Document your investment strategy

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    Document Your Investment Strategy

    By David Edwards
    Special to
    06/12/2002 07:45 AM EDT

    In dark times such as now, when no investment strategy seems to work reliably, the difference between veterans and novices is that veterans are keenly aware of their underlying investment strategy and have the discipline to stick to that strategy. Novice investors tend to deviate randomly from their primary strategy, and that often makes their situation worse.

    Investors can better understand the guiding parameters of their own investment strategy by writing them down in a worksheet such as the one I've provided below. An investor who shorts stocks can use the same worksheet to document a short-selling strategy. Parameters on the worksheet are as follows:

    The guiding principle of your strategy should boil down to a single sentence. For example, "Buy stocks that can grow earnings twice as fast as the S&P 500 for at least five years." The more complicated your philosophy, the less likely you'll be able to implement it effectively. The philosophy can be guided by quantitative, fundamental or technical parameters.

    Certain strategies work differently in different parts of the stock market. You should specify the universe of stocks you'll consider for your strategy -- for example, U.S. large-cap, European small-cap, health care stocks or all capitalizations.

    Quantitative Criteria
    Many investors use screens based on quantitative factors, which could be stock ratios such as price-to-earnings ratios, earning growth rates or price-to-sales ratios; or accounting ratios like the debt-to-equity ratio, operating margin or return on equity. Use of these screens will winnow out most stocks in your selected universe, and that will give you fewer companies to research.

    Qualitative Criteria
    Not every aspect of a company can be defined in numeric terms, so qualitative criteria can be applied against the remaining candidates from your quantitative screens. Examples include "Buy companies with defendable strategic niches (e.g., Microsoft, with its No. 1 position in desktop operating systems)," or "Sell companies with questionable accounting (e.g., Tyco)."

    Holding Period
    The holding period could be five minutes if you're primarily a daytrader, or five years or more if you consider yourself to be a long-term investor. Knowing your time frame might keep you from converting a trade into an investment if a short-term position goes against you, or keep you out of a fad stock with only short-term potential if you know that your holding period is five years.

    Few or many companies, narrow or broad sector diversification, large-, mid- and/or small-caps -- you have many choices here. I've known investment managers who've had highly concentrated, single-sector portfolios, and managers who ran portfolios so broadly diversified they should have been labeled index funds. The decisions you make on diversification increase or decrease your potential returns, and also increase or decrease the amount of risk in the portfolio.

    Sell/Close Out Strategy
    The second part of establishing a position, long or short, is determining under what conditions you would close out the position. It might be a mechanical rule (e.g., close out a position if a 10% loss is triggered), a technical rule (e.g., close a long position if the stock price falls below the 50- and 200-day moving average), a quantitative rule (e.g., sell a company if the ROE falls below the industry group average), a qualitative rule (e.g., sell any company whose accounting is under investigation) or even part of your diversification strategy (e.g., reduce by half any position which exceeds 10% of the portfolio). Writing down your sell/close out strategy helps you actually follow through to capture profits and minimize losses.


    About a year ago, I recommended keeping a trading log to develop trading rules. If you followed that advice, putting together this investment strategy worksheet should be easy. TSC readers who are also members of the American Association of Individual Investors can get strategy suggestions from a recent article entitled "The Common Traits of Successful Investment Strategies" in the AAII Journal.

    Once you have prepared the outline of your trading strategy, look back over your purchases and sales to see whether you're truly following your own plan. It's possible that you're deviating from what you think your strategy is. It's also possible that you're following more than one strategy. While there's nothing wrong with having multiple strategies, just be sure you have a way of segregating positions for evaluation purposes, and that you prepare a worksheet for each strategy.

    Here's a sample worksheet:

    Name: U.S. Growth Strategy

    Updated: June 10, 2002

    Positions: Long

    Philosophy: Buy companies' stocks that can grow earnings twice as fast as the S&P 500 for at least five years.

    Universe: All U.S. large-cap, mid-cap companies.

    Quantitative criteria: High and expanding operating margins; PE/G ratio 1.5 or less; ROE higher than industry group, sector, S&P 500, etc.

    Qualitative criteria: Focus on companies with strategic niches, No. 1 in market share, valuable brands and no accounting concerns.

    Holding period: Five years on average.

    Diversification: No more than 25% in any one sector (e.g., technology, health care, financial services); no more than 2.5% invested in an initial position; at least 32, preferably 40 stocks in a portfolio.

    Sell/close-out strategy: Sell half of any position that exceeds 10% of the portfolio; rebalance if any sector allocations exceed 25%; sell any company that loses its strategic niche (e.g., 3Com in LAN adapters); sell any company with mounting accounting concerns.

    This is only my view ... read the red stuff.

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