return
and a large negati&e rate o# return.
<b&iously, there is a relationship between the in&estor myths o# the last chapter and
the errors re&iewed here. Dach o# these mista"es is traceable to the myths. .s was said
earlier in the boo", i# you are to change your in&estment results, you must #irst change
your thin"ing. (# you ha&e read and understood what!s been written so #ar, you are
well on your way to doing this.
Mista#e /+, Not having an e0it plan 'efore 'uing
No matter how well or poorly #ounded, e&ery stoc" selection strategy produces both
losers and winners. (n the case o# both losers and winners, the reason #or selling a
stoc" is always the same0 )o preser&e capital and allow you to re1deploy it to more
pro#itable in&estments. )he rele&ant 2uestion is, $how to determine the right time to
sellC$
)he time when you can thin" most clearly about why you would e&entually sell a
stoc" is 'efore it is purchased. Be#ore you buy anything, you ha&e no emotional
attachment to it, which means you can ma"e totally rational decisions. <nce you own
something, you tend to get either greedy or scared. )hese emotions lead to a desire to
preser&e pro#its, leading to prematurely cutting o## an ascending price trend.
=o& not having an e0it plan hurts our perfor!ance
Big losses are one thing which destroys most in&estor!s per#ormance, and these are
almost always a direct result o# the in&estor #ailing to plan, be#ore entering a trade,
how he will e5it it. *ince the potential gains #rom a stoc" are always higher than the
potential losses 81,,I loss potential &ersus unlimited upside potential9, an e&en
bigger source o# under1per#ormance is selling too soon when you do #ind a great
winner.
.n e5it plan is one thing that e5perienced in&estors>traders always ha&e be#ore
initiating a position. )he reason is simple0 you must ha&e a plan and stic" to it, or else
e&ery decision you ma"e will be emotional, not rational. ?orse yet, the larger the
position is, the less rational your decision1ma"ing will be. )here#ore it is &ital to ma"e
all decisions up #ront, be#ore you are scared 8i# the position happens to go down9, or
greedy 8i# it soars9. Dmotional decisions almost always are poor ones, leading to large
losses and small gains.
)he pit#alls o# trying to manage a stoc" port#olio without a plan are many and &aried.
)he ad&ice o# #riends, stoc"bro"ers, mar"et ad&isors, and the li"e are all li"ely to ha&e
a magni#ying e##ect on the natural elements o# #ear and greed that are present in e&ery
in&estor. )hese in#luences can cause someone who does not ha&e a well1thought1out
plan to abandon pro#itable positions and hang on to losing ones. )his is e5actly why
the ma@ority o# amateur in&estors under1per#orm the mar"et0 they do not ha&e a plan.
.s the saying goes, $when you #ail to plan, you plan to #ail.$ )his saying is as true in
the stoc" mar"et as it is in any other aspect o# li#e.
?ith emotions running rampant #rom a loss or a large gain, it is &irtually impossible
to ma"e a good decision. )his is precisely the point at which most in&estors #ail0 )hey
ha&e no preconcei&ed plan #or e5iting a stoc" be#ore they buy it. .s a result, when
they hear a tip or rumor on a stoc" they get so e5cited that they #orget to as"
themsel&es what they will do i# it turns sour, or i# it soars, what will be their plan #or
letting the pro#it rideC (# the in&estor who doesn!t plan ahead also happens to belie&e
some o# the myths presented in Chapter 1 then his>her chances o# ma"ing a good
decision are almost nil. (# you are a decision1ma"er o# any "ind, you no doubt reali/e
that ma"ing decisions based on wrong assumptions renders your chances o# success to
be miniscule. %or this reason, the need #or an e5it plan based on sound theory be#ore a
stoc" purchase cannot be o&eremphasi/ed. Bn#ortunately, most in&estors don!t want to
thin" about planning ahead, 8especially #or ad&erse possibilities9 when they are
buying a stoc" 1 they put the selling criteria decision o## until it is una&oidable, and
usually too late.
3n e0it plan !ust 'e identified for ever invest!ent 'efore the invest!ent is
!ade( This plan should cover all possi'le outco!es of the trade% 'oth profit and
loss(
Mista#e /1, Plunging too !uch into a stoc# all at once
.nother common error committed by many in&estors is plunging. )his means that the
in&estor ma"es two mista"es0 %irst, they purchase entirely too large a position in a
single stoc". *econdly, they do it all at once. )he real problem with doing this is that
the in&estor puts themsel&es in a per#ect position #or their emotional decision1ma"ing
to run wild. )ypically what happens is the #ollowing0 %irst, the plunger ta"es a huge
position. )hen, his stoc" either begins declining or increasing. (n either outcome, the
emotions o# plunging wor" against the poor in&estor. %or i# the stoc" declines, the
plunger will either get scared and sell out with a loss that is a sic"ening percentage o#
his capital, or hold on in hopes o# an increase in &alue 8which may well ne&er
happen9. (# the stoc" increases in &alue, the in&estor will o#ten ha&e a large dollar gain
that is hard to resist cashing in. (n this latter case, the in&estor ma"es the mista"e o#
cutting his winnings short. (n short, plunging leads to cutting your potential gains
short and letting your losses "eep mounting...e5actly the opposite o# what you should
be trying to accomplish.
.lmost always, the plunger lac"s an e5it plan #or the purchase be#ore buying. (# the
plunger had thought about an e5it plan be#orehand, he probably would ha&e reali/ed
the potential pit#alls and would ha&e ta"en a more appropriately1si/ed position.
=lunging can wor" occasionally i# one is #ortunate enough to select a stoc" that
immediately increases in &alue and ne&er loo"s bac". 3owe&er, in most cases the
plunger has such a large percentage o# his capital riding on a single stoc" that the
emotions o# greed and #ear wor" against him in a ma@or way. )he normal #luctuations
o# stoc" prices ha&e an e5agerrated e##ect on the plunger!s emotions by &irtue o# the
huge amount o# capital represented by the position.
Ta#ing too large of a position leads to e!otional involve!ent &hich leads in turn
to poor decisions( It also e0poses ou to the potential for lots of da!age fro! one
'ad trade( Diversif $ don4t 'et the far!(
Mista#e 5, Failing to cut losses
. certain percentage o# stoc"s you choose will show themsel&es to be losers. Count
on this #act. )hese losers must be dealt with in some way in order to limit their impact
on your o&erall per#ormance. <nce a stoc" starts to decline it can become a &iscious
cycle, leading to e&en more declines. .s unbelie&able as it seems to the no&ice
in&estor, the more and longer a stoc" declines the more it is apt to continue declining,
or continue going sideways.
D&en i# a stoc" does come bac", it will li"ely ta"e a long, long time to do so, and time
is money. %or this reason, it is important to stop the bleeding once it becomes
apparent that you ha&e chosen a loser. 3ere as elsewhere, the actions o# most
in&estors are opposite the logical course o# action. 'ost hold on to their losers, hoping
against hope that the stoc" will someday pull itsel# together. *ome also hold on
because they can!t #ace up to the #act that they made a mista"e. )hey reason 8poorly9
that as long as they don!t sell, then they ha&en!t really lost anything. )his is a error
because the &alue o# their stoc" is the current mar"et price, not what they paid #or it 1
but their rationali/ation helps them #eel better about themsel&es. )he dri&ing #orce
behind this type o# thin"ing is dealt with in Chapter J.
)he other compelling reason #or selling losers is the concept o# opportunity cost, that
is, the money you could ha&e made by re1deploying your capital to a more promising
in&estment. <#ten, the opportunity cost o# holding a losing stoc" is #ar greater than the
loss on the stoc" itsel#. 7et!s say we ha&e K1,,,,, in&ested in a particular issue and it
declines to where it is worth only K;,,,,. )here are two reasons to consider selling
the stoc" in this e5ample. %irst, the stoc" is clearly in a downtrend, and li"e most
trends, the decline is most li"ely to continue. (# it does, the decision to sell may sa&e
us as much as K;,,,,, the current mar"et &alue o# our stoc".
)he second reason #or considering cutting our loss short is that by re1deploying the
K;,,,, into a stoc" that is trending upward, we increase our chances o# ma"ing up the
K+,,,, loss more 2uic"ly than i# we!d continued to hold the losing stoc", waiting #or it
to come bac". )he distinct possibility e5ists that we could ma"e up the K+,,,, loss
and ma"e an additional K;,,,, pro#it by re1deploying our capital #rom the declining
stoc" to the ascending one. .ll the while, the original purchase may still be
languishing #ar below where we dumped it. ?hile there are no guarantees that the
ascending stoc" will continue ascending, it is a much better bet statistically than the
declining one. (n the stoc" mar"et, going with the long1term statistics is a "ey to long1
term success.
Beware o# the common compulsion to hold onto your losers. (# you do succumb to
this temptation, your port#olio may still be pro#itable 8as long as you also do not sell
your winners9, but it will not be as pro#itable as it could be.
Mista#e /8, Selling too soon
.nother error that cuts seriously into many in&estors results is the error of selling a
&inning stoc# too soon. )hough it might seem that this is a relati&ely minor problem,
it actually is a &ery serious error because it robs you o# your really big pro#its. I
'elieve it is a 'igger !ista#e than failing to cut our losses% 'ecause in a properl
diversified portfolio the potential profit fro! an one stoc# is far !ore than the
potential loss( )hat!s simply another way o# saying that the most you can lose on a
single stoc" is 1,,I o# what is in&ested, but the potential gain #rom e&ery stoc" is
unlimited. (# your ob@ecti&e is to ma"e as much money as you can, then you must put
yoursel# into a position to hold onto really big winners when they come your way. (#
you ha&e a strategy that emphasi/es ta"ing the money and running e&ery time you get
a double or triple, then you are seriously shortchanging yoursel#.
Thin# 'ig
( belie&e the reason most in&estors #ail to hold onto winners long enough is that they
simply do not reali/e how big a mo&e can sometimes be reali/ed. )hey wrongly
assume that i# a stoc" has doubled or tripled then that is about the best they can hope
#or. 3owe&er, in&estors who ta"e the time to study the history o# stoc" trends "now
better. *ometimes a stoc" that has doubled will go on to ma"e another ten#old
increase #rom there. (t can 8usually does9 ta"e years #or this type o# mo&e to occur, but
o&er a se&eral year time #rame your chances o# #inding a huge upward trend is #ar
better than you!d thin". .gain, the best way to con&ince yoursel# o# this is to get a
long1term stoc" chart publication and start studying it.
Price .')ectives
.nother insidious reason #or in&estors selling too soon is the use o# price objectives.
)his is when you buy a stoc" and set a price that you will sell at i# and when the stoc"
ma"es it to the target price. )hese target prices are usually arri&ed at as a certain
percentage abo&e the entry price, or else are based on some analyst!s assessment o#
the !&alue! o# the stoc".
3owe&er arri&ed at, ( #eel that the use o# target selling prices is a seriously #lawed
practice. <ne o# the enigmas o# the stoc" mar"et is the tendency #or what seems
o&er&alued to "eep going higher still, and what seems reasonably &alued or cheap to
"eep on retreating. )he reason is that when a company!s earnings are 8or are about to
start9 growing rapidly, the price o# the stoc" may be high relati&e to the current
earnings, but only a #ew times the ne5t year!s actual earnings, i# ne5t year!s earnings
could be "nown. )he stoc" may e&en be selling #or many times the earnings estimate
#or ne5t year, because it ta"es time #or good trends to be recogni/ed and assimilated
by stoc" analysts. )hus, stoc" analysts! earnings estimates #or coming years tend to
lag when something good is brewing, @ust as they o#ten lag when bad things are in the
wor"s. )he thing to remember about this is that the aggregate consensus o# all mar"et
participants 8as re#lected in the stoc"!s price trend9 tends to be more accurate and
more timely than published earnings estimates.
(# you study stoc" trends ( belie&e you will come to the conclusion that the trend o# a
stoc" is a more accurate indicator o# when to sell than are calculated estimates o# a
stoc"!s N&alue.! ?hy then are price ob@ecti&es usedC )he reason they are so popular is
because o# the need #or retail bro"erage houses and newsletter writers to gi&e some
sort o# selling ad&ice to large numbers o# retail clients. )hrough the use o# price
ob@ecti&es, the tas" o# gi&ing ad&ice to large numbers o# people is made manageable
#or the ad&ice1gi&er. 3owe&er, it seldom results in the best possible outcome #or the
client. )his is a good reason to become your own in&estment ad&isor and port#olio
manager. )he use o# price selling targets mostly results in you capping your pro#its, as
you cannot possibly ma"e more o# a pro#it than that which is re#lected in the target
price. %inally, it should be ob&ious to all that capping your pro#its is not a good thing.
(# you employ a strategy which cuts your losses but also caps your gains, by de#inition
you!ll be worse o## than i# you had bought your stoc"s and done nothing but sit on
them #ore&er.
Don4t tr to guess ho& far a stoc# can !ove up( If ou do not give our stoc#s a
lot of roo! to !ove up&ard% ou &ill guarantee that our stoc# !ar#et profits
&ill 'e 'elo& average(
Mista#e />, *hoosing stoc#s that are in a do&ntrend
Buying stoc"s which are in a downward price spiral is the most common mista"e
among no&ice in&estors. (n order to pro#it #rom such a strategy, you need to be right
about two things at once 0 %irst, that the stoc"!s slide will end 8a surprising number
ne&er do until they become worthless9, and secondly, the timing o# when 8and at what
price9 the stoc"!s slide will end. -our chances o# being right about both things are
slim.
)he typical scenario #or this particular mista"e is an ine5perienced in&estor scouring
the stoc" pages loo"ing #or stoc"s near their 5+1wee" lows, since this in#ormation is
readily a&ailable. )he no&ice wrongly assumes that i# a stoc" is near its low #or the
year then it must be $low$ and there#ore in an opportune position to be bought. .s we
ha&e seen, the hapless bottom1#isher #inds out a#ter it is too late @ust how easy it is #or
such a stoc" to "eep on ma"ing new 8and e&en lower9 5+1wee" lows.
.s an aside, it!s interesting to note that it!s #airly common that a stoc" which is today
ma"ing a new 5+1wee" high has as its 5+1wee" lo& a price that was a 5+1wee" high?
a year ago. )hat might seem li"e a con#using statement but i# you thin" about it, it
will ma"e a lot o# sense. (# the stoc" has been in an uptrend #or a year or more, that
price which was once a new high will now be listed as the lowest price #or the past 5+
wee"s. Beginning in&estors usually do not e&en consider the possibility that this could
be true, so they "eep on buying dogs until their port#olio loo"s li"e a "ennel.
<#ten, in&estors con&ince themsel&es that buying a stoc" #rom the 5+1wee" lows list
is not a ris"y proposition because o# that stoc"!s low price relati&e to past earnings,
boo" &alue, or some other measure o# $&alue.$ But in reality buying a downtrending
stoc" is always ris"y, as you are betting against the entire mar"et!s assessment o# the
company!s earnings trend. (# a stoc" is ma"ing a serious decline it is because mar"et
participants "now some #acts about the company!s #uture earnings potential 1 #acts that
you may not be aware o# no matter how well you research the company. *eldom is the
entire mar"et wrong about these matters. *ometimes the mar"et is wrong, o# course,
but your chances o# #inding those e5ceptions are mighty slim because you are only
one o# thousands o# people who are loo"ing #or such leads. (t is &ery hard #or one
person to correctly second1guess the sum total wisdom o# thousands o# other
in&estors. )ry to "eep in mind that your ob@ecti&e is to ma5imi/e pro#its, not to
outsmart the mar"et. )he two ob@ecti&es are &astly di##erent.
'uch o# the problems associated with this strategy ha&e already been dealt with in
Chapter 1, under the section0 Buy 7ow and *ell 3igh. )here is no need to re1hash that
section now. 3owe&er, the practice o# buying downtrending stoc"s is such a per&asi&e
and ma@or error that the importance o# eliminating it #rom your bag o# tric"s cannot be
o&eremphasi/ed.
@isten to the signals of the !ar#et( If a stoc# is trending steadil do&n&ard%
there is a good reason for it( Find greener pastures else&here(
Mista#e /A, 3dding to a losing position
.nother strategic error commonly practiced by many amateur in&estors is adding
more money to a losing position. )he reasoning in the mind o# the in&estor who does
this goes something li"e this0 $( bought the stoc" when it was KL,. Now it is K+,, so
it!s twice as good a deal as it was at KL,. Besides, my a&erage cost per share will
come way down once ( add to the position.$ *ometimes this is called dollar cost
averaging 1 putting an certain dollar amount into a stoc" at speci#ied time inter&als or
at speci#ied price inter&als when the stoc" drops in &alue.
?hen an in&estor adds to a position on e2ual time periods 8ie, K1,,,, e&ery 2uarter9
independent o# the price o# the stoc", ( call it Ti!e$"ased Dollar *ost 3veraging.
?hen an in&estor in&ests an e2ual dollar amount each time a stoc" declines in price
by a certain le&el 8ie, K1,,,, with each +,I decline in price9, it is called Price$"ased
Dollar *ost 3veraging 1 8this practice is sometimes called *cale )rading and is
discussed in Chapter H9. ?hat you need to remember is that while )ime1Based EC.
can ma"e sense i# done in a controlled manner, =rice1Based EC. ma"es no sense in
any circumstances and is sure to ban"rupt you i# practiced consistently. )he rest o#
this section ( want to de&ote to e5plaining why you must ne&er practice =rice1Based
EC. as a strategy, because it is the most destructi&e o# all in&estor mista"es and
represents in the e5treme why you should ne&er add to a losing position.
)he #allacy o# =rice1Based EC. can best be illustrated by the #ollowing e5ample.
7et!s assume we ha&e the ability to anonymously obser&e a certain nai&e in&estor, 'r.
:ones, who is going to pursue a =rice1Based Eollar Cost .&eraging strategy. 'r. :ones
pic"s a port#olio o# ten stoc"s and puts K1,,,,, into each stoc", #or a total in&estment
o# K1,,,,,,. :ust #or #un, let!s also assume we "now ahead o# time that one o# the
stoc"s in 'r. :ones!s port#olio is going to go ban"rupt 8that is, decline until it becomes
worthless9 sometime within the ne5t year. 8<# course 'r :ones doesn!t "now this, and
we aren!t going to tell him, either9. But, since he is a de&out =rice1Based EC.
ad&ocate, his trading rule is that whene&er one o# his stoc"s declines 5,I in price
#rom his purchase point, he will sell K5,,,, worth o# one o# his better1per#orming
stoc"s and use the proceeds to buy more shares in the declining stoc". (# the issue
declines another 5,I #rom his second purchase point, he will sell another K5,,,, o#
one o# his other stoc"s and again add to this declining stoc". Can you guess what will
happen to 'r. :ones o&er the ne5t year as we watch him tradeC (t should be an
agoni/ing thing to watch because, as you may ha&e #igured out by now, 'r. :ones!s
strategy will o&er the course o# the ne5t year automatically allocate all of his capital
to the stock that is to go bankrupt. )his is because there are an in#inite number o#
se2uential 5,I declines that can occur between his initial purchase point and /ero. 3e
will lose his entire K1,,,,,, unless he has the good sense at some point to reali/e
what a bloody poor strategy he has.
(# you pursue a =rice1Based EC. strategy consistently, e&entually you will encounter
a ?aterloo as 'r. :ones is about to. )his is because ine&itably you will someday get a
stoc" in your port#olio that is bound #or the scrap heap. ?hen you do, cut the loss and
don!t e&en think about adding to the position <therwise, you may #ind yoursel#
standing in ban"ruptcy court with 'r. :ones.
6hen ou have a losing position% it !eans so!ething is starting to go &rong(
Never add to a losing position(
Mista#e /B, Falling in love &ith a stoc#
(t!s a common mista"e to ha&e a good run with a stoc" and then decide that you will
never sell it. *ome #ol"s ha&e a hard time parting with something that has done so
well #or them, but again, what your emotions tell you to do and what you should do
are two di##erent things. *a&e the Ntill death do us part! thing #or your marriage, not #or
your stoc"s. D&en a noted long1term in&estor li"e ?arren Bu##ett ta"es pro#its
occasionally. .s o# this writing 819959 many people are o# the mindset that bull
mar"ets go on #ore&er, but #ew remember that Bu##ett cashed out nearly completely in
the late 19H,s. Besides, #ew people ha&e the s"ill to pic" truly long1term in&estments
the way ?arren Bu##ett has. *o #or most o# us the time comes when it ma"es sense to
re1deploy our assets to something more producti&e.
D&ery gardener "nows that the #ruit o# e&en the best1growing plants e&entually needs
to be pic"ed be#ore it turns o&erripe and #inally, rotten. 7i"ewise, e&en the stoc"s that
grew so well in their season e&entually need to be sold. *ome plants are annuals,
lasting but a single outstanding season and then dying. <thers are li"e apple trees,
bearing #ruit year a#ter year, but e&entually they decline in producti&ity and die or
produce substandard #ruit. . stoc" can ha&e a phenomenal rise that lasts many years,
but most will e&entually start lagging and brea" down. (n the most e5treme case, they
may go #rom star to obli&ion and ban"ruptcy. )here#ore we must reap, but we need to
ma"e sure that our reaping is not done prematurely but allows #or long1term growth.
)he per#ect system would be one which tells us the e5act top, but that is impossible in
reality. ?e must instead #ind a balance between selling too soon and selling too late. (t
must not be done based on guesswor" but instead on the actual per#ormance o# the
stoc"s in your port#olio. )here is no doubt that our chances o# ma"ing really big
money on a stoc" increases commensurate with the length o# time we hold it. .s you
will see later, the Fe&erse *cale *trategy sets its parameters so that we do not engage
in short1term trading.
Tr to re!ain e!otionall unattached to a stoc# so that ou are not 'linded to
&hat the !ar#et is telling ou a'out it(
Mista#e /C, Tring to DGet EvenD &ith a Stoc#
<ne o# the big in&estor mista"es (!&e obser&ed is that some in&estors, once they!&e
ta"en a loss on a stoc", "eep loo"ing #or an opportunity to buy that same stoc".
?ithout reali/ing it, they become enamored o# the stoc" simply because it has $done
them wrong.$ 7i"e an adolescent who!s been beaten up, they are loo"ing to $get
e&en.$ $(!ll show that stoc",$ they say to themsel&es. By so doing they lose #ocus o#
what they are trying to do0 'a"e money, not sa&e #ace. )here are thousands o#
companies a&ailable #or them to in&est in , so why do they "eep coming bac" to a
pro&en loserC )he answer is, o# course, ego. Dgo is one o# the most destructi&e #orces
that you can unleash on your in&estment per#ormance, and we will ta"e a close loo" at
how it mani#ests itsel# in the ne5t chapter, so you can recogni/e it. (t crops up in
e&eryone now and then, but when it does, you must resist it and thin" logically.
(# you are #ishing and a #ish slips o## your hoo", do you re#use to pull in any #ish other
than the one that got away, #rom then onC <# course not 1 you throw your line bac"
into the water in hopes o# catching $a #ish,$ not $the #ish.$ (t seems ob&ious when
#ishing, but un#ortunately, many people!s common sense goes out the window when it
comes to the stoc" mar"et. )hey "eep gunning #or that one particular stoc", ignoring
the other rich targets which abound around them. )hus, one mista"e begets another.
*ometimes, people also return to a stoc" because they had such a good e5perience
with it. )hey made some good money o## this stoc" and so they ha&e warm, #u//y
#eelings #or it. .gain, this is not logical thin"ing unless the stoc" has reco&ered and is
showing itsel# still to be one o# the stronger stoc"s in the mar"et.
.nce ou have sold a stoc#% forget it% &hether it &as sold for a profit or a loss(
*hapter 5, 2no& Yourself
.s you ha&e probably seen by now, the emotions and predispositions we are all
imbued with tend to wor" against us in the world o# aggressi&e in&esting. <#ten to
succeed in this business we need to de&elop the ability to do e5actly the opposite o#
what our emotions are telling us. )o do this e##ecti&ely, it is necessary to #erret out the
real reasons why we are in&esting in the #irst place. ?hile Nto ma"e money! is li"ely
the ob&ious reason, in reality there are myriad reasons why we try our hand at stoc"s.
)hese range all the way #rom the money ob@ecti&e, to wanting to #eel good about
oursel&es, to garnering the respect o# others. )hese are at least as strong as the money
#actor, and when you thin" about it, money is usually the means #or achie&ing
something else 1 li"e respect, etc. <nly misers want money alone. %rom a practical
standpoint, we are all a mi5ture o# these reasons and more. )here#ore, i# we are to
succeed, it may be help#ul to "now what our own true moti&ations are. ?hate&er your
reasons #or wanting to succeed at stoc"s, you simply mustlearn to "eep your ego in
chec" because it is the one thing that will lead you to ma"e the wrong mo&es. ( cannot
psychoanaly/e you, but ( o##er this chapter as a means #or you to psychoanaly/e
yoursel#.
'y way o# illustrating the moti&ations o# in&estors will be to study the two basic
types o# in&estors. <ne o# these is an e5tremely humble #ellow, who does not care
much about whether he is &iewed as smart or ignorant by his ac2uaintances, but he
does what he needs to do in order to optimi/e his in&estment results. )he other is a
proud person who cares primarily about his image in his own mind and in the minds
o# others. *wallowing his pride to increase his in&estment results is out o# the
2uestion #or him.
)here is a little bit o# both persons in each and e&ery one o# us. Be#ore you embar" on
any in&estment approach it is best to search yoursel# to see which elements are present
in yoursel# and attempt to root out the attributes o# the ego1dri&en in&estor and bolster
the characteristics o# the results1oriented in&estor.
The ego$driven investor
)he ego1dri&en in&estor sees in&esting as something e5citing. 3e mostly does it as a
way to garner the admiration o# others. 3e may also see it as entertainment. 3e is
constantly tal"ing about this or that great deal, imagining that others will stand in awe
o# his prowess and immense wisdom. (n reality, he most li"ely does not really ma"e
too much money in the stoc" mar"et, a #act which he hides #rom the outside world by
any means possible.
?orst o# all #or the ego1dri&en type, he ne&er gets any better at his in&esting. )o admit
he has been doing something wrong, e&en to himsel#, is more than his sensiti&e ego
can ta"e. *ince the aura o# being an in&estment wi/ard is simply a way #or him to gain
a##irmation #rom others, he really doesn!t care too much whether the results are there
as long as he can still stay in the game and "eep tal"ing about his smart deals at
coc"tail parties. <# course, he con&eniently #orgets the bad ones and "eeps turning
o&er in his mind his best deals and how smart he must be. 3e certainly ne&er does a
post1mortem on any o# his losing trades to #igure out @ust why they were losers. 3e
simply blames the loss on his bro"er, the company!s management, or stoc"
manipulators. 3e can!t as" anyone what he may ha&e done wrong, since to admit he!s
made a mista"e to someone else goes directly against the grain o# his ob@ecti&es 1 to
appear wise to others.
<ne way in which our #riend 'r. Dgo deals with losses is by stubbornly holding on to
his losing trades, no matter how bad they get. 3e reasons that until he sells, he hasn!t
really lost anything, so why sellC Ne&er mind that his bro"er sends him statements
e&ery month telling him that his account &alue has dwindled 1 he really has lost
money 1whether or not he admits it or not. (n this way he assures himsel# that he can
ne&er really re1deploy what!s le#t o# his capital into something more promising.
)he ego1dri&en in&estor doesn!t en@oy buying a stoc" that has already doubled in
&alue, e&en i# it could increase another 1,,,,I #rom there. )he idea that someone else
was $smarter$ than him and bought at a lower price is more than he can bear thin"ing
about. <n the other hand, he dearly lo&es to buy stoc"s that are in a downtrend
because there is a chance that he will be the one who will buy the stoc" at its low #or
the year. (magine what bragging rights that would gi&e him <# course, most o# the
time he buys these types o# stoc"s and they @ust "eep going down, down, down. But
that!s <O, as these deals are un"nown to anyone in his circle o# #riends. )he prospect
o# that unli"ely but alluring $buying the bottom$ scenario "eeps him coming bac" #or
more 1 losses, that is.
D&en when he does get luc"y and happens to stumble into a winner, 'r. Dgo is his
own worst enemy. 3e waits until the stoc" hits a new high #or the year and then
promptly sells out to loc" in his pro#it. <# course, this stoc" was in an uptrend and
"eeps right on sailing #ar abo&e where he e5ited. )hat!s <O by 'r. Dgo, though0 he
now has a pro#it that can be e5aggerated the ne5t time he sees his #riends. ?ill they
e&er be impressed
)hus, the ego1dri&en in&estor!s strategy is complete0 he always holds onto his losing
stoc"s and when something starts to go right, he bails out #aith#ully. 3e has plenty to
tal" about at parties, but there is no way he can e&er ma"e a decent pro#it. )he real
tragedy is owed to the #act that since he blames others #or all o# his problems, he will
ne&er get any better.
The results$oriented investor
)he results1oriented in&estor seldom tal"s with others about his in&estment results.
Feally, he is too busy trying to ma"e his results better. 3e is ne&er too proud to buy a
stoc" that is ma"ing new highs, reali/ing that those who are buying the stoc" most
li"ely "now #ar more than he does 1 and a winning company is more li"ely to "eep on
winning than a losing company is. )he #act that someone else was smarter and bought
at a lower price does not worry him6 it is against his nature e&en to ha&e such a
thought occur to him. 3e is #ar too #ocused on trying to pic" stoc"s that are
per#orming well to entertain these types o# thoughts. 3e compares his per#ormance
against others! per#ormance only as a means o# learning and getting better.
?hen the results1oriented in&estor #inds himsel# with a stoc" that is /ooming ahead,
he holds on, letting the stoc" continue to do well #or him. Con&ersely, when a stoc"
stumbles badly enough that his predetermined plan says it is time to e5it, he acts in an
unhesitating manner. 3e #ollows his plan #or buying and selling whether that means
selling at a gain or at a loss. 3e also ne&er sells a stoc" as it is ma"ing a new high,
since his concern is not in selling the top but rather in letting his winning positions run
their course. 3e does not mind selling a stoc" a#ter it has retreated 5,I in &alue, i#
being patient through price corrections is what allows him to capture the occasional
1,,,I gain.
<ne big di##erence between the results1oriented in&estor and the egoist is what he
does with losses. ?hile 'r. Dgo blames others and learns nothing, the results1oriented
chap studies in great detail how his loss occurred, and e&entually #igures out the
#allacies in his thin"ing and>or system. )here#ore he always gets better and better at
what he is doing. 3e e&en "eeps a noteboo" on each loss and records what he could
ha&e done better.
Don4t forget &h ou are investing, To make money( If ou have an other reason
for investing% find another pastti!e(
*hapter 8, Stoc# Pic#ing
*toc" in&esting is something that has been made out to be #ar more complicated than
it needs to be. )here are #ar more complicated approaches to stoc"1pic"ing than those
presented in this chapter, but the guidelines presented here will result in 95I o# the
results o# those approaches with only 5I o# the time, e##ort, and con#usion. *ince the
name o# this boo" is %i&e 'inute (n&esting, ( ha&e chosen to build these guidelines in
such a way as to minimi/e your time commitment while helping you a&oid the
in&estor mista"es outlined in pre&ious sections.
19 7oo" #or positi&e price momentum
'ost in&estors search diligently #or companies where some good situation is
de&eloping 1 and right#ully so. )hey do this by as"ing bro"ers, loo"ing #or
stories in the press, etc., but #ew stop to reali/e that the stoc" mar"et itsel#
gi&es them a list o# such companies e&ery day in the #orm o# the new 5+1wee"
highs list. 'ost li"ely it!s because they ha&e belie&ed some o# the
misconceptions dealt with in Chapter 1 and wrongly #elt that i# something
appeared on the new1highs list, it!s too late to buy. .ctually, nothing could be
#urther #rom the truth.
)he simplest, best way to assemble a list o# potential high per#ormers is to
re#er to this new 5+1wee" highs list included in @ust about e&ery #inancial
newpaper. ( highly ad&ocate that in&estors begin their stoc" pic"ing
e5peditions by re#erring to this list. Femember that companies on the new1
highs list do not get there because a certain #inancial reporter li"es them, or
because the go&ernment thin"s they are good #or society, or because a
bro"erage #irm will get a he#ty commission i# the stoc" appears there. *toc"
mar"et in&estors themsel&es who are "nowledgeable about the company in
2uestion put them on the list by &oting with their own hard1earned dollars,
bidding the price up to new highs. *toc"s do not appear on it unless there is
something in fact really good and tangible happening with the company!s
prospects. %urthermore, #ew good situations de&elop in one day6 they de&elop
o&er many wee"s, months, or years. *o, many o# the uptrends e&idenced in the
new highs list will most probably continue on #or some time. Not all will, but
as long as our strategy allows #or weeding out those stoc"s that do not
continue increasing in price we will probably be all right. )his part will be
dealt with later in the boo".
.s" yoursel# the #ollowing two 2uestions0
1. 3ow o#ten does a company ma"e a new price high when something
good isn!t happeningC
+. 3ow o#ten does a company where something really good is happening
#ail to trade close to or at a new high priceC
( belie&e the answer to both o# these 2uestions is seldom. .ll trends e&entually
come to an end and stoc"s can go #rom ma"ing new highs to ma"ing new lows
with breathta"ing rapidity. But e&en in that e5treme case, i# you utili/e the
Fe&erse *cale *trategy introduced in Chapter A, you may be able to react
be#ore ma@or damage is done to your port#olio &alue. (# something &ery good
or bad starts to happen to a company!s earnings trend, it will most li"ely start
to show up in the trend o# the stoc" long be#ore you will read about it in the
press 1 or hear about it #rom your bro"er. But the stoc"s that show positi&e
momentum by appearing on the new1highs list ha&e a e5cellent chance o#
continuing their trends. (n a nutshell, the new1highs list techni2ue isn!t
in#allible, but then neither is the stoc"1pic"ing ad&ice o# your bro"er.
( belie&e you are almost always better o## pic"ing your own in&estment ideas
because you will "now why you pic"ed them. .lso, you will be more aware o#
what is happening in the mar"et since you won!t ha&e delegated responsibility
#or your money to someone else 1 someone who most li"ely has hundreds o#
indi&idual accounts to o&ersee. (t is your money and the more personal
attention you can gi&e to it, the better o## you will be. Certainly, unless you are
&ery wealthy, you can gi&e more attention to your port#olio than can a bro"er
or ad&isor. 3owe&er, it may be best to let your ad&isor manage the ma@ority o#
your money, while you try the strategies in this boo" with your true ris"
capital.
%inally, i# you do not belie&e that the stoc"s on the new1highs list tend to
outper#orm others, pic" a group o# ten stoc"s #rom the new highs list and a
group #rom the new1lows list. )rac" how each group per#orms o&er the ne5t
#ew months. Bnless you happened to pic" a &ery unusual time period, you will
see that the new1highs as a group seriously outpace the new1lows group. (# you
are into instant grati#ication, you could also go to the library and pic" a
random list #rom a year or two ago and see how they ha&e done since then. (#
you do, be sure you account #or stoc" splits that may ha&e occurred in the last
year, since there may well be some where that has happened 1 especially
among the stoc"s which appeared on the new1highs list. ( highly encourage
anyone to per#orm this simple and unambiguous e5periment.
-our per#ormance can be #urther enhanced by not only choosing stoc"s
ma"ing new 5+1wee" highs, but better yet pic" stoc"s that are at all time new
highs in price. )his will ta"e a little more wor" #or you because you will not
#ind such a list in the newspaper. )he best way to distinguish between issues
ma"ing new 5+1wee" and those ma"ing new all time highs is by loo"ing at a
long1term chart boo". <b&iously, any stoc" ma"ing a new all1time high will
also be on the new 5+1wee" high list, so begin your search with the 5+1wee"
high list.
+9 Ei&ersi#y between industry groups
Because stoc"s within an industry tend to mo&e more or less in loc"step, ma"e
an attempt to di&ersi#y your port#olio between at least three industry groups.
)his will help to reduce some o# the ris" in your port#olio and ha&ing your
money spread o&er se&eral industries will help e&en out more o# the ups and
downs in your account &alue than i# you had e&erything in one industry.
?hether you are in&esting in stoc"s, #ine art, certi#icates o# deposit, bonds, or
whate&er, the #irst rule o# in&esting is0 Ei&ersi#y.
J9 Beware o# stodgy stoc"s
?hen selecting stoc"s, beware o# pic"ing those stoc"s that mo&e &ery little
whether the mar"et is good or bad. )hese are generally re#erred to as
$de#ensi&e$ stoc"s because they are held by those wanting to de#end
themsel&es against the possibility o# a bear mar"et. )hese conser&ati&e pic"s
tend to underper#orm the mar"et o&er the long run, ma"ing them a poor
substitute #or issues with real growth potential. Dspecially during mar"et
downturns, de#ensi&e issues hold up well, gi&ing the illusion that there are
good things happening to their underlying businesses. (n reality, they hold up
well mostly because in&estors #loc" to them #or sa#ety. ?hen the mar"et turns
better, these types o# companies tend to simply sit still while the rest o# the
mar"et charges ahead.
*o, it is best to a&oid de#ensi&e stoc"s lest you get le#t behind when a bull
mar"et appears. (ssues considered to be de#ensi&e include utility companies,
gold stoc"s, #ood companies, oils, real estate in&estment trusts, and closed1end
mutual #unds. Closed1end mutual #unds are mutual #unds which ha&e a #i5ed
number o# shares outstanding and trade @ust li"e a stoc" on an e5change.
?hile they can sometimes post large increases in price, #or the most part they
sputter along and do not o#ten ha&e the potential #or large increases in price.
?hile there ha&e been times when each o# these groups has done &ery well,
#or the most part they are a waste o# time #or those who are willing to ta"e a
little more ris" in order to ma"e a lot more money. *o it is best to e5clude
de#ensi&e stoc"s, at least #rom the aggressi&e portion o# your port#olio.
L9 ?eed out ta"eo&er situations
( would generally recommend that you loo" o&er recent news items around a
company be#ore you ma"e a #inal decision to buy its stoc". )he reason ( say
this is that some o# the stoc"s on the new1highs list are stoc"s o# companies
which are in&ol&ed in real or rumored merger or buyout situations. )hey are
generally a small minority o# the stoc"s on the new1highs list, but be aware
that this possibility e5ists. )a"eo&ers and buyouts are unnatural, all1at1once
e&ents which are highly speculati&e and thus do not lend themsel&es to
prudent in&esting. <nce a #irm is "nown to be a potential ta"eo&er target the
price is dominated not by the company!s mar"et position or products, but
rather by the de&elopment o# the buyout o##er. .lso, most o# the potential #or
#urther price ad&ances is gone once the initial $pop$ #rom the buyout has
occurred.
%or purposes o# this boo", try to a&oid buying stoc"s which ha&e become
"nown to be the target o# a buyout. Buyouts, when they occur, are big news
and are generally well1"nown. )he easiest way ( ha&e #ound to spot companies
where a ta"eo&er has occurred is by loo"ing at the price chart. )a"eo&ers are
almost always e&idenced by a one1day increase in the price o# the target
company!s stoc" o# between +,I and 1,,I. (# you see that type o# pattern,
dig deeper. )here is an e5cellent chance that this company is in a buyout
situation and should there#ore be a&oided.
59 Chec" out the Chart
Be#ore you buy a stoc", ta"e a loo" at its price chart #or the past year or two.
)his will gi&e you a snapshot o# the stoc"!s personality #rom a &olatility
standpoint. ( li"e to a&oid stoc"s which ha&e high wee"1to1wee" &olatility and
instead pre#er ones which ha&e a tendency #or a cleaner trend. (# a stoc" has a
&ery &olatile price pattern, then it generally means the company has no clear
ad&antage in the mar"etplace #or its product, ser&ices, etc., &ersus the
competition. *ince there are many companies out there which do ha&e a clear,
sustainable ad&antage in their particular mar"et, ( generally opt to purchase
these instead. .s an e5treme e5ample, #ollowing is a chart o# a stoc" which
has shown a &ery &olatile price pattern in the past year0
( would probably not buy 3D( (nc. at this point due to its highly erratic price
pattern with no clear, discernable trend. )he stoc" is also a long way #rom
hitting a new all1time high, although it!s not too #ar #rom ma"ing a 5+1wee"
high. Because o# its poor trend in combination with the degree o# up and down
#luctuation in its price, ( would de#initely a&oid this issue at this time.
.s an e5ample o# a stoc" which shows an e5cellent trend pattern and low
&olatility, study this chart o# .mgen, (nc. .s you can see, the stoc" is ma"ing a
new all1time high combined and is mo&ing more steadily upward than many
other stoc"s. ( would tend to #a&or a stoc" with this type o# price chart.
.s a rule o# thumb, the lower1priced a stoc" is, the more tendency it has to be
&olatile in its trend pattern. )his is a good reason to a&oid low1priced stoc"s
and is one o# the main reasons ( insist on buying stoc"s that are abo&e K15 per
share.
(n addition to &olatility, the chart can also gi&e you a clue to other important
#acts about the stoc", such as i# it!s in the midst o# a ta"eo&er situation
8characteri/ed by a large one1day mo&e and a relati&ely stable price pattern
therea#ter9, or whether it!s a new issue. New issues sometimes appear on the
5+1wee" highs list not because they are particularly strong stoc"s, but simply
because they do not ha&e much trading history behind them. (t is best to "now
about these things and ( can thin" o# no #aster way o# #inding out than by
loo"ing at the stoc"!s chart.
)here are se&eral ways to obtain a chart o# a company!s recent price history.
By #ar the best and cheapest way these days is by computer, but there are
many published chart ser&ices as well. 'ans#ield Charts and Eaily Graphs are
good choices. *tandard and =oor!s also publishes a compact boo" o# stoc"
charts which gi&e two years! price history on many stoc"s.
Oeep in mind that no matter how you get your chart in#ormation, you only
need it when intitially selecting a stoc" #or purchase with %i&e 'inute
(n&esting. .s you will see later in the boo", you do not need to lug a computer
or chart boo" around with you in order to manage your port#olio. Charts are
only use#ul #or getting a 2uic" #eel #or the stoc"!s trend, &olatility, and as a
tipo## #or weeding out ta"eo&ers and new issues. (n %i&e 'inute (n&esting,
they are not necessary #or day1to1day management o# your port#olio.
H9 <ther Criteria
<ther than what!s already been mentioned, are there other criteria which are
simple but can help you narrow your stoc" pic"s down to a more succinct listC
-es, and ( will try to gi&e a brie# o&er&iew o# them here. -ou can then choose
how many o# these criteria you would li"e to use. No matter how #ew you
choose to use, as long as you apply the #irst #our sections o# this chapter you
will not go too #ar wrong. )hese items should be considered $#inesse points$
that can be used to narrow your choices down to a select #ew.
1. #arnings $ro!th.
<ne way to #urther narrow your list o# potential stoc"s is to #ocus on
those that are reporting high rates o# earnings growth. Eo not thin" that
because a company is presently generating rapid earnings growth that
it cannot continue to do so well into the #uture. (t o#ten ta"es years or
e&en decades #or competition to nulli#y such a company!s competiti&e
edge in the products or ser&ices it pro&ides, and it is this competiti&e
edge that allows the rapid growth in sales and earnings. *o, pay close
attention to the earnings trend o# your potential stoc" selections. ?here
can you get this in#ormationC (t can be gotten #rom any number o#
publications including *tandard and =oor!s and also the Malue 7ine
(n&estment *ur&ey. *o #ar, though, the easiest place to #ind summary
in#ormation on earnings growth is (n&estor!s Business Eaily. (BE has
earnings per share ran"ings #or e&ery stoc" in the mar"et, e&ery day.
%or this reason, it is superior to the other sources o# in#ormation
because all the in#ormation can be #ound in one place, and in a similar
#ormat so that each company!s earnings growth number can be directly
compared to e&ery other company. (BE categori/es earnings growth on
a percentile basis, called the Darnings =er *hare ran"ing. )his number
ranges between 1 and 99, with 99 being the most positi&e. .ll else
being e2ual, try to pic" issues which ha&e the highest earnings growth,
because these are the companies which ha&e a demonstrated edge in
their particular mar"et.
+. Market Capitali%ation.
'ar"et capitali/ation is another thing you will want to pay attention to.
'ar"et capitali/ation is simply the total mar"et &alue o# all the
company!s outstanding shares, or total shares multiplied by the price
per share o# the company!s stoc". ( generally li"e to a&oid the &ery
biggest capitali/ation stoc"s, say those with capitali/ations o&er K5
billion 8in 1995 dollars9 or so. )his number will change o&er time,
since the de#inition o# a $big$ company is constantly increasing.
?hy ta"e mar"et capitali/ation into account when pic"ing stoc"sC )he
larger the base o# earnings a company is wor"ing #rom, the less li"ely
they are to be able to grow earnings at a sustainable clip o# J,I or
more 1 and the less li"ely we are to be rewarded with a wind#all pro#it.
*o, try to stic" with the smaller1company stoc"s appearing on the new1
highs list.
J. &uy the Price Performers.
)ry to choose stoc"s that ha&e per#ormed well &ersus other stoc"s in
the mar"et, #rom a price standpoint. *imply put, choose the stoc"s that
ha&e run up most in &alue. )his approach goes directly against human
nature, but by adding this to your list o# criteria you will greatly
increase your chances o# #inding a phenomenal winner. -ou can
determine how well a stoc" is doing by loo"ing at it!s current price
&ersus its 5+1wee" low 8not high9. )he higher it is in percentage terms
&ersus its low point, the better. <r, an easier way is to use (n&estor!s
Business Eaily because it pro&ides Felati&e *trength ran"ings on e&ery
stoc", e&ery day. (# you are using (n&estor!s Business Eaily, also try to
choose stoc"s with a relati&e strength ran"ing that is high. 7i"e the
D=* ran"ing mentioned earlier, this runs #rom 1 to 99, with 99 being
the most #a&orable and meaning that the stoc" is mo&ing upward in
price better than 99I o# the stoc"s in the mar"et. ( li"e to #ocus on
stoc"s e5hibiting a relati&e strength ran"ing o# 9, or better. (# you do
not ha&e a subscription to (BE, ma"e sure you at least pic" up a
newstand issue whene&er you are pic"ing new stoc"s to in&est in, as by
now you can see how much time and e##ort it can sa&e you in gathering
in#ormation. ( consider this publication to be well worth the price o# an
annual subscription.
L. Share Price.
%inally, try to limit your purchases to stoc"s sporting a share price at or
abo&e K15>share. By so doing you will enhance your chances o#
in&esting in stoc"s with good trending potential. 7ow1price stoc"s tend
to ha&e &ery choppy trading patterns and are much more sub@ect to
#alse trend re&ersals. ( actually pre#er to in&est in stoc"s priced in the
KJ, to K5, price range, as ( #ind they are o#ten well1established enough
to ha&e a high success rate, but i# they are smaller capitali/ation issues
they also are small enough to ha&e nice growth potential.
Short$ter! ti!ing
'any in&estors let short1term timing considerations o&erwhelm their choice o# which
stoc"s to buy. ( belie&e this is an error, and also greatly complicates their stoc"1
pic"ing criteria. =eople become so con#used by what is happening with short1term
oscillators, mo&ing a&erages, chart #ormations, and other mumbo1@umbo that these
things begin to dominate all other considerations. (n this boo" ( want to totally de1
emphasi/e short1term timing and #ocus on the big picture0 7ong1term results.
)he simple reason #or my philosophy is, ( would rather buy a stoc" that is
o&ere5tended and may ha&e a relati&ely small short1term pullbac" in price but on its
way to a 1,,,,I gain than one that is not at all e5tended but on its way to only a 5,I
gain. (n #act, on wee"ends ( o#ten loo" at the largest percentage price gainers #or the
wee" and ( strongly consider those stoc"s #or purchase. ( am not a#raid to buy a stoc"
@ust because it is mo&ing decisi&ely upward. ( belie&e that i# you use the Fe&erse
*cale *trategy as de&eloped later in this boo", you will accumulate your positions
gradually enough that you will not need to worry about whether a stoc" is
o&ere5tended, undere5tended, or other short1term timing concepts. )here#ore, you can
"eep your stoc"1pic"ing techni2ues as simple as what is presented in this chapter.
Funda!ental 3nalsis
-ou may ha&e noticed that there is nothing in this chapter regarding how to per#orm
#undamental analysis o# industries, companies within that industry, #inancial analysis
o# earnings statements and balance sheets, etc. =erhaps you e5pected any boo" on
stoc" pic"ing to include these topics, but %i&e 'inute (n&esting does not. )he simple
reason #or this is that i# the mar"et is saying that a certain company!s earnings are
e5pected to grow 8e&idenced by an accelerating upward stoc" trend9, why should we
#ind reason to dispute what the mar"et is sayingC .s long as we ha&e a loss1cutting
mechanism in place, we do not need to use #undamental analysis to &alidate what the
mar"et already has told us about the #uture earnings o# the company. )he opinion o#
the aggregate mar"etplace has #ar more credibility in my eyes than does the opinion o#
any #undamental analyst, no matter how good. *o ( will always go with the opinion o#
the mar"et, as opposed to anyone else!s opinion, including my own. )o me, anyone
who tells me that a stoc" which is mo&ing up shouldn!t be mo&ing up, has by
de#inition missed something in his analysis.
)o ma"e my point on the #utility o# #undamental analysis #or the a&erage in&estor,
thin" o# how you would determine i# the grass in your lawn was growing 2uic"ly.
?ouldn!t you @ust measure the grass today, wait a #ew days, then measure it again and
subtractC (# you did this and disco&ered that the grass was growing 2uic"ly, would
you then go out and conduct a sur&ey o# the temperature, rain#all and hours o#
sunlight per day to &alidate that the conditions #or growing grass are indeed goodC 'f
course not( -ou would rightly conclude that the conditions #or grass growth are good
based soley on the #act that the grass is growing. D&en i# you did coo" up some
#ormula to predict grass growth based on en&ironmental conditions, would you trust
your #ormula more than your direct measurement o# the grass!s actual growthC (# your
#ormula said that grass shouldn!t be growing and yet it was growing, would you stop
mowing your lawnC .gain, to do so would be preposterous. -ou would ha&e to
conclude that something is wrong with your #ormula.
Bn#ortunately, common sense o# this sort does not get applied in the stoc" mar"et by
many people. D&en though we can directly measure through a stoc"!s price trend what
the company!s growth prospects must be, there is always someone there to try to ma"e
us lose sight o# that simple #act by pointing to his $analysis.$ -ou can be sure that #or
e&ery #antasticly bullish trend, there is some analyst somewhere saying why it
shouldn!t be happening all along the way.)he best you can do is to not listen to such
opinions, and, again, go bac" to the mar"et as your one source o# ad&ice.
3 final &ord, "u Eualit
?hether you are in&esting in stoc"s, art, coins, or real estate, it is my opinion that it is
always best to buy the highest 2uality you can possibly a##ord. .ny re&iew o# the
return on rare coins or masterpieces o# #ine art will 2uic"ly re&eal that the best returns
on in&estment ha&e been en@oyed by those who bought the rarest and highest1priced
items. )he same principle is true in stoc" in&esting. Eo not be a#raid to pay a high
price relati&e to earnings, boo" &alue, or sales. (n #act, ( would ignore such items. (
recommend that you buy the stoc"s which are mo&ing up persistently in price, and
don!t concern yoursel# that these stoc"s tend to cost a little bit more than some more
boring issues. 3istory shows that the premium paid #or high12uality items o# any "ind
is generally worth the e5tra money.
6hen pic#ing stoc#s for invest!ent% appl these criteria,
+( -estrict our stoc#$pic#ing to stoc#s !a#ing ne& >1$&ee# highs(
1( Diversif 'et&een at least three different industr groups(
5( 6eed out defensive stoc#s and those involved in 'uout situations(
8( Don4t 'e afraid to pa up for Fualit(
*hapter >, =o& to Evaluate a Trading Strateg
*haracteristics to loo# for in an investing sste!
<b&iously, there are many strategies that can be used in stoc" in&esting, but there are
certain characteristics to loo" #or in any plan #or in&esting. Be#ore we can de&elop a
strategy #or in&esting, we need to ha&e a set o# criteria by which to @udge i# it is a
good plan or not.
Building upon our pre&ious discussions about common in&estor mista"es and stoc"1
mar"et myths, ( o##er the #ollowing eight criteria as the means by which to @udge an
in&estment plan 1 any in&estment plan. )he degree to which a strategy stac"s up well
against these criteria determines its desirability. )he &ery best strategies will satis#y
the #ollowing eight re2uirements0
1. Lets gains run their course cuts losses short.
)his is a necessary element #or any good plan o# in&esting, especially the part
about letting gains run to their #ull potential. .s long as a port#olio is well1
di&ersi#ied, you can probably a##ord to ma"e the mista"e o# holding onto your
losers, but you absolutely must not ma"e the error o# prematurely cashing in
your winners. *ince we e5pect our gains o&er long periods o# time to e5ceed
1,,I o# our initial in&estment, the amount o# damage that can be done by
cutting our winning stoc"s short #ar surpasses the damage we can do by #ailing
to cut losses. 3owe&er, #or optimal per#ormance it is best to both cut losses
and ride winners as long as possible.
'uch has been written about what the ideal point is #or cutting losses. *ome
say it is 1,I, that is, that you should ne&er lose more than 1,I on a stoc"
trade. <thers say you should ne&er lose more than ;I. ( ha&e #ound that
cutting losses this short leads to e5cessi&e trading and e5cessi&e losses, and
does not allow a good stoc" enough room #or normal day1to1day #luctuations.
?hen cutting losses to ;I or 1,I, it is e5tremely easy to get bumped out o# a
stoc" only to ha&e it reco&er and begin soaring again without your being on
board.
%or this reason ( pre#er to ta"e a radically di##erent &iew o# loss1cutting( I ai!
never to lose !ore than 5 G of ! total account value on a single stoc#
trade. .s an e5ample, ( might set my stop1loss point bac" J,I #rom my
purchase point and in&est no more than 1,I o# my account!s assets into a
single stoc". )here#ore, ( will not sell the stoc" unless it gets into serious
trouble and #alls J,I. (# the worst happens and the stoc" does lose J,I o# its
&alue, ( will ha&e lost only JI o# my account!s assets on the trade since ( only
in&ested 1,I o# my accounts assets into the stoc". *o, 1,I times J,I e2uals
JI. ( belie&e that this approach to loss1cutting is #ar superior to arbitrary rules
which re2uire cutting losses too short. (# you can aim to lose no more than JI
o# your cash on any one trade, it will ta"e a long string o# uninterrupted losers
in order to seriously deplete your trading capital. <# course, there is nothing
magical about the JI number, but the point is to "eep your possible losses
#rom any one trade to a &ery small amount. D&en in a mar"et dip, it is
improbable that all o# your positions will drop to your sell point.
+. $radual entry into major positions as long as the position continues to be
profitable.
(t is ine&itable that any system which attempts to let gains run will e&entually
build some large positions in a #ew stoc"s as the stoc"s grow in &alue. )hat is
the good way to de&elop a large position. .lso, it is <O to build a position by
adding to the position as it ad&ances in &alue6 in #act, most pro#essionals
continually add to their stoc" holdings as the price mo&es in their #a&or. (n this
way, they ma5imi/e the potential reward #or holding a particular stoc" or
bas"et o# stoc"s.
3owe&er, some approaches cause an in&estor to plunge a large amount o# his
capital into and out o# the mar"et all at one time. )his is the type o# approach
which must be a&oided at all costs. (t is ris"y to enter any mar"et all at once
because it ma5imi/es your ability to lose a lot o# money in a hurry. <ne poor
timing decision can result in a loss o# a large percentage o# your capital, and
these drawdowns in capital really hurt you. . JJI loss o# your capital re2uires
a 5,I gain on the remaining capital @ust to get to the brea"e&en point. (t is
also unnecessary to ta"e such darede&il ris"s because most trends last long
enough that there is plenty o# time to get on board and a lot o# money can still
be made by entering a trend in se&eral installments as it is de&eloping.
J. Mimimal chance of a large loss from any one position.
)his is an ad@unct to G+, as the gradual entry into a position is a means #or
minimi/ing the chance o# loss #rom a single bad decision. .gain, it cannot be
emphasi/ed too much that massi&e drawdowns in your capital are to be
a&oided at all costs. .ny plan o# attac" should score well in the area o#
"eeping our eggs in many bas"ets as opposed to one6 and we should not ha&e a
large percentage o# our assets in a single stoc" unless our average purchase
price is far belo! the current market price. (# we do well at that, we can
sustain a large one1day drop in the price o# a stoc" without losing much, i# any,
o# our original in&estment.
L. Clear predetermined criteria for initiating adding to or li)uidating a
position.
(n the heat o# battle when you are dealing with your hard1earned money, the
instructions #rom your system must be as clear as crystal. (# not, you will #ind
yoursel# ma"ing @udgment calls that relie&e your short1term stress, and yet are
poor long1term decisions. =recise and unambiguous signals and marching
orders are the best way to head o## the e##ects o# euphoria and #ear. -ou may
still #eel these emotions, but as long as your system is sound and you adhere to
it #astidiously, e&erything will turn out well.
5. Sells a stock once it begins to underperform.
?hile we want to ma"e sure we ha&e a means #or riding a stoc"!s trend #or as
long as it can go, when it becomes clear that the trend is beginning to
pro#oundly wea"en or e&en re&erse, we need to ha&e a system which allows
#or selling the stoc" so we can re1deploy capital to greener pastures.
H. Ma*imum dollars invested in biggest !inners.
(# a strategy allows us to build a large position in an issue that is lagging or
e&en losing money #or us, there is something seriously wrong with that
strategy. )he common complaint one hears #rom many stoc" mar"et
participants is that they wish they hadn!t in&ested so much in P-Q Company
and they wish they had in&ested more in .BC Co. )his mis1allocation o#
assets is usually accomplished &ia some o# the common in&estor mista"es in
Chapter +, especially the mista"es o# adding to a losing position, or plunging.
. success#ul system needs to ensure that our biggest in&estments are in our
best stoc"s, not in our worst.
A. Minimum dollars invested in losers+underperformers.
)his is the con&erse o# GA. (t is interesting to note that the only ways you can
accomplish ha&ing too much in&ested in a loser is to either plunge into it all at
once and #ail to cut your loss, or add to a losing position once it is established
as a loser. Both o# these are deadly mista"es and any system we de&elop must
preclude us #rom commiting these sins.
;. ,ot time consuming to maintain.
)his is important because throughout this boo" ( assume that the reader!s time
is his most &aluable asset, and probably in short supply as well.
6hen an invest!ent plan is not really a plan
<ccasionally, one will hear statements such as $sell a stoc" once its earnings growth
slows,$ or $hold a stoc" as long as its product loo"s good.$ <#ten, these types o#
statements are haw"ed as rules #or in&estment. ( want to ma"e a point that these types
o# statements are not really plans at all, in and o# themsel&es. )hey are #ar too
sub@ecti&e #or the &ery tangible world o# the stoc" mar"et, where stoc"s are gi&en a
speci#ic price e&ery minute o# e&ery trading day. (n order to be use#ul #or decision1
ma"ing by us mere mortals, the system used must tell the in&estor e*actly when to
buy or sell, and how much to buy or sell. 3ow can you spot that precise moment
when a company!s product turns #rom good to bad, or when a company!s earnings
ha&e $slowedC$ Chances are, you can!t. *ince a stoc"!s price generally re#lects such
e&ents long be#ore they actually happen, these sub@ecti&e sorts o# approaches tend to
be a day late and a dollar short unless you are incredibly well1connected to the
company in 2uestion. D&en i# you were well1connected, then you could be trading on
inside in#ormation, which is against %ederal law.
(t is concei&able that i# you could de&elop some non1sub@ecti&e criteria about how to
tell when a #irm!s product or earnings are losing their edge, you might possibly be
able to de&elop a true 8non1sub@ecti&e9 system around it. D&en i# you could do it, it
would be di##erent #or e&ery industry, ma"ing it &ery time1consuming to implement.
)here#ore, this type o# approach is not &ery practical #or the a&erage person and
de#initely &iolates our re2uirement that our strategy not be time1consuming to
maintain. )here is a di##erence between sub@ecti&e rules o# thumb #or trading, and a
non1sub@ecti&e system #or trading. 7earn to recogni/e the di##erence and you will be
se&eral steps ahead o# the ma@ority o# in&estors.
*hapter A, The 6orld4s Worst Trading Strateg
)he ne5t step down our road to in&estment success in&ol&es brie#ly re&iewing the
&orst stoc" trading strategy ( can imagine, a simple strategy "nown as Scale
Trading. ?hy would we want to learn about the worst strategyC Because once we
"now the worst possible strategy, one that is destined to ma5imi/e losses o&er the
long run, then we can re&erse its ideas to cra#t a strategy which does @ust the opposite
1 it will be destined to produce some tremendous long1term gains. )his is precisely
how ( came to de&elop the Fe&erse *cale *trategy introduced in the ne5t chapter,
which has ser&ed me &ery well and will also ser&e you well i# you adhere to it. ( want
you to not only "now what the strategy is but also to understand how it was de&eloped
and why it wor"s.
( want to mention that the comments in this chapter #ocus on scale trading as applied
to stoc#s onl. *cale trading can be a &iable strategy when applied to commodity
#utures, mostly because commodities ha&e inherent &alue meaning that they cannot
decline to /ero &alue. But e&en then, it re2uires a lot o# capital and ad&ance planning
to be success#ul. (ndi&idual stoc"s can and do become worthless on occasion, which is
one o# the main reasons why scale trading is such an un#it approach #or stoc"
in&esting.
Scale Trading
<ther than the #act that it is simple, this strategy has no redeeming &alue. (t is the
mani#estation o# all the most de&astating in&estor mista"es. ?hile it can produce
small pro#its o&er short periods o# time, e&entually it al!ays leads to the poorhouse
when applied to indi&idual stoc"s. *cale trading is not a &ery popular or widespread
strategy e5cept among e5treme neophytes, as anyone using it will not last &ery long in
the stoc" mar"et. ( li"e to thin" o# it as the #inancial e2ui&alent o# bungee1@umping0
(t!s e5citing, ris"y, ta"es a lot o# guts, and occasionally, the cord snaps Ne&ertheless it
is use#ul to study this method because o#ten much can be learned by studying a truly
bad approach to anything and then re&ersing its concepts.
*cale trading can be applied to a single stoc", or a port#olio o# stoc"s with e2ually
disastrous results.
(t is accomplished by ta"ing an inital position and then adding to it in predetermined
increments as the position declines in &alue, and selling those purchases as they
increase in &alue. %or instance, the in&estor might buy +, shares o# stoc" at K5,>share
8#or K1,,,,9 and decide to buy another K1,,,, worth o# stoc" i# the price declines by
+,I. (# the price increases #rom K5, be#ore declining to KL,, he will sell his +, shares
8purchased at K5,9 #or KH,>share, #or a pro#it o# K+,, less commissions. *o, another
+5 shares are added at KL, with the idea o# selling those ac2uired at KL, i# the price
then increases to K5,, and so on. )he purchase and sale le&els #or this particular
situation are shown in the #ollowing table0
Scale Trade fro! >H% 1HG declining purchase incre!ents(
Price
@evel
3!ount Invested
This Purchase
Shares 'ought
This Purchase
*u!ulative I
Invested
*u!ulative
Shares .&ned
*u!ulative
Value of Shares
*u!ulative
*ostJShare
Total ProfitJ
;loss<
5, K1,,,, +, K1,,,, +, K1,,,, K5,.,, K,
L, K1,,,, +5 K+,,,, L5 K1,;,, KLL.LL 8K+,,9
J+ K99+ J1 K+,99+ AH K+,LJ+ KJ9.JA 8K5H,9
+5 5>; K99; J9 KJ,99, 115 K+,9LL KJL.A, 8K1,,LH9
+, 1>+ K1,,,L L9 KL,99L 1HL KJ,J59 KJ,.L5 8K1,HJ59
1H J>; K999 H1 K5,99J ++5 KJ,H;H K+H.HL 8K+,J,A9
1J 1>; K99H AH KH,9;9 J,1 KJ,9L5 K+J.++ 8KJ,,LL9
1, 1>+ K99H 95 KA,9;H J9H KL,15+ K+,.1A 8KJ,;JJ9
; J>; K99; 119 K;,9;L 515 KL,J+, K1A.LL 8KL,HHL9
H J>L K1,,,, 1L9 K9,9;L HHL KL,L5H K15.,L 8K5,5+;9
5 J>; K999 1;H K1,,9;+ ;5, KL,5HJ K1+.9+ 8KH,L199
L 1>L K1,,,1 +JJ K11,9;J 1,;J KL,H51 K11.,H 8KA,JJ+9
)he scale trader is hoping to pro#it by, #or e5ample, selling any shares ac2uired at J+
on a subse2uent rise to L,, any shares purchased at +, 1>+ would be sold at +5 5>;,
and so on until the stoc" ad&ances to H,, at which point the scale trader sells o## the
last o# his shares 1 those purchased at 5,.
)here is no limit to the amount o# times that a stoc" can oscillate between any two or
more o# the price le&els. Dach time this happens the trader poc"ets another K+,,
pro#it, e5cluding the e##ect o# commissions.
(t seems li"e a #oolproo# approach to the neophyte trader, but let!s trace what happens
with this trading method through a hypothetical situation. .s indicated, our trader
ma"es up the chart as shown abo&e, and ta"es his position o# +, shares purchased at a
price o# K5,>share. 7et!s say the price then slips to KL,, and a subse2uent +5 shares are
purchased at that price. %rom there, the price increases to K55, meaning that the +5
shares ac2uired at L, are sold when the price reaches K5,, netting a pro#it be#ore
commissions o# K+,,. .t this point, +, shares ac2uired at K5, are still in his in&entory.
3owe&er, he doesn!t get to sell those shares, as the price drops #rom K55 all the way
down to KJ, 1 so +5 shares are purchased at KL,, and another J1 shares at KJ+ be#ore
increasing again to KL,. )he shares purchased at KJ+ are sold #or KL, #or another K+,,
pro#it. %antastic0 3e has so #ar generated a KL,, reali/ed pro#it and ne&er had more
than KJ,,,, in&ested at any point. )he only negati&e so #ar is that it too" #our months
to do this, but KL,, pro#it on a KJ,,,, in&estment o&er #our months is not bad. *o #ar,
so good.
%rom KL,, the price then ta"es another di&e down to K15. *hares are purchased at KJ+,
K+5 5>;, K+, 1>+, and K1H J>;. )hen the price runs up to KJ, be#ore retreating bac" to
+5 5>;. 4uite a wind#all #or our trader as he sells the shares ac2uired at K1H J>; #or
K+, 1>+, and the ones scooped up at K+, 1>+ #or K+5 5>;. %rom this, he nets out
another KL,,, bringing his total trading pro#its to K;,,. )rue, he has a K1,,LH
unreali/ed loss bringing his net pro#it to a negati&e K+LH, but he reasons that when the
price goes bac" up to KH, he will ha&e completed his trade and sold out e&ery single
position #or a pro#it. .t this time, though, he narrowly misses selling his shares
ac2uired #or K+5 5>; at J+, since the price topped out this time at KJ,.
Ne5t, the une5pected happens. )he company that our scale1trading #riend is trading
reports that it is under %ederal in&estigation concerning #alse #inancial reporting. )he
ne5t day, the stoc" opens a #ew points lower and @ust "eeps on dropping until it hits
K1, J>;, its closing price #or the day. )hough sha"en by the news, our #riend is
disciplined about his system and buys slugs o# the stoc" right on schedule at K+5 5>;,
K+, 1>+, K1H J>;, K1J 1>;, and K1, 1>+. 3e is getting a little worried because he is
eight months into this trade and he has an K;,, reali/ed gain and a KJ,;JJ unreali/ed
loss so #ar. 3e also is reali/ing that so #ar he has nothing to show #or his nearly K;,,,,
in&estment e5cept a net loss. 3e starts to wa"e up at night wondering what will
happen to his position, since although he reali/ed that this could happen, he ne&er
thought that it actually !ould happen.
Bn#ortunately #or our #riend, in the #ollowing months the in&estigation re&eals that the
company does actually ha&e some #raudulent practices. )his re2uires that the balance
sheet and income statements #or some pre&ious years are re&ised to re#lect the e##ects
o# the management mistatement and co&erup. )he e5perienced 8though croo"ed9
management o# the company is ousted #or their sins and replaced. *o the price o# the
stoc" wor"s its way lower and e&entually le&els out between KL and K5 per share, and
it languishes in the low single digits #or the ne5t five years. <ur scale trading #riend
has a KH,,,, to KA,,,, unreali/ed loss in addition to his K;,, trading gain, and ten or
ele&en thousand dollars in&ested in the stoc" he still holds. <nce in a while o&er the
ne5t #ew years he may get a K+,, trading gain as the stoc" bounces around, but these
pale in relation to what he has in&ested and what he could ha&e earned e&en #rom a
passboo" sa&ings account. <n top o# this, he also has to li&e with the !orry #or the
ne5t #i&e years that the stoc" will #urther decline, causing him to either gi&e up his
strategy completely or in&est e&en more money. Now he reali/es that so much time
has passed that e&en i# the stoc" rises bac" up to KH, someday, his annual rate o#
return #or the amount in&ested will be miniscule.
(t is scary to reali/e what can happen when you get caught up into a #lawed strategy
such as scale trading. )his little story might sound e5treme, but ( assure you that
e&ery single day someone gets the bright idea to do e5actly what our poor #riend in
the story did. )hin"ing they ha&e disco&ered a money machine, they begin scale
trading and the rest is simply a matter o# time. )he trader in the story was disciplined 1
he held to his system against all odds, but he still got mired into a terrible mess. )he
lesson to be learned is that to be success#ul, you not only ha&e to be disciplined, but
the theory on which your system or method is based must be correct as well. . bad
theory well implemented still results in a loss.
<# course, not e&ery scale trade results in a disaster, in #act most o# them probably
result in a pro#it sooner or later. But the potential #or pro#it is small considering the
time, worry, and capital in&ested. )he typical pattern with scale trades is a series o#
small pro#its #ollowed by one gigantic and ine&itable loss.
*ome #ol"s e&en apply the scale trading techni2ue to se&eral di##erent stoc"s at the
same time. )his does nothing but compress the amount o# time it ta"es to loc" on to a
stoc" that @ust "eeps declining and declining in &alue 1 it may e&en become totally
worthless and enter ban"ruptcy proceedings. <r, almost as bad, it may decline #rom
K5, all the way down to K1,>share and sit there #or a long time. =erhaps it will sit
there #or years or e&en decades while the poor trader sits trapped in his losing position
earning little or nothing on his money. -ou can rest assured that anyone who uses this
approach consistently in the stoc" mar"et will meet this demise #airly early1on in the
process. )he #atal assumption made by the scale1trading theory is $what goes down
must come up,$ and as we ha&e discussed earlier, this simply is not the case with
stoc"s.
(n the e5ample abo&e, i# the price o# the stoc" declines to slightly abo&e K1>share, the
hapless scale1trader will own stoc" with a mar"et &alue o# KL,9,, in which he has
K1A,9,, in&ested 1 a loss o# K1J,,,,. (# the company goes ban"rupt, the numbers
would be worthless stoc" and at a sic"ening loss o# at least K1A,9,, 8i# he had sense
enough to stop buying once the stoc" #ell below K1>share9. )his is a#ter starting with
only K1,,,,, and the usual case is that the neophyte #eels his strategy is so #oolproo#
that he starts with K5,,,, or some other large amount. )he only sa&ing grace is that
people tend to pursue this strategy when they are young, #oolish, and ha&e little
money to lose. *o i# our no&ice scale trader started with a K1,,,,, initial position at
K5,>share instead o# the K1,,,, position in the e5ample, he li"ely won!t lose the entire
K1A,,9,, we might e5pect him to lose. )his is because unless he inherited his money,
he probably won!t ha&e that much to lose.
The positives of scale trading are,
1. (t is simple and not sub@ecti&e.
+. (t can generate lots o# small gains in choppy mar"et conditions.
The negatives of scale trading are,
1. ?hen applied to a port#olio o# stoc"s, the stoc"s which do worst suc" up the
most capital as more and more purchases are made while it declines. .ll
capital is automatically allocated to the worst1per#orming stoc"s in the
port#olio while the best stoc"s are sold o##. )he result is at best a disastrous
underper#ormance &ersus the mar"et or at the worst a total loss o# capital. (# a
scale trader uses margin 8borrows money #rom the bro"er to buy e&en more
stoc"9, the trader may, under the right conditions, creati&ely #ind a way to lose
e&en more money than he has. )he biggest problem is that scale trading cuts
the trader!s gains and lets his losses run, @ust the opposite o# what you want to
do.
+. (t is impossible to plan how much capital it will ta"e to e5ecute the strategy
since you ne&er "now how #ar down a stoc" will go be#ore it reco&ers 1 i# it
does reco&er. )here are an in#inite number o# 5,I declines between any
positi&e number and /ero, there#ore an in#inite number o# purchases you
would need to ma"e to #ully e5ecute the strategy. %ew people ( "now ha&e
unlimited capital.
J. D&entually, e&eryone who practices scale trading encounters a stoc" that
declines precipitously and then goes ban"rupt. )he losses #rom such an
occurance are huge. )here ha&e been a plethora o# seemingly roc"1solid
companies o&er the years that ha&e ended up in ban"ruptcy court.
L. )he scale trader never gets the #ull bene#it o# a #a&orable trend since he is
always selling his winners and buying more o# his losers.
5. D&en when a scale trade is success#ul, the amount o# pro#it to be had is &ery
small relati&e to the amount in&ested and especially relati&e to the ris" o#
catastrophic loss.
H. ?hen a scale1trader #inds himsel# loc"ed into a large losing position, he can!t
e&en get the ta5 bene#it o# a writeo##, since his strategy ma"es no pro&ision #or
him to sell out his position. <# course, i# a ban"ruptcy should occur, then he
can write o## the entire amount
<b&iously, scale trading is not a strategy to pursue unless you want to guarantee
yoursel# substandard returns peppered with an occasional #inancial disaster. (n the
ne5t chapter we will ta"e this lemon o# a method and ma"e lemonade. By re&ersing
the scale trader!s tactics, we will construct the Fe&erse *cale *trategy, which will gi&e
us some moderately large gains, some small losses, and some huge gains which will
ma"e it all worthwhile. Better yet, the rules o# this strategy will be as #orthright and
unambiguous as in the scale trading method
*hapter B, The -everse Scale Strateg
I &ant to e!phasiKe that perhaps the 'est strateg of all% for !ost people% is to
si!pl appl the stoc# pic#ing criteria in the past chapters% then 'u and hold
their selected stoc#s &ithout ever selling the!( <# course, you will need to select a
substantial number o# stoc"s to achie&e an ade2uate le&el o# di&ersi#ication, but #or
results &ersus ris" and time e5pended, it is hard to beat a buy1and1hold strategy. (
recommend the simple buy1and1hold approach #or the &ast ma@ority o# people.
)his chapter, and #ollowing chapters, are written only #or those who are willing to
ta"e more ris" o# loss and e5pend more time in order to ha&e a chance at winning big.
3owe&er, "eep in mind that you can always lose big whene&er you employ any type
o# trading strategy
(n the pre&ious chapter, we studied the worst o# all trading strategies. (t systematically
snowballs your losses and @ettisons your best stoc"s @ust as they start to become
winners. =racticed consistently, the scale1trading approach is a sure1#ire tic"et to the
soup line. )he Fe&erse *cale *trategy, on the other hand, is de&eloped by inverting
the *cale )rading approach, and in the right mar"et conditions may deli&er large
pro#its o&er time. Be#ore we get into the details o# the Fe&erse *cale *trategy, though,
let!s ta"e a side trip to e5amine how all port#olios ine&itably act o&er time.
The one inevita'le characteristic of all stoc# portfolios(
)o begin with, let!s thin" about a port#olio o# ten stoc"s held o&er a period o# time,
say, #i&e years. %or now, let!s not worry about which stoc"s are in the port#olio. )he
only thing we "now about the port#olio is that it is composed o# ten stoc"s. Now let
me as" the 2uestion, $what can we predict about the port#olio #i&e years #rom nowC$
(n other words, what is certain to happen o&er the ne5t #i&e yearsC
%irst o# all we can-t predict what the total return on the port#olio will be, because that
will depend on mar"et conditions o&er the ne5t #i&e years, and also will depend on
how well our ten companies indi&idually per#orm o&er that period o# time. *toc"s
ha&e historically returned on average about 9I per year, but o&er any #i&e year period
this can range #rom a negati&e number to a &ery positi&e number o# +,I per year or
more. (t also &aries considerably #rom company to company. *o ob&iously we can!t
accurately predict what each indi&idual stoc" in the port#olio will return, either.
(t may be disheartening to you to reali/e how little we actually can #oretell about the
#uture per#ormance o# our port#olio. 3owe&er there is only one thing that we can
#airly con#idently predict about any bas"et o# stoc"s, and it is this0
3t the end of the five ear holding period% so!e stoc#s in the portfolio &ill have
perfor!ed vastl 'etter than others(
%or the sa"e o# re#erence, ( will call this the Varia'ilit *oncept.
)his is not e5actly a re&elation. ?e could e5pect that one or two o# the stoc"s will
ha&e tremendously outper#ormed the mar"et a&erages, which might mean a mo&e o#
two, #our, or maybe e&en ten or more times our entry price, depending on mar"et
conditions. *ome will ha&e pro&en to be dogs, perhaps declining marginally, or in the
e5treme case, gone out o# business in the meantime. . large portion o# the stoc"s will
ha&e per#ormed pretty much in line with the mar"et. (# you!&e chosen your stoc"s
randomly, there!s also a &ery good chance that your ten1stoc" port#olio will ha&e
returned something close to what the mar"et a&erages returned o&er the #i&e years.
*ince e&ery port#olio o# stoc"s contains #uture winners and #uture losers, we are le#t
with this0 The challenge of investing is to !a#e sure that &hen ou get to the end
of our holding period% ou find that !ost of our !one &as invested in the
stoc#s &hich perfor!ed the 'est% and relativel little &as invested in the stoc#s
&hich did the &orst.
)o reali/e how this concept can be use#ul to us, we also ha&e to add to it another #act
we!&e already discussed in great length about the stoc" mar"et0
Stoc#s !a#e large !oves in continuous trends &hich al!ost al&as ta#e !onths
or ears to develop(
7et!s call this the Trend *oncept.
7arge price mo&ements are gradual incremental e&ents, not all1at1once step #unctions.
)hey are e&olutionary, not re&olutionary. ?hether the mo&e is up or down, a really
big mo&e does not normally happen o&ernight unless there is a merger announcement,
ban"ruptcy #iling, or something o# that sort. D&en then, the actual announcement has
o#ten been preceded by an uptrend 8in the case o# a pending buyout9 or a downtrend
8in the case o# a pending ban"ruptcy #iling9. )he reason #or this is that there are
always some #ol"s who "now about these pending announcements be#ore they
happen, e&en i# they are not supposed to "now. )heir buying or selling leading up to
the announcement mo&es the stoc" while the public is still clueless as to why it is
mo&ing.
=utting the )rend and Mariability concepts together, it becomes apparent that there
will most li"ely be a &ide gap in the returns 'et&een the 'est$perfor!ing and
&orst$perfor!ing stoc# in our ten$stoc# portfolio. (t is e2ually apparent that this
condition &ill develop slo&l% with the gap in total returns between the best and
worst stoc" growing steadily as the holding period lengthens. )he union o# these two
ine&itable e&ents should lead logically to this conclusion0
If onl &e could find a &a to gradually allocate our invest!ent dollars to the
'est$perfor!ing stoc#s in our portfolio as they are becoming the 'est$perfor!ing
stoc#s% then &e4d have a tre!endous chance of greatl increasing our invest!ent
returns a'ove and 'eond &hat &ould 'e achieved ' si!pl choosing those
sa!e ten stoc#s and holding the! in eFual dollar a!ounts(
-eversing the Scale Trading e0a!ple
?hat we need, then, is to de&elop a system that will accomplish this allocation o#
capital to our strongest and best1per#orming stoc"s. .s it turns out, we can do this by
simply re&ersing the scale trading approach learned about in the last chapter. *o in
other words, we add e)ual dollar amounts to our stock positions as they move up in
price, instead o# when they mo&e down in price. )his is what ( call the -everse Scale
Strateg. (n the rest o# this chapter, you will see how the mathematics o# this
approach wor" greatly in our #a&or.
*ince one picture is worth a thousand words, ta"e a loo" at the #ollowing chart. (t is a
price chart o# ?ireless )elecom, a stoc" which ( began buying in early 199L, and still
own as o# this writing. I purchased the stoc# after it had alread !ore than
dou'led in value% at slightl a'ove I1Jshare 8mar"ed by the arrow9. ( added an
e2ual dollar position 8not an e2ual number o# shares9 with e&ery 5,I increase in
price #rom the pre&ious purchase le&el, represented by the hori/ontal lines in the chart
below. )hat is, each successi&e purchase was #or less shares than the pre&ious
purchase.
=ursuing the Fe&erse *cale *trategy ( purchased positions at appro5imately K+.,A 8all
prices are ad@usted #or stoc" splits which occurred during the stoc"!s rise9, KJ.1,,
KL.H5, KH.9A, K1,.LL, and K15.HL. )he price has not yet reached K+J.LL or ( would
ha&e purchased an e2ual dollar amount there, too. %or the sa"e o# an e5ample, let!s
say ( put K+,,,, into the stoc" at each o# those price le&els, and e&ery time ( did ma"e
a new purchase, ( mo&ed my stop1loss order 8i# you are not #amiliar with stop1loss
orders, they are e5plained in Chapter ;9 up to the price o# the pre&ious purchase.
3ence, my sell point was constantly rising during this time, most recently at a price o#
K1,.LL. <b&iously, ( owned other stoc"s in mid1199L when ( #irst bought a position in
?ireless )elecom, but at that time ( had no idea this particular stoc" would increase as
much as it did in &alue &ersus the other stoc"s. ( didn!t need to "now, because my
strategy guaranteed that i# it made an e5ceptional mo&e, ( would ha&e a
disproportionate amount o# money in&ested in it. .s ( said earlier in the boo"% it is
'est to avoid prediction altogether% and rather rel on a strateg &hich can
guarantee a good allocation of our dollars(
(# you #ollowed the *cale )rading e5ample as presented in the last chapter, you saw
how no matter what happened, the scale1trader!s poor strategy allocated most o# his
capital to the worst1per#orming stoc"s gradually, with a large loss being the ine&itable
result. 7i"e a snowball rolling downhill, the tendency #or a declining stoc" to "eep on
declining, in combination with the scale trader!s #oolish trading rules re2uired the poor
trader to buy more and more while his position became worth less and less. <nce you
ha&e really grasped how #oolish the scale trading strategy is, it becomes much easier
to see how wise it is to #ollow the Fe&erse *cale *trategy. )o gi&e you a #la&or #or the
ad&antages o# adding to a position as it mo&es up in price, #ollowing is a brie# contrast
o# *cale )rading &ersus the Fe&erse *cale *trategy0
Scale Trading -everse Scale Strateg
=ositions added only i# stoc" declines. =ositions added only i# stoc" increases.
-our a&erage cost per share is always
abo&e the current mar"et price a#ter
second purchase.
-our a&erage cost per share is always
below the current mar"et price a#ter
second purchase.
*acri#ices large long1term gains #or small
short1term gains.
*acri#ices small short1term gains in order
to reali/e large long1term gains.
Bnlimited potential #or loss. Bnlimited potential #or gain.
'a"es no attempt to cut losses. .dds to
losing positions.
Cuts losses. Eoes not add to losing
positions.
(n a port#olio, automatically allocates
ma@ority o# capital to worst1per#orming
issues.
(n a port#olio, automatically allocates
ma@ority o# capital to best1per#orming
issues.
The Sno&'all Effect
)o help you en&ision the principle o# the Fe&erse *cale *trategy, (!d li"e to o##er the
#ollowing illustration. (magine you are standing at the top o# a large hill. -ou ha&e
made #i&e snowballs, all e2ual in si/e, and you gi&e each o# them a e2ual push to start
them rolling downhill. <ne o# the snowballs starts out o"ay but doesn!t get &ery #ar, as
it hits a roc" that was hiding below the sur#ace o# the snow, e5ploding the snowball
into smithereens. )wo others ma"e it about hal#way down the hill, but then stall out
because they became large and happened to be on a part o# the hill that was not as
steep as some other areas. *till another ma"es it a bit #urther than those two, but then
hits a wet area and gets bogged down. <ne o# the snowballs, howe&er, happens to
ha&e @ust the right type o# snow and a nice steep incline, and its 2uic" start,
momentum, and a#ter a while, sheer si/e ma"e it unstoppable. (t goes se&eral times
the distance o# any o# the other snowballs.
)he analogy between snowball1rolling and a port#olio o# stoc"s is a good one.
<b&iously, the snowball that rolls the #arthest gets the biggest and pic"s up more
snow gradually as it goes. )he si/e o# the snowball can represent either losses or
gains, depending on whether you are using the *cale )rading approach 8snowballing
losses9 or the Fe&erse *cale *trategy 8snowballing gains9. Feally, both the *cale
)rading approach and the Fe&erse *cale *trategy cause a snowballing e##ect. -ou
ha&e to choose which strategy you would pre#er0 <ne which snowballs losses or
pro#its. )ough choice, huhC
?ith snowballs, as in the stoc" mar"et, there are things you can control and things
you cannot control about the stoc"s you are in&esting in. -ou can control how big you
ma"e each snowball initially, and you can control how much o# a sho&e you gi&e
each. %rom then on, many o# the #actors are out o# your control or unpredictable. D&en
though we can!t predict which snowball will roll the #arthest, the hill still gi&es more
snow to the one that e&entually does go the #urthest, because it adds snow to it
gradually as it progresses. 3ence, the beauty o# the Fe&erse *cale *trategy is that @ust
as the hill and gra&ity ma"e sure the snowball that goes the #urthest gets the most
snow, our strategy will ma"e sure that the stoc" which ad&ances the #urthest gets most
o# our capital.
Trading rules for the -everse Scale Strateg, an e0a!ple(
)o learn how to implement the Fe&erse *cale *trategy, let!s run through an e5ample
#or one single stoc". .lthough we will be using the Fe&erse *cale *trategy in a
port#olio o# se&eral or more stoc"s, it is much easier to illustrate the concept using @ust
one stoc".
%irst, we construct a chart similar to what the scale trader in the last chapter
constructed, only our chart begins at the initial purchase price and goes up, each
succeeding decision point being 5,I higher than the pre&ious one, 8instead o# 5,I
lower, as with scale trading9. )he trading rule is0
6e &ill invest an additional designated nu!'er of dollars at each price level as
that level is reached $ and onl if it is reached(
.s you can see, we will be adding an e2ual dollar amount at each price le&el. )his
dollar amount is the same as our initial position in dollars, but a reduced number o#
shares due to the higher price paid #or each successi&e purchase. %or a stoc" where
our initial purchase was at K+, per share, our decision chart would loo" as #ollows
8the inital entry position is highlighted90
-everse Scale Strateg $ >HG purchase incre!ents ;*hart /+<
Decision
Point
Price @evel
3!ount
Invested
this Purchase
L
Shares
'ought
*u!ulative I
Invested
*u!ulative
Shares
.&ned
*urrent
Value of
Shares
*u!ulative
*ost per
Share
Total I ProfitJ
;@oss<
7oss1cutting
point
1J 1>L N>. N>. N>. N>. N>. N>. N>.
Initial entr
point
1H I+%HHH >H I+%HHH >H I+%HHH I1H(HH IH
Eecision point
1
J, K99, JJ K1,99, ;J K+,L9, K+J.9; K5,,
Eecision point
+
L5 K99, ++ K+,9;, 1,5 KL,A+5 K+;.J; K1,AL5
Eecision point
J
HA 1>+ K1,,1J 15 KJ,99J 1+, K;,1,, KJJ.+A KL,1,;
Eecision point
L
1,1 1>L K1,,1J 1, K5,,,5 1J, K1J,1HJ KJ;.5, K;,15;
R *ince shares can only be bought in increments o# one, this number does not always e2ual K1,,,, #or each purchase, but the cost o# the
closest increment o# one share that can be purchased with K1,,,,.
.gain, each successi&e Eecision =oint is arri&ed at by multiplying the pre&ious one
by 1.5. *o the #irst decision point is calculated by multiplying the K+, initial entry
price by 1.5, which yields KJ,6 KJ, times 1.5 results in KL5, and so on #or as #ar as
you need to go.
<ur other trading rule is0
6henever our stoc# increases to reach a decision point and then retreats all the
way back to a previous decision point% &e &ill sell out our entire position in the
stoc#(
?hy do we ha&e this trading ruleC *imply because i# a stoc" retreats enough to ma"e
it all the way bac" to a pre&ious decision point, then it!s a good bet it!s lost enough
momentum that it will ha&e a hard time becoming a mar"et leader once again. (n other
words, its uptrend may be ending or about to go dormant #or a long, long time. *o, it!s
best to trade it in and start o&er with another more promising issue. .s we ha&e
discussed in earlier chapters, we need to gi&e a mar"et1leading stoc" plenty o# room
#or normal retreats o## its highs in order to be able to ride the long trends when they
de&elop. 3owe&er, we ha&e to draw the line at some point. Gi&en that our decision
points are 5,I apart, the prospect o# $whipsaw$ losses or prematurely bailing out o# a
stoc" are limited with this approach.
)o illustrate, let!s assume we too" our initial position at K+,>share as indicated in
Chart G1. <&er the ne5t year, the stoc" increases in &alue gradually to K1,5>share, as
graphically illustrated in Chart G+. ?e would ha&e pic"ed up shares at KJ,, KL5, KHA
1>+, and K1,1 1>L, #or a total o# 1J, shares owned, re#erring once again to Chart G1.
Because the stoc" reached the Eecision =oint GL at 1,1 1>L, our sell point would ha&e
ratcheted up to HA 1>+.
*hart /1,
7et!s say then that the stoc" retreats bac" to the KHA range. *ince the stoc" has at that
point &iolated our sell Eecision =oint GJ by #alling below KHA 1>+, we unhesitatingly
enter a mar"et order to sell the entire 1J, shares. %or the sa"e o# simplicity, let!s
assume we were able to sell our shares at e5actly KHA 1>+. ?e could then compute our
pro#it #rom the trade as #ollows0
Su!!ar of Purchases and Sale ;*hart /5<,
Shares
Purchased
Price per
Share
Total *ost *o!!ission Net *ost
=urchase G1 5, K+, K1,,, K+5 I+H1>
=urchase G+ JJ KJ, K99, K+5 I+H+>
=urchase GJ ++ KL5 K99, K+5 I+H+>
=urchase GL 15 KHA 1>+ K1,1J K+5 I+H5C
=urchase G5 1, K1,1 1>L K1,1J K+5 I+H5C
)otal cost o# all the purchases0 K5,1J1.
)otal shares purchased0 1J,
=roceeds #rom 1J, shares sold at KHA 1>+ S K;,AA5. 'inus K +5 commission S K;,A5,.
Net Profit S K;,A5, minus K5,1J1 or I5%A+M.
:ust to illustrate the pre&iously made point about the Fe&erse *cale *trategy ma"ing it
hard to get sha"en out o# a stoc" prematurely, please note what our sell decision point
would ha&e been had the price topped out at only K1,, instead o# at 1,1 1>L or higher.
(n that case, the price would ha&e had to retreat #rom K1,, all the way down to
KL5>share in order to trigger a sellout o# the position, since it ne&er reached the K1,1
1>L le&el and there#ore KHA 1>+ ne&er became our sellout point. Now, ( "now
emotionally it might seem disheartening to you to ha&e to sit idly by while a stoc"
sin"s #rom a pea" o# K1,, down to KL5. But belie&e me, there are plenty o# times
where this discipline o# being able to ride out the occasional temporary steep
correction will be the very thing that allows you to sometimes go on to ma"e a huge
gain o# 1,,,,I or more. Oeep in mind that gains o# 1,,,,I happen much more o#ten
than you!d thin" i# you are using the stoc"1pic"ing criteria presented in Chapter L. (t is
also much easier to ride a stoc" down temporarily i# it is only one o# many stoc"s you
own, so ma"e sure you di&ersi#y
%or the sa"e o# co&ering all the bases in the last e5ample, what would ha&e happened
i# our stoc" had turned out to be a loser instead o# a winnerC (# a#ter we too" our inital
position at K+, per share, the stoc" declined to 1J 1>L or lower 8K+, di&ided by 1.59,
we would ha&e sold the inital position and started loo"ing #or a new stoc" to start o&er
with. ?e would ha&e incurred a loss o# KJJA.5, plus two K+5.,, commissions, #or a
total loss o# KJ;A.5,. ?e then would go prospecting #or a new stoc" to trade.
Femember, we do not want to "eep gunning #or the same stoc" once we!&e been
bumped out o# it by our system.
-is# and -e&ard
?hile you might or might not be impressed with a pro#it o# KJ,H19, "eep in mind that
we ne&er e5posed oursel&es to a loss o# more than KL,, or so in this trade. *o, the
potential #or pro#it here is unlimited 8limited only by the per#ormance o# the stoc"
being traded9, while the potential #or loss is 2uite limited.
)he real power o# the Fe&erse *cale *trategy lies in using it to harness the power o#
margin borrowing. *o in the Chapter ; we will e5plore how the Fe&erse *cale
*trategy can go hand in glo&e with the controlled use o# borrowing to enhance the
return on your port#olio. Chapters 9 and 1, will co&er implementation details and
trading rules. ?hen we are done we will ha&e the per#ect blend o# limited loss, limited
personal cash in&estment, and unlimited pro#it potential. 3owe&er, "eep in mind that
anytime you use margin borrowing to buy stoc"s, you are ta"ing a larger ris" o# loss
than i# you didn!t. )here is still no #ree lunch.
*hapter C, Margin Po&er
.s long as money has e5isted, ris"1ta"ers ha&e multiplied their e##orts through the use
o# other people!s money. )here is probably no place where the use o# other people!s
money can be used to such ad&antage 8i# you ha&e a well1thought out plan9 or to court
disaster 8i# you don!t ha&e a plan9 than the stoc" mar"et. (n real estate, #or instance,
you can borrow money, but there will be a ban"er there to ma"e sure you don!t ma"e
too bad a deal and thus put the ban"!s loan in @eopardy. (n the stoc" mar"et there are
#ew such sa#eguards. -ou are #ree to lose all o# your money 8and more9 i# you are not
@udicious in the use o# debt le&erage.
(n the stoc" mar"et, it is possible to easily borrow money, using the &alue o# the
stoc"s you own as collateral. .s o# this writing, current margin rules allow a person to
borrow in order to 'u up to t&ice as !uch stoc# as you ha&e cash in your account.
By using margin, you now magically ha&e the same number o# dollars in your
account, but more stoc" than you had be#ore. )his practice is called trading on
margin. Eoes it sound ris"yC -ou had better belie&e that it is, i# it!s done in an
uncontrolled #ashion. ?hen using margin, the need to ha&e an airtight plan and the
discipline to #ollow that plan is doubly important. D&en then, people can and do lose
money trading on margin, because you can ne&er tell what will happen in the stoc"
mar"et. 3owe&er, i# you do ha&e a reasonable plan and discipline, you can ob&iously
ma"e a lot more money in stoc"s than you can by trading #rom a 1,,I cash position.
(# you try trading on margin, you can lose a lot more money than you could on a cash1
only basis. *o, be aware o# the ris"s o# margin as well as the potential.
)he Fe&erse *cale *trategy that we @ust introduced can be used with margin le&erage
while "eeping the ris" to a manageable le&el. )o e##ecti&ely use margin, the #irst, most
important rule is that you never borrow money in order to add more shares to a losing
position. (# you are carrying a losing position on anything, it is by de#inition trending
downward at least #rom your entry point. .s you ha&e seen, in the Fe&erse *cale
*trategy we only add to positions as they are trending in our #a&or, upward. ?e
already concluded that we didn!t want to buy into downtrending stoc"s e&en when
trading #rom a cash position. ?e certainly don!t want to add to any losing position,
and with the ability o# margin to magni#y gains and losses we must be especially
care#ul not to add to a losing position when we are borrowing to do it.
)he other thing to "eep in mind with the use o# margin is that while current
regulations allow us to #inance up to 5,I o# the &alue o# the stoc"s we own, such a
le&el o# le&erage is almost ne&er a wise mo&e. %or instance, i# you ha&e a K+,,,,,
account you can borrow #rom your bro"er to purchase up to KL,,,,, worth o# stoc".
)he use o# that much le&erage means you are paying a huge amount o# interest
relati&e to the cash in your account, which will deplete your capital rapidly with each
passing day i# your stoc"s happen to sit idle and mar" time. )his use o# the ma*imum
allo!able amount o# margin le&erage also means that i# the position mo&es against
you, you are li"ely to lose a huge amount o# your account e2uity, in other words the
part o# the account you actually own. (n #act, with margin you can actually end up
losing more than all o# your money, under the most e5treme conditions.
.s we said be#ore, current regulations allow us to buy twice as much stoc" as we ha&e
cash. )hat is the most ris" we are allowed to ta"e, but we are not going to ta"e
anywhere near that le&el o# ris" with our hard1earned money. *o, our rule #or use o#
margin will be0
To control our use of leverage% 6e &ill choose our initial position siKe in a stoc#
so that &e &ill al&as have enough cash on hand to make our inital purchase and
half of our second purchase% &ithout 'orro&ing anthing(
(n the chart below, (!&e ta"en our pre&ious chart #or illustrating the Fe&erse *cale
*trategy and added two columns, $=ercent #inanced,$ and $Cumulati&e Cash
Eeposited.$ *ince each successi&e purchase is always K1,,,, in &alue in this e5ample,
we deposit K1,,,, to ma"e the #irst purchase and K5,, to ma"e the second purchase in
accordance with our rule #or margin trading. <ur total cash deposited #or this trade is
there#ore K1,5,,.
-everse Scale Strateg% >HG Price Incre!ents ;*hart /+<(
Decision
Point
Price
@evel
3!ount
Invested
this
Purchase
L
Shares
"ought this
Purchase
*u!ulative I
Invested
*u!ulative
Shares
.&ned
*urrent
Value of
Shares
Total I ProfitJ
;@oss<
Total I
"orro&ed
Percent of
Position
Financed
*u!ulative
*ash
Deposited
+, K1,,,, 5, K1,,,, 5, K1,,,, K, K, H(HG I+%HHH
J, K99, JJ K1,99, ;J K+,L9, K5,, KL9, +M(BG I+%>HH
L5 K99, ++ K+,9;, 1,5 KL,A+5 K1,AL5 K1,L;, 5+(5G I+%>HH
HA L>; K1,,1J 15 KJ,99J 1+, K;,1,, KL,1,; K+,L9J 5H(CG I+%>HH
1,1 +>; K1,,1J 1, K5,,,5 1J, K1J,1HJ K;,15; KJ,5,5 1A(AG I+%>HH
151 A>; K1,,HJ A KH,,H; 1JA K+,,;,A K1L,AJ9 KL,5H; 11(HG I+%>HH
++A A>; K911 L KH,9A9 1L1 KJ+,1++ K+5,1L+ K5,LA9 +B(+G I+%>HH
R *ince shares can only be bought in increments o# one, this number does not always e2ual K1,,,, #or each purchase, but the cost o# the
closest increment o# one share that can be purchased with K1,,,,.
)he Cumulati&e Cash Eeposited column shows the total amount o# our own dollars
we would ha&e deposited, which in this e5ample is ne&er more than K1,5,,. )his
column added to the Cumulati&e Eollars (n&ested column and the )otal =ro#it>8loss9
column e2uals the Current Malue o# *hares column, because the current &alue o# the
stoc" we!&e in&ested in is composed o# three elements0 19)he cash we!&e deposited
8thin" o# it as our down payment, +9 )he amount we!&e borrowed #rom the bro"er
8thin" o# this as our mortgage on the stoc"9, and J9 )he accumulated pro#it we carry
in the position. -ou see, the bro"er!s regulation re2uires us to only put up 5,I o# the
&alue o# the stoc", and we can use any unreali/ed gain as part o# the 5,I
downpayment we are re2uired to ma"e. )his means that once we get to the third
purchase and beyond, neither the bro"er!s regulations nor our trading rule re2uires us
to add any more o# our o!n money to the trade, no matter how many more purchases
our strategy re2uires us to ma"e.
)he =ercent %inanced column shows how much o# the current &alue o# stoc" we own
is #inanced with borrowings #rom our bro"er. .s you can see, at no time do we e&en
get close to the 5,I threshhold, since the ma5imum borrowing we do tops out at
J1.JI o# security &alue as we add our third position. %rom then on, our pro#its
snowball to such an e5tent that we are not reFuired to add another di!e of our o&n
!one to the trade #or each purchase a#ter the second one, no matter how many
purchases we e&entually end up ma"ing. -et, our percent #inanced declines #or each
position added a#ter the third one. )he beauty o# this approach is that when we loc"
onto a real winner, can really pile onto the position without putting up much o# our
own money. %rom the chart, you can see that should we e5ecute our strategy on a
stoc" which runs #rom K+,>share to K++A A>;, we will ha&e an open pro#it o# K+5,1L+,
less the minimal amount o# interest paid on the borrowed portion and commissions.
<ur total in&estment o# our own cash was only K1,5,, on the trade. -ou may not #ind
a stoc" li"e this e&ery year, but they are ine&itable i# you stic" with the Fe&erse *cale
*trategy and the stoc" pic"ing criteria #rom Chapter L. (# you loo" at the )otal =ro#it
column, you will see that you do not need anything e&en close to a ten#old mo&e to
ma"e a large pro#it relati&e to the K1,5,, o# your own money in&ested.
)he decision to use margin or not is yours alone. -ou can still use the Fe&erse *cale
*trategy without borrowing, by simply ceasing to buy additional positions when you
run out o# cash. )he decision points in the chart are still use#ul in such a case #or
deciding when to sell out your position. <b&iously, the use o# margin ma"es a big
di##erence in your return only when the stoc" ma"es a big mo&e. 3ere is how the
pro#it picture would loo" i# you simply too" a K1,,,, position and didn!t add to it at
all0
-everse Scale Strateg% no !argin leverage ;*hart /1<,
Decision
Point
Price
@evel
3!ount
Invested
this
Purchase
L
Shares
"ought this
Purchase
*u!ulative I
Invested
*u!ulative
Shares
.&ned
*urrent
Value of
Shares
Total I ProfitJ
;@oss<
Total I
"orro&ed
Percent of
Position
Financed
*u!ulative
*ash
Deposited
+, K1,,,, 5, K1,,,, 5, K1,,,, K, K, ,.,I K1,,,,
J, K, , K1,,,, 5, K1,5,, K5,, K, ,.,I K1,,,,
L5 K, , K1,,,, 5, K+,+5, K1,+5, K, ,.,I K1,,,,
HA L>; K, , K1,,,, 5, KJ,JA5 K+,JA5 K, ,.,I K1,,,,
1,1 +>; K, , K1,,,, 5, K5,,HJ KL,,HJ K, ,.,I K1,,,,
151 A>; K, , K1,,,, 5, KA,59L KH,59L K, ,.,I K1,,,,
++A A>; K, , K1,,,, 5, K11,J91 K1,,J91 K, ,.,I K1,,,,
Bsing both Chart G1 and Chart G+, we can construct the #ollowing comparison o# the
pro#it results o# the same trade both with and without using margin le&erage0
Profit *o!parison of Margin versus *ash$onl "asis ;*hart /5<,
Price @evel Profit
Using Margin
Profit
6ithout Margin
3dditional Profit
fro! Margin
+, K, K, K,
J, K5,, K5,, K,
L5 K1,AL5 K1,+5, KL95
HA L>; KL,1,; K+,JA5 K1,AJJ
1,1 +>; K;,15; KL,,HJ KL,,95
151 A>; K1L,AJ9 KH,59L K;,1L5
++A A>; K+5,1L+ K1,,J91 K1L,A51
*o, i# the stoc" mo&es #rom K+, to K++A A>;, the di##erence in pro#it is nearly K15,,,,,
whereas the di##erence in our o!n dollars in&ested is only K5,, 8the K1,5,, deposit in
the margin e5ample &ersus the K1,,,, cash deposit in the non1margined e5ample9. %or
stoc" trends o# smaller proportions, the di##erences are less huge, but still substantial.
)he use o# margin is always more ris"y than not using it. )his is simply because
whate&er you do to try to control the ris", you still own more shares than you would i#
you were trading without the use o# borrowed money. 3owe&er, ( #eel anyone who is
com#ortable ta"ing a little more ris" #or a lot more potential reward should use
margin, and ( will assume throughout this boo" that the reader intends to use margin
in building stoc" positions using the Fe&erse *cale *trategy.
Precautionar Guidelines
*ome important principles to remember when using the Fe&erse *cale *trategy0
1. Ne&er buy a larger dollar position in your subse2uent positions than you too"
in the initial entry into the trade. (n our e5ample where we bought K1,,,, o#
stoc" at +,, #or instance, never buy more than K1,,,, o# that stoc" in any
single subse2uent purchase. (# you brea" this rule you will increase your
a&erage cost per share signi#icantly enough that you will practically guarantee
yoursel# a loss at some point.
+. <nly buy at the decision points. Eon!t try to ma"e $e5tra$ buys between
decision points. )his is @ust another way o# brea"ing the #irst rule and lea&es
you e5posed.
J. Ne&er set your decision points closer than 5,I in price abo&e the pre&ious
one. (# you do, you can get whipsawed by normal mar"et #luctuations,
resulting in less pro#it and e5iting trends prematurely. -ou will "ic" yoursel#
as you watch your stoc" reco&er and start ma"ing new highs once again 1
without you.
L. Eo not depart #rom these guidelines
3ppling the -everse Scale Strateg to Portfolios of Stoc#s
Bp until now we ha&e concentrated on how you would go about ma"ing buy and sell
decisions #or @ust one stoc" at a time, because it!s much easier to e5plain the concepts
this way. (t!s easy to adapt the Fe&erse *cale *trategy to a port#olio en&ironment
because all we ha&e to do is construct a separate decision chart #or each o# the #i&e,
ten, or howe&er many stoc"s are in our port#olio, and 'egin &ith an eFual dollar
a!ount in each stoc#. (n the ne5t chapter we will re&iew in a step1by1step manner
how to use our strategy to accumulate and manage a port#olio o# stoc"s.
6hen using the -everse Scale Strateg to !anage a portfolio of stoc#s% al&as
'egin &ith an eFual dollar a!ount invested in each stoc#( Do not tr to guess
&hich stoc#s &ill perfor! 'est(
Diversification
%or the sa"e o# being clearly understood, let me state this in no uncertain terms0 -ou
should never in&est a ma@or amount o# money in @ust one stoc". %or one thing, it is
ris"y because all o# your eggs are in one bas"et. %urthermore, it is unnecessaril
ris"y. (# you ha&e a number o# stoc"s in your port#olio and use the Fe&erse *cale
*trategy, those #ew that per#orm e5ceptionally well will be added to as they progress
upward in price. )his will guarantee that in the #inal analysis your best1per#orming
stoc"s will ma"e up a larger percentage o# your port#olio than your poorer1per#orming
ones. *o you don!t need to try to second1guess which stoc" will per#orm best
be#orehand.
(# you are disciplined and #ollow the strategy, you will ha&e the bene#it o# starting
with a shotgun approach at the outset and progressing to more o# a ri#le1shot as the
winners begin to emerge. *o don!t try to hit a home run by in&esting all your money in
one stoc". Chances are, you!ll simply stri"e out. Ignoring principles of
diversification and investing our !one in onl one stoc# is a ris# and
foolhard thing to do $ don4t do it(
(n my opinion, you should ne&er in&est in less than #i&e stoc"s to begin with, and
that!s the bare minimum number assuming you @ust don!t ha&e enough money to in&est
in more. .s a rule o# thumb, aim to ha&e about ten stoc"s in a Fe&erse *cale *trategy
port#olio. )here is nothing magical about the number ten, but ( #eel this number
represents a good balance between di&ersi#ication and the time re2uired #or trac"ing
the stoc"s.
Do not churn our account:
<nce you ha&e chosen the stoc"s you will trade, do not change stoc"s 8selling one,
buying another9 unless it meets the predetermined e5it plan. )hat is, do not sell a
stoc" unless it hits one decision point below the pre&iously achie&ed decision point.
D&er. (# you do depart #rom this system you will no doubt end up ma"ing emotional
decisions, and they will most li"ely be poor ones. =lus, you will lose peace o# mind
because ou &ill no longer have a plan that you are resol&ed to stic" with no matter
what. (n short, you!ll be right bac" where you were be#ore you read this boo".
)here ha&e been a number o# studies o&er the years showing that e5cessi&e trading
tends to reduce in&estment results. )he other name #or e5cessi&e trading is churning.
?hate&er you call it, it is a waste o# time and generally is a tipo## that the in&estor
doing this is con#used about their strategy or is in&esting #or e5citement rather than
pro#its.
(# you resol&e to use the Fe&erse *cale *trategy, stic" with it consistently. (n the long
run it will be the best policy.
Guidelines for placing orders
Mar#et orders versus @i!it .rders
?hen you place an order with your bro"er, they will as" you i# you want to e5ecute
your trade as a market order or as a limit order( You should always use !ar#et
orders &hen 'uing or selling stoc#s( . mar"et order speci#ies a willingness to buy
at the current mar"et price, whate&er it may be. . limit order instructs the bro"er to
buy at a speci#ied price. . mar"et order ensures that you will ha&e your order #illed,
but the e5act price is not guaranteed. . limit order guarantees that you will not pay a
higher price than you speci#ied, but does not guarantee that your order will be #illed.
*o why not use limit ordersC Because i# you do, you will #ind that what would ha&e
been your most pro#itable orders are seldom #illed, as the mar"et mo&es away #rom
your speci#ied price. <n the other hand, the orders that are #illed on a limit order will
most li"ely turn out to not be your best potential trades. )he reason #or this is that
stoc"s o# companies where something really good is happening will mo&e steadily
upward at times, without pausing to bac"trac" and #ill the orders o# those who ha&e
decided to use limit orders. )he use o# limit orders generally means that a person is
being greedy, hoping to cut his purchase price by a small amount. But, instead, the
hapless limit1orderer is constantly le#t behind by the really good stoc"s, and wonders
why his biggest #ish got away.
Bottom line, in real li#e with the Fe&erse *cale *trategy it is not critical that you get
#illed at e5actly the prices listed in the decision chart. ?e are going a#ter the big gains
and a 2uarter or hal#1point &ariation won!t matter much in the long run. (t is important
to al!ays use mar"et orders as opposed to limit orders. It is !uch !ore i!portant
to get our order e0ecuted than it is to get a specific price(
Stop$loss orders
)here is another type o# order you should "now about, called a stop1loss order. )hey
are commonly re#erred to as simply Nstop orders.! )his order is placed below the
mar"et price i# it is a sell stop order, or abo&e the mar"et i# it is a buy stop. (# the
stoc"!s mar"et price reaches the price speci#ied in the stop order, then the stop order
becomes a mar"et order to buy or sell. .s an e5ample, let!s say we bought shares o#
.BC Co. at K+,. )hey then rise to reach the #irst decision point price o# KJ,>share,
signaling that our sell signal will be reached i# and when the price o# the stoc" goes to
K+,. ?e could place a sell stop order #or our shares at K+,, which would instruct the
bro"er to enter a mar"et order to sell our shares if and onl if the mar"et price o#
.BC Co. again returns to K+, or below. (# we enter it on a good till cancelled basis
8G)C9, the order will stand until it is either triggered by the stoc"!s price reaching
K+,, or until we cancel the order. (# you do not speci#y G)C status #or this or any
other type o# order, your order will be classi#ied as a day order, meaning it will e5pire
at the end o# the day it is entered. *o be care#ul to speci#y G)C on stop orders i# you
want them to last more than a day. <therwise you may ha&e a #alse sense o# security
that your order is still entered when it really is not.
Currently, stop orders are only a&ailable on listed 8New -or" *toc" D5change and
.merican *toc" D5change9 stoc"s, and not on N.*E.4 8<&er1the Counter9 stoc"s.
3owe&er, some bro"ers are starting to o##er stop orders on N.*E.4 stoc"s. *o,
perhaps soon these orders may be a&ailable #or all stoc"s in your port#olio. ( certainly
hope so, because stop orders are a &ery use#ul thing #or the a&erage in&estor who
cannot be watching the mar"et constantly. )hey in essence watch it #or you.
(# you cannot watch the mar"et during the day 8and who canC9, ( encourage the use o#
stop orders once you ha&e accumulated a large position in a company!s stoc". )he
decision point parameters are set #ar enough apart with the Fe&erse *cale *trategy
that using intraday prices 8which is what stop orders are triggered by9 or closing
prices will not li"ely change your per#ormance &ery much and may gi&e you greater
peace o# mind.
*hapter M,I!ple!enting the -everse Scale Strateg,
3 Step$'$Step 3pproach
Now that you ha&e a good grounding in the Fe&erse *cale *trategy, we are ready to
re&iew the steps needed #or you to implement it. <b&iously, going through these steps
the #irst time will ta"e more than #i&e minutes, but a#ter you are set up it should only
ta"e #i&e minutes a day to maintain and e5ecute the strategy.
Step +, Deter!ine ho& !uch ou can afford to co!!it to this strateg(
.ll stoc" mar"et in&estments in&ol&e some degree o# ris", no matter what your
approach to the mar"et. Bear mar"ets, national emergencies, and other #actors are
unpredictable and cause most stoc"s to decline temporarily when they do occur.
Because o# this unpredictability o# short1term stoc" mar"et per#ormance, you should
only in&est capital which you will not need #or at least five years. )here#ore, it!s
necessary to establish e5actly how much you can a##ord to commit to a longer term
strategy such as the one we!&e @ust de&eloped 1 your pool o# $ris" capital.$ )he term
$ris" capital$ means di##erent things depending on the psyche and ris" tolerance o# the
indi&idual in&ol&ed, and determining that number #or you personally is outside the
scope o# this boo". -ou alone must determine how much you can commit, but the
#ollowing are some things to consider when ma"ing that decision0
19 .nvestment e*perience.
(# you ha&e ne&er be#ore traded stoc"s, start small in using the Fe&erse *cale
*trategy until you are &ery com#ortable with the *trategy and with your
understanding o# the mechanics and practices o# stoc" trading. (# you lac"
con#idence, there is no use compounding your discom#ort by adding the stress
o# trading with the lion!s share o# your money. -ou will learn things as you
trade that will gi&e you con#idence in handling larger amounts. Be patient and
gi&e yoursel# time to learn be#ore committing big money.
+9 #stablish an emergency fund.
By de#inition, i# you are not going to commit #unds which you will need in the
ne5t #i&e years, then you must establish an emergency #und. No one, no matter
what position they are in, can rule out the possibility o# a personal emergency
o&er the ne5t #i&e years. 'ost #inancial e5perts recommend si5 months! li&ing
e5penses, and ( would consider that the minimum amount necessary.
J9 /ge.
)he older you are, the less years you ha&e to reco&er #rom re&erses in the
stoc" mar"et. (# you are only #i&e or ten years away #rom retirement, it goes
without saying that you may want to be a little more conser&ati&e in the
amount o# capital you de&ote to an acti&ely managed stoc" port#olio. 'ore
predictable in&estments such as bonds, CE!s, con&ertible securities and such
may need to compose the ma@ority o# your holdings.
Bsing these #actors, you need to ta"e an honest loo" at your situation and assess @ust
how much you want to commit to a relati&ely ris"y, longer1term in&estment program.
I do not reco!!end that ou trade on !argin &ith the !a)orit of our !one:
Do not speculate in stoc#s &ith !one that ou &ill need to consu!e &ithin the
ne0t five ears(
Step 1, *hoose an 3ppropriate "ro#erage Fir!
.s ( see it, there are se&eral criteria to use in choosing a bro"erage #irm to handle your
account0 19 Commission structure, +9 (nsurance, and J9 .ttitude.
01 Commissions.
?ith this method 8or any other, #or that matter9, it is &ital that you cut your
commissions to the bone in order to ma5imi/e net returns. (n most instances,
this will mean using a discount bro"er instead o# a #ull1ser&ice bro"er. )o
enhance net returns, commissions should total no more than 1I to +I per
trade, or else you are paying too much. )he techni2ues in this boo" wor" with
accounts o# any si/e abo&e K5,,,,. But the smaller your account si/e, the
harder it becomes to maintain reasonable di&ersi#ication without incurring
large commissions as a percentage o# your account &alue. *o i# you ha&e a
relati&ely small account and are buying stoc"s in K+,,,, increments, choose a
bro"er which will handle your trades #or less than KL,. -ou should ha&e no
trouble #inding a discount bro"er that will handle your trades #or less than that
amount actually, and ( recommend you do so. 'y bro"er charges K+5>trade
and ( get a le&el o# ser&ice that has always been more than ade2uate. )he
smaller your account si/e, the more closely you!ll ha&e to pay attention to
#inding a bro"er who can "eep your commissions down to 1I to +I o# the
principal amount per trade.
21 .nsurance.
'a"e sure your bro"erage account is insured in case they should go ban"rupt.
Be#ore you open an account, as" to see 8in writing9 what would happen in the
case o# the bro"erage #irm!s ban"ruptcy. )he &ast, &ast ma@ority o# #irms these
days ha&e ade2uate insurance in case o# #ailure through the *ecurities
(n&estors =rotection Corporation 8*(=C9, but the possibility that a #irm
wouldn!t ha&e insurance e5ists and it!s good to in2uire about such things
be#ore committing your #unds.
31 /ttitude.
Eiscount bro"ers are essentially order1ta"ers who o##er no ad&ice, which is
precisely what we want and need. D&en so, be#ore you open an account it is
good to call the #irm!s customer ser&ice department and as" a #ew 2uestions,
e&en i# you ha&e to ma"e some up. ( belie&e that you can learn a lot about the
attitude o# the bro"erage #irm and its employees by spea"ing with them
personally. )his pro&ides a good reality chec" on whether you will be able to
do business with them or i# there will be a clash between their culture and your
personality.
Step 5, Deter!ine ho& !an stoc#s ou &ill invest in(
(t!s best to pursue the Fe&erse *cale *trategy with ten stoc"s or more i# you can, with
#i&e stoc"s being the absolute minimum number to achie&e ade2uate di&ersi#ication.
Because o# the practical constraint o# trying to mimimi/e commissions as a percent o#
the &alue o# your port#olio, the goal o# owning ten or more stoc"s is probably only
realistic with accounts o# K+,,,,, or more. (# your account is small 8between K5,,,,
and K+,,,,,9 you may ha&e to settle #or #i&e to nine issues and get a &ery ine5pensi&e
discount bro"er in order to "eep commission e5penses manageable.
3!ount of *apital 3vaila'le -eco!!ended Nu!'er of Stoc#s
K5,,,,1K1,,,,, %i&e
K1,,,,,1K15,,,, *i5 or *e&en
K15,,,,1K+,,,,, *e&en to Nine
K+,,,,, T Bp. )en or 'ore
(# you are ade2uately capitali/ed, though, ten issues represents an acceptable le&el o#
di&ersi#ication and is a manageable number o# issues to trac" daily. )his number is not
critical, though. (# you #eel you ha&e time, and a #airly large amount o# ris" capital
8say, more than K1,,,,,,9 you can ha&e #i#teen or twenty stoc"s in your port#olio. (
would not try this method with less than #i&e issues, because the &olatility in your
account will li"ely be emotionally ta5ing. <ne thing to "eep in mind is that the more
stoc"s you ha&e, the better your chances o# #inding an e5ceptionally good1per#orming
stoc".
To deter!ine the dollar a!ount ou &ill invest in each position, ta"e the number
o# dollars in your trading account and multiply by H5I. )hen, ta"e this results and
di&ide by the number o# issues you will be trading in your account. )his will yield the
dollar amount you will initially in&est in each issue.
.s an e5ample, let!s say you ha&e K15,,,, in your trading account. 'ultiplying
K15,,,, by H5I yields K9,A5,. K9,A5, represents the total amount that you !ill invest
to begin !ith. Now, i# we tried to split K9,A5, up into ten stoc"s, we would only be
in&esting K9A5 per stoc". *ince we would ha&e a hard time "eeping our commissions
down to the 1I to +I o# principal le&el on a K9A5 trade 8#or instance, i# our
commission was K+5 per trade we!d be spending K+5>K9A5 or nearly + 1>+I9, we opt
to trade si5 issues instead o# ten, a#ter re#erring to the chart abo&e. K9,A5, di&ided by
H yields about K1,H+5 per stoc". )his amount, K1,H+5, is the amount we will in&est in
each o# our si5 issues.
)he reason we are using only H5I o# our capital at #irst is that we want to abide by
the margin trading rule we de&eloped in Chapter ;0
To control our use of leverage% 6e &ill choose our initial position siKe in a stoc#
so that &e &ill al&as have enough cash on hand to !a#e our inital purchase and
half of our second purchase &ithout 'orro&ing anthing(
Bsing no more than H5I o# our capital #or our initial positions in our si5 stoc"s
ensures that we are in compliance with this part o# our trading strategy.
Step 8, Deter!ine &hich issues ou &ill invest in
Oeep it simple. Bse the criteria #or stoc"1pic"ing presented in Chapter L, which is
essentially0
1. Festrict your stoc" pic"ing to the 5+1wee" highs list 8better yet, use stoc"s
ma"ing new all1time highs in price9.
+. ?eed out de#ensi&e issues such as precious metals, oils, utility companies,
closed1end mutual #unds and #ood>grocery issues.
J. ?eed out stoc"s selling #or less than K15>share.
L. 7ean toward the smaller1capitali/ation stoc"s remaining on your list that meet
criteria 1 through J abo&e.
5. )o maintain ade2uate di&ersi#ication, select stoc"s #rom se&eral di##erent
industries.
H. Chec" out the chart o# the stoc" #or clues on goodness o# trend, &olatility, and
whether or not a buyout situation is responsible #or its being on the 5+1wee"
highs list.
-ou can be assured that these stoc"s are high1potential and they will ha&e a e5cellent
chance o# leading the mar"et in a bullish en&ironment. (# we use this criteria to choose
the si5 stoc"s we will buy and #ollow in our e5ample, our chances o# ha&ing some
really big winners will be increased dramatically o&er @ust about any other method.
?hyC Because we are getting our recommendations directly #rom the mar"et, where
in&estors are &oting with their dollars. Not #rom a bro"er who may not e&en ha&e his
own money in&ested in the stoc" he!s selling to you. Femember, stoc" bro"ers are
success#ul because they "now how to get people to buy stoc"s, not necessarily
because they "now how to ma"e money.
)o continue our e5ample, a#ter applying the criteria abo&e, let!s say we end up
choosing the #ollowing si5 stoc"s 8these are hypothetical e5amples only90
Stoc# Purchase Price
Qeneca K5H J>L
3ummingbird K5, J>L
CBC (nternational KJ1 1>;
)i##any KLH J>L
%irst Eata KH9 1>+
(mperial Bcp K+L
.s we determined earlier, we will purchase K1,H+5 worth o# each stoc".
Step >, "u our intial positions in each stoc#
Now that you ha&e chosen which stoc"s to build positions in, calculate based on the
most recent closing price o# each stoc" how many shares you will initially buy in each
issue. Eon!t worry that they are not in e&en 1,,1lot 2uantities, which they almost
certainly will not be. (nstead concentrate on buying an e2ual dollar amount in each
issue purchased. %or e5ample, we pre&iously calculated an initial position o# K1,H+5
#or each o# our si5 issues. )here#ore, i# one o# the stoc"s on our buy list is Qeneca and
it is selling #or K5H J>L, we would place an order to buy +9 shares 8K1,H+5 di&ided by
5H J>L, rounded up to the ne5t e&en1number share 2uantity9 at the mar"et price. )his
calculation would be repeated #or each o# the other #i&e stoc"s you are buying using
their speci#ic closing prices #rom the pre&ious day.
3ere!s a help#ul hint0 )ry to place the orders well be#ore the 90J, .' mar"et opening
so that you will recei&e the day!s opening price. <dd lot trades 8less than 1,, shares9
are usually upcharged some amount #or a handling charge, but this is o#ten wai&ed i#
the order is entered be#ore the mar"et opens. .lso, you!ll be more li"ely to get a price
closer to the pre&ious day!s close by getting in when the mar"et #irst opens. .s
always, use mar"et orders and not limit orders.
<nce your orders are #illed, be sure to ma"e a note o# the price per share you actually
paid #or each position.
Step A, *onstruct our predeter!ined entr and e0it plan !atri0(
Now that we ha&e ta"en our intial positions, all that is necessary is to #inish #illing out
the Fe&erse *cale *trategy Eecision Chart, as shown in the e5ample below. (n this
chart, we de#ine the #irst #ew Eecision =oints 8more can be added later, #or those
stoc"s which ma"e he#ty ad&ances9 #or each stoc" based on your initial entry point
into that stoc". )he number o# shares we ac2uire at each decision point can be
penciled in as these ac2uisitions occur, as well as the total number o# shares owned.
%or each stoc" indi&idually, the sell point is always one le&el 8JJI9 below its highest
Eecision =oint reached, as co&ered in Chapter A. <nce we ha&e constructed this
wor"sheet we can carry it with us and pencil in ac2uisitions as our decision points are
reached. )hen we will "now which Eecision =oints ha&e been reached, and hence we
will also "now @ust by loo"ing at the chart what our current sell point is #or each
stoc", as well as the ne5t buy point. (n "eeping with our e5ample, here is how the
chart would be #illed out #or the si5 stoc"s we pic"ed out #or our e5ample port#olio,
once we!&e ta"en our initial positions0
-everse Scale Strateg Decision *hart
*o!pan Neneca
*o!pan =u!!ing'ird
*ymbol QDN *ymbol 3B'C%
)arget
=rice>share
*hares
=urchased
)otal *hares
<wned
)arget
=rice>share
*hares
=urchased
)otal *hares
<wned
(nitial sell point JA A>; 8n>a9 8n>a9 (nitial sell point JJ A>; 8n>a9 8n>a9
(nital entry point 5H J>L +9 +9 (nital entry point 5, J>L J+ J+
Eecision point 1 ;5 1>; Eecision point 1 AH 1>;
Eecision point + 1+A J>L Eecision point + 11L 1>L
Eecision point J 191 1>+ Eecision point J 1A1 1>L
*o!pan *U* Int4l *o!pan Tiffan
*ymbol CB *ymbol )(%
)arget
=rice>share
*hares
=urchased
)otal *hares
<wned
)arget
=rice>share
*hares
=urchased
)otal *hares
<wned
(nitial sell point +L J>L 8n>a9 8n>a9 (nitial sell point J1 1>; 8n>a9 8n>a9
(nital entry point JA 1>; LL LL (nital entry point LH J>L J5 J5
Eecision point 1 55 J>L Eecision point 1 A, 1>;
Eecision point + ;J 1>+ Eecision point + 1,5 1>L
Eecision point J 1+5 1>L Eecision point J 15A J>L
*o!pan First Data *o!pan I!perial "an#corp
*ymbol %EC *ymbol (B.N
)arget
=rice>share
*hares
=urchased
)otal *hares
<wned
)arget
=rice>share
*hares
=urchased
)otal *hares
<wned
(nitial sell point LH J>; 8n>a9 8n>a9 (nitial sell point 1H 8n>a9 8n>a9
(nital entry point H9 1>+ +J +J (nital entry point +L H; H;
Eecision point 1 1,L 1>L Eecision point 1 JH
Eecision point + 15H J>; Eecision point + 5L
Eecision point J +JL 5>; Eecision point J ;1
Step B, Monitor our positions
.#ter we ha&e ta"en our positions, it!s pretty much a game o# waiting to see what
happens ne5t. ?e must chec" per#ormance o# all the issues in our port#olio a#ter the
close o# every trading day in order to see i# you need to add to any o# your positions or
sell any o# them. (# you can, chec" twice a day, but this is not a re2uirement #or
success. D&en though our decision points are placed #ar apart, under certain mar"et
conditions large mo&es can happen in a single day, so it!s critical to "eep on top o#
de&elopments 1 and so the necessity o# chec"ing in e&ery day. )he way to accomplish
this is by using a discount bro"er that o##ers a touch1tone 2uoting and order entry
ser&ice, which should bring the time necessary to chec" up on things down to about
about two or three minutes a day. ?ho "nows, we may become a $7ess )han %i&e
'inute$ (n&estor (# your discount bro"er does not o##er this ser&ice, #ind one who
does and sa&e yoursel# a lot o# time. )hese ser&ices allow you to set up a list o# stoc"s
whose closing prices will be automatically reported to you at the end o# the day when
you call. ?ith this type o# ser&ice, monitoring your stoc"s can easily be accomplished
by e&en the busiest persons. ( li"e the touch1tone 2uote retrie&al ser&ices because e&en
i# ( am on a business trip, ( can chec" my in&estments at 1,=' in my hotel room, and
( don!t need a computer to do it. (# a buy or sell point has been reached, ( can enter the
necessary orders right there on the telephone, without tal"ing to anyone or ha&ing to
wait until the bro"er gets in in the morning.
( strongly recommend that when you ha&e built a #airly large si/e position in a
success#ul stoc", use good1til1cancelled stop1loss orders, which were described in
Chapter ;. ( use these whene&er ( ha&e made two or more purchases in a stoc",
because at that point ( ha&e enough in&ested in the stoc" to warrant protecting mysel#
with such a mechanism. 3owe&er, there is no reason you can!t choose to use a stop1
loss order on e&ery position in your account. )his helps to a&oid the situation where
you call in at the end o# the day only to #ind that your stoc" has #allen to substantially
below your Eecision =oint #or selling. *top orders gi&e you peace o# mind #or "eeping
your mind on your @ob during the wor" day, without the distraction o# needing to
watch your in&estments. <ne necessary discipline #or the use o# good1till1cancelled
orders o# any "ind is that you must "eep meticulous records o# your orders, so that
you "now e5actly which orders you ha&e entered and which ones you ha&e cancelled.
<therwise, you may end up e5ecuting orders which you did not intend to e5ecute.
Step C, 2no& and 3ppl the Trading -ules
.s you monitor the stoc"s in your port#olio, e&entually one or more o# the stoc"s will
reach the ne5t decision point abo&e where you got in, or will decline below the
decision point pre&iously reached. (n either case, action on your part is re2uired. )hus
it is good to re&iew and "now the trading rules well so that you can apply them
decisi&ely.
Trading rule /+, 6henever a stoc# advances so that it touches a
Decision Point not previousl achieved% add a dollar a!ount
to our position in that stoc# appro0i!atel eFual to the
dollar a!ount originall 'ought(
(n our e5ample, we bought K1,H+5 worth o# Qeneca at K5H J>L, so i# Qeneca rises to
touch K;5 1>;, we will call the bro"er and add 19 shares 8K1,H+5 di&ided by K;5 1>;9
to our position. ?e would update the Qeneca portion o# our decision chart as #ollows
in the highlighted area0
*o!pan Neneca
*ymbol QDN
)arget
=rice>share
*hares
=urchased
)otal *hares
<wned
(nitial sell point JA A>; 8n>a9 8n>a9
(nital entry point 5H J>L +9 +9
Eecision point 1 ;5 1>; +M 8C
Eecision point + 1+A J>L
Eecision point J 191 1>+
No other stoc"s! decision charts are a##ected by this change. ?e are ma"ing decisions
#or each stoc" separately, based on the per#ormance o# that stock alone. Now that the
chart has been updated, we can see all the in#ormation we need to "now0 ?e can see
that the Eecision =oint o# K;5 1>; has been reached, that we now own L; shares, and
that in order #or us to sell our entire position Qeneca would ha&e to decline to K5H J>L
or lower. )his scenario is co&ered in the ne5t trading rule.
3ad Qeneca risen to K191 1>+ or higher o&er the ne5t se&eral months or years, we
would ha&e added positions at K1+A J>L and at K191 1>+, #or a total position o# about
H; shares. .t that point, the new sell stop #or all H; shares would be at K1+A J>L.
Trading rule /1, 6henever a stoc# declines to touch the previous
Decision Point% sell the entire position(
(#, instead o# ad&ancing, Qeneca had declined instead o# ad&ancing and had dropped
as low as KJA A>; a#ter we too" our intial position, we would ha&e to sell out the intial
position 8+9 shares9 #or a loss. <b&iously, we ne&er got the signal to add to the
position because we are assuming here that it reached KJA A>; be#ore it got the
opportunity to hit K;5 1>;.
<nce one o# the sell points is reached, do not hesitate. *ell. 7i"ewise, do not hesitate
to buy whene&er a new decision point is reached during an uptrend. *ometimes the
best stoc"s rise &ery 2uic"ly, so to act decisi&ely is all1important whether buying or
selling. 3e who hesitates is lost. (# you belie&e in your plan, there is no reason to be
hesitant.
Trading -ule /5, .nce ou have sold a stoc#% re$co!!it the proceeds
of that sale to a different stoc# ;or stoc#s< than the one ou4ve
)ust sold( To pic# this ne& issue% use the sa!e criteria used in
choosing our original list of stoc#s(
.s we!&e re&iewed, some people, once they!&e ta"en a loss on a stoc", ta"e it
personally and they "eep trying to $get e&en$ with the stoc" by loo"ing #or an
opportunity to buy it again. Eon!t #all into this trap, because i# you do you are acting
li"e the Dgo1Eri&en (n&estor described earlier in the boo". %orget the loss and the
stoc". (# a stoc" has #allen #ar enough #rom its highs that it!s now down at least JJI
#rom the pea" 8the percentage di##erence between e&ery Eecision =oint and its ne5t
lower Eecision =oint9, then it may be entering a downtrend, and you don!t want it.
)a"e what!s le#t and buy a di##erent stoc", one now ma"ing new highs. -our money
will be better employed and your account won!t end up loo"ing li"e the dog pound.
. )rading Fule #or Bear 'ar"et (nsurance
(n any trading system, the most important thing is to preser&e your capital. Capital
preser&ation is all1important because i# you seriously deplete your trading capital, it
becomes &ery di##icult to get bac" e&en to where you started out, much less ma"e a
pro#it since you are then wor"ing with a smaller amount o# capital.
)he two main sources o# capital depletion are #rom !hipsa! losses 8rapid1#ire in and
out trading, which almost always results in lots o# small losses and large commission
e5penses9 and #rom #ailing to cut losses on poor in&estments. )he Fe&erse *cale
*trategy already has many capital1preser&ing mechanisms built into it. .mong these
are di&ersi#ication among many securities, our loss1cutting decision rules, and the #act
that we do not add to positions until they are showing us a good pro#it. .lso, our
decision points are set #ar enough apart 85,I9 so that whipsaw losses are e5tremely
unli"ely, especially when applied to stoc"s selling #or more than K15 per share.
3owe&er, #or good measure we need to address the worst1case scenario in order to
short1circuit the prospect o# se&eral losses coming in 2uic" succession. )hese types o#
e&ents tend to occur during bear mar"ets. *ince bear mar"ets are a reality and are
unpredictable, we need to add the #ollowing trading rule to ensure that we can sur&i&e
those ine&itable times when the mar"et goes down #or an e5tended period, pulling
almost all stoc"s down with it0
Trading -ule /8, 6hen ou4ve 'een forced out of a stoc# position ;'
appling trading -ule /1<% do not reinvest the proceeds of that
sale into another stoc# until the Standard and Poor4s >HH
stoc# inde0 ;co!!onl referred to as the SOP >HH< !a#es a
ne& >1$&ee# high(
)he purpose o# this trading rule is to #orce us to wait until the mar"et as a whole is
showing signs o# positi&e momentum be#ore re1committing #unds. (n other words, we
do not want to get into a situation where we are buying a new stoc", selling it #or a
loss, using the proceeds to buy another new stoc" and then being #orced to sell it #or a
loss, and so on in 2uic" succession. )his can happen during &ery se&ere mar"et
downturns. )hat!s why we want to wait until the mar"et has shown some strength
be#ore re1committing #unds to a new position. -our win to loss ratio will be much
better i# you obser&e this rule.
*ince the mar"et 8as measured by the *T= 5,, inde59 is commonly ma"ing 5+1wee"
highs, most o# the time you will not ha&e to wait too terribly long to rein&est proceeds
o# a sale. (# )rading Fule GL does pre&ent you #rom rein&esting #or a long period o#
time, there is a &ery good reason #or it, and you will no doubt be glad that you were
patient in waiting #or a new 5+1wee" high #or the *T= 5,, be#ore recommitting
#unds.
<# course, it goes without saying that any stoc" you would pic" #or rein&estment
needs to be chosen using the criteria #rom Chapter L.
Step M,Periodic 3d)ust!ents
.s your account &alue grows, you will ha&e to periodically ad@ust the si/e o# the
initial positions you are ta"ing in a stoc". %or instance, i# our K15,,,, account e2uity
grew to K+5,,,, and we sold one or two stoc"s, we probably wouldn!t want to ta"e
new initial positions to replace them that were as small as we originally too". (nstead
o# ta"ing K1,H+5 initial positions, we might decide to ta"e positions that were
proportionally in line with our new account e2uity balance, say K+,A,, in this case.
?ith any success#ul in&estment plan, these types o# ad@ustments need to be made as
the amount o# money you ha&e to in&est grows.
)he other thing you could do in such a case is to stic" with the K1,H+5 initial position
si/e and simply wor" with a larger number o# stoc"s. %or di&ersi#ication purposes,
this is the pre#erred route to ta"e, at least until you reach the goal o# ha&ing ten stoc"s.
)he main thing to beware o# is that you don4t over$co!!it ourself. ?hen you sell a
stoc", don4t invest !ore in ne& stoc#s than ou received in proceeds fro! the one
ou4ve sold. (# you adhere to this rule, you will ne&er o&ercommit yoursel#.
*hapter +H, Getting Started
(# you are a beginner in the world o# in&esting, it is natural to be a bit apprehensi&e
about getting started in&esting in stoc"s. D&en though you now ha&e a good strategy,
you may want to see this strategy wor" be#ore committing a ma@or amount o# #unds to
it. .#ter all, bear mar"ets are an unpredictable reality and it could so happen that you
will begin trading at @ust the wrong time. %or those who are #ear#ul o# this and may
wish to begin by ta"ing a &ery conser&ati&e stance in the mar"et, it is a #ine thing to
do especially i# you ha&e limited e5perience in in&esting. You can never err '
giving ourself ti!e to learn so!ething 'efore plunging headlong into it. (t!s a
#airly sa#e bet that i# you don!t #eel li"e you "now what you are doing, then you are
probably right and would be well ad&ised to start on the conser&ati&e end o# the scale.
<nce you are com#ortable with these concepts and your ability, you can start getting
more aggressi&e. Bntil then, the #ollowing chapter addresses some ideas #or ad@usting
our system in order to accomplish a more care#ul approach when you are @ust starting
out.
Starting s!all(
<ne o# the simplest ways to reduce your ris" as a beginner is to implement the
Fe&erse *cale *trategy with @ust 5,I o# your capital. *o i# you ha&e K+,,,,,
a&ailable #or stoc" in&esting, you may want to @ust pretend you ha&e K1,,,,,, pic"
#i&e stoc"s using the procedure in the te5t, then in&est @ust K1,5,, in each one o#
them. )his will lea&e you with K1+,5,, in cash to begin with which will earn interest
#or you as you are learning. *hould you ha&e the mis#ortune o# entering the mar"et as
a bear mar"et is beginning, your interest earnings will help to o##set any temporary
losses or worries. %rom this cash1rich position, you can learn while remaining
com#ortable that you won!t lose your entire sta"e.
Ti!e$'ased diversification
.nother way o# reducing ris" is by gradually implementing the Fe&erse *cale
*trategy one stoc" at a time. *uppose you ha&e K+,,,,, in your account and your
long1term goal is to ha&e your money spread out o&er se&en stoc"s. *o, in this case
you employ the #ormula #rom the last chapter and multiply your K+,,,,, times H5I
and then di&ide that number by se&en. )his means that your initial position in each o#
the se&en stoc"s would be about K1,;;5. )here is no reason you ha&e to rush out and
buy all se&en stoc"s at the same time. (nstead i# you are a little ner&ous, add one
position each month. )his will mitigate the possibility o# starting your in&estment
program at the beginning o# a bear mar"et and ma"e it unli"ely that you will ha&e a
bad e5perience right out o# the gate. *o, the #irst month o# your program you would
only ha&e one stoc", with K1,;;5 total in&ested and K1;,115 in cash. )he ne5t month,
you would at that time choose another stoc" that is ma"ing new highs in price and
meets our other criteria, lea&ing you with KJ,AA, in&ested in two stoc"s, and
appro5imately K1H,+J, in cash, and so on until you ha&e your se&en stoc"s. *ince we
manage each stoc" separately in this *trategy, i# your #irst stoc" does well and hits its
ne5t Eecision =oint be#ore month two, you may actually end up ha&ing KJ,AA,
in&ested in the #irst stoc" before ha&ing purchased the second issue. )his will be
relati&ely rare, but i# it happens it is cause #or celebration, not panic, and you should
implement your strategy @ust as you would i# you were starting with all se&en issues
right o## the bat. )hat is, do not let the success o# the #irst purchase hinder you #rom
adding your second issue in month two, e&en though you may already ha&e KJ,AA,
in&ested in the #irst one. (n either case, you will ha&e your se&en positions in hand
when month se&en #inally arri&es.
Needless to say, i# you want to be &ery care#ul, you could add one position e&ery two
or three months, instead o# one e&ery month. (t all depends on what ma"es you #eel
most com#ortable gi&en your own personal le&el o# ris" tolerance.
Mar#et Mo!entu!
.n additional line o# de#ense is to wait until the broader mar"et is showing signs o#
strength be#ore beginning. Bull mar"ets usually do not end o&ernight, so i# you wait
until the *T= 5,, ma"es a new 5+1wee" high be#ore you select and purchase your
stoc"s #or the #irst time, you will ha&e a good chance o# success as you start. (n the
last Chapter, )rading Fule GL was added to "eep us #rom re1committing #unds #rom a
sale until the *T= 5,, ma"es a new 5+1wee" high. )here is no reason that you can!t
apply the same principle in order to determine a reasonable time in which to start
your in&estment program. (n #act, ( thin" that this is a &ery good idea.
-e!e!'er the "asics
.s you enter the world o# stoc" in&esting using the Fe&erse *cale *trategy, ( wish you
the best o# results. ( could wish you luc", but luc" has nothing to do with in&esting.
<nce you start applying the principles in this boo", you will #ind that your luc" will
impro&e greatly.
(# you are e&er con#used about what to do, re1read the sections on *toc" 'ar"et
'yths 8Chapter 19 and (n&estor 'ista"es 8Chapter +9. .&oid the mista"es and the
myths and you will #ind that you can #igure out on your own what to do. )he best
policy is to understand the principles and trading rules o# the Fe&erse *cale *trategy,
not to memori/e them. (# you let this be your guide, your results will be much better
than they would be otherwise.