In a previous post, we discussed four simple steps to help you create your own investment strategy.
The first step is to select the stock screen you want to follow. The second is to choose how many stocks you will own. The third step is to determine how much you will invest in each stock. Finally, you need to set “buy” and “sell” rules.
Establishing proper buy and sell rules is arguably the most critical step in creating an investment strategy. Let’s say you invest $10,000 in one of our stock screens by equal-weighting $1,000 into each of the top ten stocks on that screen. How do you know when to sell or when to buy more?
Below, we’ll answer those questions and talk about the importance of rebalancing your portfolio.
Buy and Sell Rules
Without a clear set of rules to indicate when to buy and when to sell, investors are bound to let emotions get the best of them. When human emotions drive investment decisions, the returns on a portfolio are always negatively impacted.
Removing emotions from the decision making process allows investors to systematically invest without second-guessing themselves. Following a simple rule-based investment strategy prevents investors from buying high and selling low.
Although following a rule-based system doesn’t guarantee every investment will be profitable, it does ensures that investors don’t consistently make poor choices.
There are three factors which need to be considered when establishing buy and sell rules:
How often will you rebalance your portfolio (buy & sell)?
What metrics does a stock need to meet before being bought?
What metrics does a stock need to meet before being sold?
Rebalancing
The first criteria when establishing buy and sell rules is determining how often you will rebalance your portfolio. Rebalancing is a fancy way of saying buying new stocks and selling existing ones.
It’s important to schedule exactly when you will rebalance your portfolio. It could be once a year, once a month, once every couple of weeks, or once every several days. Whatever you decide, you need to stick with your decision.
Staying on schedule prevents you from trying to time the market and obsessing over the right time to invest. FOMO, or fear of missing out, is a real thing. It’s way too easy to worry about missing opportunities as stocks start going up or are on their way down.
Nobody can know when the market in general or a specific stock will hit a bottom or a top. It’s best to simply set a rebalancing schedule and follow it consistently.
Buy Metrics
Once you’ve established how often you will buy stocks, you need to determine what metrics a stock needs to meet before being bought.
Step #1 when creating your own investment strategy is to select the stock screen you want to follow. Just because a stock qualifies for the specific screen you’re using for your investment strategy, doesn’t mean it should be bought at any given moment.
Most likely there will be several stocks all qualifying for a particular stock screen. To further filter through this list of investment opportunities, a single metric needs to be the deciding factor.
For example, our Net Current Asset Value (NCAV) stock screen shows all stocks whose current assets are greater than total liabilities. The stock screen also calculates the net current asset value of each qualifying stock ([current assets – total liabilities] / total shares).
If investing based on this stock screen, it makes intuitive sense to consistently invest based on the stock with the lowest price to net current asset value. Here are all the buy rules for our net current asset portfolio:
Check for new qualifying stocks every 36 calendar days.
Purchase the qualifying stock with the lowest price / ncav.
Only purchase a stock if its price < its ncav. If the qualifying stock with the lowest price / ncav is already owned, purchase the qualifying stock with the next lowest price / ncav. If no qualifying stocks have a price / ncav ratio < 1 which are not currently owned, the portfolio will wait another 36 days before buying a stock. Sell Metrics Selecting a sell metric is just as critical as picking a buy metric. There’s no sense in holding onto a stock forever. Valuation and fundamentals are constantly changing. What was a good investment at one time is not necessarily a good investment at another time. Sometimes it’s necessary to sell a stock when it becomes overvalued after a price increase. Other times, you need to sell even though a stock is down if the fundamentals of the business have deteriorated. Sell rules can be based on a stock’s valuation, the company’s fundamentals, or the amount of time a stock is owned. If a stock is sold because of its valuation, this will most likely be because a price increase has made the stock overvalued. When selling due to fundamentals, more often than not the stock will be sold because it no longer qualifies for the particular stock screen. Selling based on the amount of time a stock is owned is arbitrary but can still be affective. The Stock Market Blueprint’s Shadow Stock Portfolios use a combination of all three types of sell metrics. For example, here are the sell rules for our NCAV portfolio: Check every 36 calendar days to see if a stock should be sold. Sell when a stock is no longer in the top 10 qualifying stocks on the stock screen. Sell when a stock’s price is greater than its net current asset value. If a stock is no longer in the 10 top because of price appreciation, sell right away. If a stock is no longer in the top 10 because it ceases to qualify for the screen, sell only after owning for at least one year. Relative vs. Absolute You’ll notice that there are two factors for determining when to sell based on valuation; a relative value and an absolute value. Because this Shadow Stock Portfolio holds a maximum of 10 stocks, the relative valuation metric says to sell when a stock is no longer in the top 10. This makes room in the portfolio for more undervalued stocks and hopefully allows a stock to be sold at a gain. The absolute valuation metric says to sell when a stock is priced above its net current asset value. Because the buy rules for this portfolio say to only buy stocks below their net current asset value, selling above the net current asset value tries to ensure the stock is sold at a gain. Waiting at least one year before selling a stock which no longer qualifies for the stock screen prevents a stock from being sold at the bottom of a business cycle. More often than not, a stock will no longer qualify for a stock screen due to deteriorating operating results. Rather than selling right away when this happens, it’s ok to wait a year or so to let both the operational results and stock performance recover. Be Consistent In order to remove subjectivity from investment activities, it’s imperative to establish buy and sell rules. The specifics of each rule are not important. Individual investors need to determine what the best buy and sell rules are based on their temperament. What is important is that, once established, buy and sell rules are consistently followed. This is the only way to ensure human emotions do not interfere with investment returns.