Cut your losses. Basic investing rules in examples (1)

Most investors concentrate on how to get rich fast.

Well, “greed is good” but only if controlled.

What are popular mistakes that we make ? I`m going to describe some with examples in a few posts.

The rule to test today is as follows:

1.Cut your losses and size your transaction properly

Suppose you`ve got $50,000 that you`re going to invest.

What is the maximum acceptable loss ?

I`d say 2 % or, if you are really aggressive, 3 % of your capital.

So it equals $1,000 or $1,500 accordingly.

Now let`s look at some real life example.

I`m not sure whether a current rally in stocks has any fundamentals but it`s only theoretical example and please don`t follow it without your own analysis or professional advice.

It`s your decision !

On Friday we could see a spectacular session for Google( GOOG). Now the price bounced from the bottom on March 10 at $ 413.62.

Now we are above $500 after Friday frantic rally.

Let`s assume you decide to get in at $500 a piece.

How many stocks can you afford ?

If you are a long term investor, you should give up Google around its previous bottom. So, in total you may lose around $100 ( the costs of slippage and commission should be considered).

We started with an assumption that you could afford to lose 2 % or 3 % of your capital. Now it`s easy to calculate.

The correct number of Google shares for the aggressive trader would be 15 and for the traditional one 10.

Why should you do it ?

Always look for the situations where your profit/risk ratio exceeds 2.

Even if you have only 2 in 5 profitable transactions, you still make money !

How come ?

You lose 3 x -$1,000= -$3,000 and make a profit 2 x $2,000 = 4,000.

$4,000-$3,000 = $1,000

You`ve got a total profit of $1,000.

Remember the key to success is to cut your losses !

Any comments are welcome.

Good luck !

Warren Buffett : Buy index funds

Warren Buffett has his followers all over the world. Everybody would like to be rich like him and eagerly wants to listen to his advice.

Our guru often has meetings with business students who ask him many questions.

A few days ago Fortune published an interview with him. Thanks to Get rich slowly blog I started to think about this passage :

What advice would you give to someone who is not a professional investor? Where should they put their money?

Well, if they're not going to be an active investor - and very few should try to do that - then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They're not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don't buy all at one time.

Now, I`m really happy that I agree with him. The best tactics for an average person is just to buy index fund gradually. Cut costs, don`t transfer your money to fund managers for nothing.

The key to success is to buy systematically and not to do it at one time.

I would add one more hint.

Control your loss, and don`t let your capital shrink more than 15 % from the peak.
In that case, I`d convert index fund to some safe one, and next month start repurchasing it again.

For a typical investor it`s more important to focus on increasing positive cash flow by expanding own business, working overtime or devoting her or his time to education rather than just looking for good stock picks.

You`ll achieve more pursuing these ways.

Best stocks to buy ? Frugal life.

The stock market looks very shaky.

I doubt whether you can make a lot of money just buying equity.

The economical data and companies` earnings are poor. They don`t convince me to put more cash in stocks.

On the other hand, there is a lot of help from financial institutions which don`t let the markets go down.

My suggestion is to stay calm and buy index funds very slowly in small portions.

Now it`s more important to increase your positive cash flow.

I think it`s essential to become more frugal.

I`ll give you a simple example from my life.

This morning I went to a corner shop and wanted to buy a big five-litre bottle of mineral water. I wasn`t surprised that the price had gone up but now it`s $2.60. It was around $2 last time. I got so angry that rushed to another shop and found the same bottle at $1.70!
Two bottles made $1.8 of savings in 15 minutes.

No bank would offer such interest rate.

I`m not going to tell you that you should start buying clothes at Salvation Army stores.

No.

The inflation is back in town and it`s more important to be frugal than to look for good picks in stocks.

I`m not an expert on that but I can recommend you many great sites like Wisebread, which provide you with very useful tips.

Why are we doing it ?

Of course, our long-term goal is to become financially independent.

I`m rich. What next ?

Last Thursday I had to drive about 50 miles all over Polish capital city Warsaw. After some time, I noticed I had become a participant in a rat race. All the folks driving were speeding.

- Hurry up ! Hurry up !

Then I realized that all my life might be like this.

You make $1mln, so now it`s time to make two. Then five and so on.

I think this is crazy.

While striving to become financially independent, you should focus on something else, not money itself.

For me to be wealthy means that I don`t have to compete every day, get up early at dawn, work hard and finish my day coming back home late at night too tired even to talk to my family.

I`d rather prefer to spend my time with them and my friends or on pursuing my hobbies.

I like travelling. Should I have $5 mln , it`ll be more important for me to set off to New Zealand instead of fighting to get another $100,000.

I wouldn`t like to die of heart attack at the age of 45 as a rich workaholic.

I know that many people often love their work more than their family ( compare how much time they devote to each one) but my values are different.

Get rich and get a life.

How to get rich ? Create stocks and sell them.

Most people think that you can get rich trading stock or derivatives.

Yes, it`s possible but ask your stockbroker how many people he knows became wealthy in this way.

Many investors spend hours on studying charts and financial reports.

However, the first problem is that most people focus their efforts on what to pick.

Remember! You never get rich just buying.

You make money selling and turning stocks into cash.

So, now when you have a good trading system which includes buy/sell signals, maximum possible drawdown and so on, you may lose your money anyway.

That`s sad but historical data are often useless. I`m not so pessimistic like Nassim Taleb or Howard Malkiel but I`m quite aware of difficulty in beating the market.
Therefore, I decided to purchase some index funds instead of individual stocks and then gradually add some favourite ones.

However, I started to wonder who makes really big bucks in the stock exchange ?

In most cases the folks who didn`t buy any equity in the market.

Isn`t it wonderful to get shares at $1 a piece and sell them at $30, $50 or $100 level ?

Yes, it`s possible.

How to do it ?

Set up your own business, develop it and go public.
You could keep most of your stake or just retire.
I know it`s difficult but your life is supposed to be a constant challenge.



For lazy people like me, there`s another opportunity.

You should start piling up cash to become an angel investor – a person who just invests money in startups.

The problem is that you need at least $ 100,000 in dosh.

This is one of my goals to achieve. The current interest rates for savings in banks are rather discouraging and I needed such a stimulus.

I am aware of risk involved so you should invest up to 20 % of your resources in one business.

Now I could afford only around $2,000 to put at a stake. It`s enough only for a porcelain angel but I`ve got quite a good goal and that`s a lot.

Even if you are in a bad situation, maybe just start with repaying your smallest debt.

Time to act !

To buy gold or not to buy

That is the question.

No, I`m not going to write about "Hamlet".

This year gold has become a hot commodity. All the experts from my plumber to a pizza man advised to invest in gold bars.

It was supposed to be a safe and secure investment.

Of course, if a milkman tells you it`s time to turn to something, you should be sure of some correction movement.

Now, when aurum is 10 % below its peak, I decided to add some to my portfolio.

I`ve got 1/2 oz in a bar and the other 1/2 electronically.

In my opinion, it`s good to diversify your money and keep 10-15 % of it in gold.

I don`t expect big gains but I`d prefer to keep gold bars instead of greenbacks.

If you are not so sure, maybe turn cash into something of more value. Even tinned food is better than dollars right now.

Wall Street pundits encourage people to purchase some stocks, but I`d prefer something more tangible. I don`t trust them for the time being.

I`ll wait for more economic data and bank audits for 2007.

What to do with $100 ?

If you happen to have such a banknote, I think it`s great that you started to think how use it wisely.

You can`t get rich with it for sure.

However, if you ask yourself such a question and search it here on the Internet, maybe it`s time to become a conscious investor ?

I suggest you put it in some index fund and look for another hundred.

That`s a great moment to start.

Just be consistent and add at least a $100 every month.

Let the compound interest do the trick and don`t be discouraged for a few difficult years in the beginning.

Don`t withdraw any funds.

Wait and see.

You should expect real money after 20 years or so.

The prize will be really nice.