People always want to know how they can improve their profits in the stock market. And I keep telling them it’s simple. There are three easy things you can do right now to boost your returns. It’s so easy.
It really is.
Here are the 3 steps you can take:
1. Only buy the best ETFs – ones that are already going up
2. Avoid high fees
3. Keep a risk balanced portfolio.
That’s it. Those are pretty easy things you can implement immediately. If you can do this, you can make money in the stock market.
The rules for successful stock market trading aren’t hard. But despite that, the average 401k investor in the stock market gets creamed by the stock market.
A formal study from the stuffy Journal of Pension Benefits documents the horrible performance of most investors. Here’s what it says:
"The elephant in the room that no one seems to want to discuss is that individual investors as a whole do a poor job managing their own investments…It is, by and large, a recipe for disaster…It has long been known that individual investors don’t typically fare well in their efforts at do-it-yourself investing."
This notion has been validated by numerous studies, including one by Dalbar, Inc., which revealed the staggering margin by which the average individual investor trails the returns of the broader market. Here’s what Dalbar, Inc. says:
"Wow. Nobody wants to talk about it, it’s that bad. When the stock market only makes 8% per year, giving away 6% eats up almost all of the possible returns. In fact, it’s possible you’ll get a better return from Social Security than you will from the stock market."
Fortunately, there is help.
Improving Your Returns with True Diversification
There is more to making money than just blindly hopping on the trends.
If you want to really make money, you need to take active control of your investing.You can’t just sit back and gripe about your lousy returns when you’re not doing anything to prevent loss.The best way to improve the performance of any trading strategy is to balance the risk taken on each trade.
Diversification works wonders for increasing returns. But it only works when you actually diversify.
Most people do not get similar exposure to the risk of their investments. They dramatically over-invest in some of their portfolio, and under-invest in others. It’s like only watering ½ of your garden but expecting it all to grow.
To get great returns, you need to give each and every investment a fighting chance to make money for your portfolio. Each investment needs to be able to provide meaningful returns for you to make real money.
Many people split their portfolio 50-50 or 60-40 between stocks and bonds. This doesn’t work. It ends up being only slightly better than burning $100 bills in a fire. Why? Stocks are 3-4 times more volatile than bonds. All of the returns and risk are due to what happens to the stocks in the portfolio.
The only way bonds will have equal impact on the portfolio is for the allocation to be 75% bonds, 25% stocks – or even higher.
You can balance the dollar amount allocated to an ETF selection by the risk taken by each ETF. You can do this in your other accounts also.
You can take into account how much risk each ETF has, and then adjust the amount of shares to trade. That way you know you get equal exposure to each of your investments. This came in extremely helpful this month for me because the month allocated extra dollars to real estate and preferred stocks,which have outperformed the S&P 500. That’s how true diversification can help you also.
As a result, your system could be up about.5%, while the S&P 500 is down nearly a full percent. Instead of under-performing the stock market by 6% a year, your system can outperform the stock market, in this case by nearly 8% per year.
When you create a system to allocate your funds, your system should tell you exactly how many shares of each ETF to buy so you’re not under- or over-investing. Risk balancing works great for really pushing returns upwards. If you want to know the steps – and are a real math geek – here you go:
1. Find ATR: Find the Average True Range (ATR) for each of your Stocks/ETFs
2. Find Volatility: Divide the ATR by the Price of the Stock/ETF
3. Invert Volatility: Take 1/(Step 2) for every stock Find Total Vol: Total up Step 3 for your entire portfolio
4. Find Percent Allocation: Divide Step 3 by the total given Step 4
Step 5 will give you the percentage of your account that you should allocate to that investment. It’s a bit complicated, but you can do it. An easier way would be to have someone else do it for you. Either way, you can outperform the S&P and give your accounts the boost you want.
Copyright (c) 2012 Trend Following 101
