The greatest investor whom we know is probably Warren Buffett. He is a master of the art of focus investing, where he understands the economics of a business extremely well, buys a big chunk of it when it goes on sale and makes a huge profit. His guru, Benjamin Graham was more conservative in that respect. As he writes:
In setting up this diversified list he has a choice of two approaches, the DJIA-type of portfolio and the quantitatively tested portfolio. In the first he acquires a true cross-section sample of the leading issues….[shortened]… This could be done, most simply perhaps, by buying the same amounts of all thirty of the issues in the Dow-Jones Industrial Average.”
Adequate but not excessive diversification, minimum of 10 and maximum of 30 issues.
Obviously, when we buy a stock, we buy based on the perceived value being far greater than the current price of the stock or on the fact that it has a lot of momentum.
Beginners cannot be Warren Buffett. Even seasoned investors are rarely like him. So certain principles can help guide the average investor as he begins his foray into the dangerous world of individual stock investment.
What are these principles? They are as follows:
1. The Trailing Stop Principle
We set our trailing stop 25% below the buy price and adjust it up, but never down.
Here’s how it works: If we buy a stock at $50, we’ll automatically set our trailing stop 25% below that price (which is $37.50).
Trailing stops are always adjusted up, never down.
So presuming the stock moves higher, so does our trailing stop. If our $50 stock eventually hits $100, then our trailing stop would be $75 (or 25% of $100). If the stock declines to $75, then we sell it, no matter what.
If the stock moves lower, say to $40, the initial trailing stop of $37.50 stays. If the stock goes down to $37.50, we will sell it, no matter what.
2. The Position Sizing Principle
This ensures that you never have too much invested in any one play. It makes sure you do not put your whole nest egg into one basket.
We never put more than 4% of our investment funds in any single stock investment.
When our 4% maximum single stock investment is combined with our 25% trailing stop, we should never lose more than 1% of the value of our total portfolio.
Let’s say you have $100,000 to invest. The maximum you would put into any one stock would be $4,000. And if you use a 25% trailing stop, the most you could ever lose in that play would be $1,000 (one hundredth of your total portfolio).
Some really experienced investors will buy more when the stock has fallen by 25% and they may reap a jackpot or may go bankrupt. When you follow these principles, it is unlikely that you will lose all your money.
As the master himself says:
Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. -Warren Buffett