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How to Beat the Stock Market by Following Five Simple Rules

InvestorEducation / Learning to Invest Mar 31, 2011 - 05:43 AM GMT

By: Money_Morning

InvestorEducation

Best Financial Markets Analysis ArticleKeith Fitz-Gerald writes: Most investors operate on some variation of the "set it and forget it strategy."

And that's why - more often than not - they're surprised by the terrible things that happen to their money when the stock market stumbles.


But it doesn't have to be that way.

Studies show you can dramatically boost your performance and potentially beat the stock market by following five simple rules.

Those five rules are:

1.Set goals and monitor your progress.
2.Concentrate your assets.
3.Structure your portfolio and rebalance at least yearly.
4.Use trailing stops to limit risk.
5.Don't chase the train if it's already left the station.

Breaking Down the Fab Five

Rule No. 1: Set Goals and Monitor Your Progress: Most investors have no understanding of where they've been - let alone where they want to be. So start out by figuring out where you want to wind up. Then craft a plan that helps you get there.

For instance, if you really want above-average income, don't waste your time with growth-only choices that pay no dividends. Various studies show that dividends and reinvestment can contribute as much as 97% of total long-term stock-market returns.

Similarly, if data shows that 75% of the world's economic activity now takes place outside U.S. borders, investors who have only 6% of their holdings in international stocks will end up with a substandard portfolio. For decades, we've heard over and over how international investments should comprise 5%, 10% or at most 15% of our portfolio's total value. Any more than that is foolhardy and risky, the pundits tell us.

Yet, best-selling author and famed Wharton Business School Professor Jeremy Siegel believes that such long-held conventional wisdom on international investing should be thrown right out the window. In fact, an allocation of 40% or more may be more appropriate, Siegel says. And that matches my own research.

Rule No. 2: Concentrate Your Assets: Many investors are familiar with the concept of "diversification"- or, at least the form that Wall Street practices. Common wisdom tells you to spread your assets around, reasoning that this will protect you from a single catastrophic loss. But that's actually akin to rearranging the deck chairs on the Titanic. No wonder investing icon Warren Buffett reportedly quipped that "diversification is for people who don't know what they are doing."

Like Buffett, I think it's far more important to concentrate your assets. In doing so, you're investing in a more limited list of things that you can better understand, keep tabs on, and react to. That also suggests that you're investing in the certainty of projected returns, rather than trying to protect your money against things you can't control in the first place.

That's why I advocate investing in globally unstoppable trends with literally trillions of dollars behind them. I'll bet you can probably name most of them with relative ease: Inflation, global commodities and natural resources, the emergence of China and its effect on global earnings, bond bubbles, population growth, and more. My good friend and Money Morning colleague, Larry D. Spears, described eight such trends - and accompanying investments - in a two-part report just this week [Editor's Note: Readers can access Part I or Part II of the aforementioned series by Spears, right from here, free of charge.]

Rule No. 3: Structure Your Portfolio and Rebalance at Least Yearly: Most investors get caught up in one of two extremes. Either they "over-manage" their portfolios, and wind up trying to maneuver through every possible swing, shimmy, and shake the market throws at them - usually with limited success. Or they don't pay any attention whatsoever - and when they finally do examine their statements, they're left to wonder why their 401(k) turned into a 201(k).

To properly structure your assets, consider a simple, proven model - such as the 50-40-10 strategy we recommend here at Money Morning, as well asin our sister publication, The Money Map Report. Because you've got three clearly defined "tiers" to play with, every investment has a place - and a specific role - in your portfolio. [Editor's Note: For a full report on this investing model, please click here. It, too, is available free of charge.]

The 50-40-10 pyramid that represents our investment model is a lot like the "food pyramid" many of us remember as kids.

The stuff on the bottom - the 50% we assign to safety and balance - is the food that tastes like wallpaper paste, but that your mom insisted (and correctly so) "was good for you."

The middle layer - the 40% we put in global income and growth - is the stuff that actually tastes great and is stuff you want more of. The top 10% - the wild "rocket riders" - is the beer and chips, the chocolate mousse, or whatever other delight you can envision.

If you examine your statements and find that one segment - the 50, the 40, or the 10 - has gotten too large, it's a simple, self-reinforcing matter to sell some of your winners and redistribute that money into new choices to bring your money back into balance.

There's another benefit, too. When used properly, a strategy such as the 50-40-10 ensures that you achieve the three goals that are common to all successful investors. In short, you:

•Maintain discipline - in an automated way.
•Generate higher-than-average income.
•And achieve a greater overall stability for your portfolio.

That's not to say that a 50-40-10 portfolio can't come under pressure if the markets do. But we can say that, over time, the comparative stability it creates can help you avoid surprises that clobber most investors and doom them to sub-par returns.

Rule No. 4: Use Trailing Stops to Limit Risk: Think of it as a plumber would. Big losses - like water in your living room from a broken pipe - are expensive and tough to recover from. They can set you back years, which is why it's best not to incur them in the first place.

Instead, do what the world's most successful investors do - focus the majority of your efforts on avoiding losses in the first place. Success here will really make a difference, especially when you consider that most investors have been halved twice in the last decade - once from 2000-2003 and again from 2007-2009.

The simplest way to avoid catastrophic losses is through the use of protective or "trailing" stops.

Trailing stops work in one of two ways. You can set them at a certain percentage or absolute dollar amount below your purchase price when you first buy a stock or other security. And if that stock starts to run, you can "slide" it up, and keep it at a certain percentage below the current price.

In either case, the "stop" establishes a certain price at which you will "exit" the position - automatically and with no questions asked.

For instance, we advocate a 25% trailing stop, which means that if we buy shares in "XYZ Corp.," and XYZ falls 25% from our initial purchase price, we're out - no emotion, and no potential for vacillating with indecision as the loss widens.

Similarly, if we've owned XYZ for years, and it's risen tremendously, we'll move our trailing stop up in lockstep. That way, we'll keep at least some of those profits, should the stock ever fall more than 25% from its successfully higher peaks.

With today's technology, there's simply no excuse for not employing trailing stops as a means of protecting your savings. Almost every broker now offers software or the online capability to easily establish and monitor your investments, including the use of trailing stops.

Rule No. 5: Don't Chase the Train If It's Already Left the Station: Most investors have an uncanny knack for doing exactly the wrong thing at precisely the worst possible moment - meaning they buy or sell at times that inflict the greatest amount of financial damage on themselves. That's why it's well documented that investors sell at market bottoms and buy when things have already run up (and are ready to reverse).

Given human nature, that's completely normal.

But that doesn't mean you can't avoid such emotional pitfalls in your own investing.

That's especially true now, when many investors are trying to make up lost ground by piling in at a time when the U.S. Federal Reserve has its foot on the gas in a well-intentioned but ultimately misguided effort to re-inflate the markets and stimulate our economy.

The way I see it, piling into stocks in a wholesale fashion right now is like running down the platform in an attempt to catch a train that left the station in March 2009 - after the market has gained 95% (as measured by the U.S. Standard & Poor's 500 Index). If you do that, the odds are strong that you'll trip and fall - right off the platform and onto the tracks.

I think it's far b etter to buy your ticket, and then calmly walk for the train that you know is waiting (which closely relates to No. 3 above).

Remember, all investments contain risk. But by following the five simple rules I've just outlined you can go a long way to ensuring a healthier, more profitable portfolio that's capable of generating market-beating returns.

Editor's Note: Keith Fitz-Gerald is a former professional trade advisor and CTA who specializes in global futures trading and hedging.

He's also one of three financial experts who recently helped devise an investment strategy that actually mimics the huge gains being netted by Wall Street's biggest player - Goldman Sachs Group Inc.

This strategy has made Goldman a fortune - $13.39 billion to be exact - and you can find out more about how it works by clicking here.]

Source : http://moneymorning.com/2011/03/30/...

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