Seeking a better return than they can get elsewhere, many Canadians are choosing stocks for their RRSPs. Whatever stock-picking system is being used in the search for winners, here are some smart rules that should increase the chances that this do-it-yourself approach will pay off.
1. Devote enough time to it. To be successful, not only will you have to spend time researching the stocks to buy, you will also have to spend several hours each week monitoring company announcements, stock prices and industry developments. Investors often ask, “Which would be a good stock to put in my portfolio for the long-term?” They think they can buy a stock and then forget about it. This kind of thinking leads to failure. If you are unable to devote the necessary time and mental rigour, you are probably better off putting your money in a mutual fund where a manager picks stocks on your behalf.
2. Use a disciplined approach. The key will be to let your winners run and to quickly get rid of your losers before they do too much damage to your portfolio. For this, you will have to adopt a system and stick to it, no matter how uncomfortable it may be to do so.
3. Don’t over-diversify. Keep things manageable. A portfolio of between 10 and 15 stocks is optimum for someone seeking superior returns. Keep only your best ideas in the portfolio and sell the weakest-looking stock every time you add a potential star performer. If you have a lot more stocks in your portfolio, you will have trouble keeping up and making the right decisions. Wide diversification leads to returns similar to the market overall. If that is what you want, it would be better then to put your money in an index fund and free-up your time for leisure or to make more money in your chosen career.
4. Never add to a losing position. If you buy a stock and then it starts going down, you should try to understand what is going on and seek to preserve capital rather than committing more capital. You could be wrong about the stock’s potential. There may be things happening behind the scene that are not evident. Don’t buy more to average down. If you decide to keep the stock, look to add only when it is higher than when you first bought it, since that would be the proof that your original idea for buying it was correct.
5. Use stop-losses. This would mean setting a rule that if a stock declines by, say, 10 per cent, you will sell it to preserve capital. If you have owned a stock for a long time and you have significant gains, using a stop-loss is key to preserving those gains. If you have just bought a stock, this is the best way to ensure that you can correct the mistake and have capital to try again. A stop-loss won’t always look like the best thing after the fact. Some stocks go down temporarily and then quickly recover in a ‘whip-saw’ action. But while the stop-loss won’t work well in such cases, it will for other stocks, even blue-chips, that keep sliding. Loblaw Cos. Ltd. was a strong performer for many years but in the past year its stock has fallen from over $75 to under $55 per share recently. If you had employed a rule to sell anytime the stock drops 10-per-cent, you would have sold at around $67 per share. In some cases, you may have to set the stop-loss trigger at wider than 10 per cent, such as for some commodity related stocks like junior gold explorers where the stock-price swings can be far greater and still be on a definite up-trend.
6. Listen to the market. Be aware of the broad trends. Market professionals know that buying into a good company that is in a good-performing sector (showing relative strength) is usually more profitable than buying into a good company that is in a sector that is losing ground. Put another way, there is a better chance of achieving stock-price appreciation for an oil and gas explorer with good prospects when oil and gas prices are rising than when they are falling.
Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.
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©2006 Wayne Cheveldayoff