life ideas

August 25, 2007

24 Essential lessons for investment success

Filed under: Uncategorized — manoftoday @ 7:21 pm

today by 400 major US institutions. With decades of investing xperience, the author shares the lessons he has learned in a simple question-and-answer ormat, for those who may be first-time investors getting their feet wet, and to improve the prformance of those who may have been playing the market for some time. Learn commonsense
strategies, know when to buy and sell at the right time, and successfully manage your own portfolio. Your journey to financial security and freedom begins here.

Lesson 1. What Every Investor Should Know Going In
• Cut your losses early. It’s like buying fire insurance.
• Always cut your losses at 8% below your purchase price.
• Be persistent. Learning to invest doesn’t happen overnight. It takes time, effort, and
• Always sell your worst performing stock first, not your best-performing stock.
• Do not make emotional decisions. We tend to get attached to our trading decisions and
cannot admit our mistakes.

Lesson 2. Getting Started: There’s no time like the present!
• You don’t have to wait until you have the right job or reach the right age, start now and
gain experience over the years.
• Decide whether you want a full-service broker or a discount firm.
• Research on the stockbroker you’re considering. Where do they get their information?
Are they truly interested in products that are right for you? How much commission do
they get if they are a discount brokerage? Do not go with low commission firms.
• Open a cash account first, and then after a few years’ experience, consider a margin
account that lets you borrow money from your broker.
• Each week you must spend time tracking your investments. Learn to read charts so you get the facts, not opinions.
• As a beginner, avoid volatile investments, such as low-priced stocks, futures, options,
and foreign stocks. Most of the outstanding companies to invest in should be between
$15 to $150 a share.
• It only takes $500 to $1000 to get started. Add to your investment account from savingsfrom your salary.
• If you have $5,000 concentrate on owning up to two high-quality stocks. You should ownno more than six to ten stocks if you are in the $100,000 up range. There’s
no reason to own more than 20 stocks because you simply can’t keep track of all their

Lesson 3. Follow a system rather than your emotions
• Do not get emotionally involved with your stocks. Follow a set of buying and selling rules.
• Do not buy a stock under $15 a share. The best companies that are leaders in their fields simply do not come at $5 or $10 per share.
• Learn from history and study the best stock market winners.
• Always conduct a post-analysis of your stock market trades so you learn from successes and mistakes.
• Of the best-performing stocks of the last 45 years, the average share price before they
went on to double or triple was $28 a share.
This is a historical fact. Cheap stocks involve
far greater risk. You get what you pay for.

Lesson 4. Fundamental analysis or technical analysis?
• A combination of fundamental and technical investment styles is essential to picking
winning stocks.
• Fundamental analysis looks at a company’s earnings, earnings growth, sales, profit
margins, and return on equity.(ithink free cash flow is important)
It narrows down your choices so you are only dealing withquality stocks.
• Technical analysis involves learning to read a stock’s price and volume chart and timing your decisions properly.
Volume, or the number of shares of stock trades per day or per week is a key to
interpreting supply and demand correctly. It is a signal that big institutions may be buyingor selling your stock, which could impact price positively or negatively.
The bestinstitutional investors use both fundamental and technical analysis in their
purchase decisions.
Most of the big winners have Return on Equity ROE (an indicator of financial
performance) of 20% or more.
Most have management ownership or the management
owns a percentage of the stock.

Lesson 5. First among fundamentals: Earnings and Sales
• Microsoft, Home Depot, and Cisco Systems were among the big winners in the 80’s. All
their stocks had enormous gains after posting their sales and earnings figures.
• The ROE’s of Microsoft, Home Depot, and Cisco were 40%, 28%, and 36% respectively.
• Rule of thumb: Look for stocks with annual earnings growth rates of 30% or more and
ROE’s of 17% or higher.
• To make big money, you have to buy the very best companies at the right time. Microsoftwas up 266% in only 30 weeks in 1986, following the 6 months after its IPO
or initialpublic offering. Home Depot was up 912% in less than 1 and ½ years
from 1982, CiscoSystems and Price Co. advanced 2,000% and 750 % respectively since 1990 and 1982.
• Strong sales and earnings are among the most important characteristics of winning
• Buying a stock as it is coming out of a price consolidation area or base is crucial to
making large gains.

Lesson 6. Relative Price Strength: a key technical tool
• Relative price strength is one key technical indicator that shows you what value the
market itself places upon a stock.
• We calculate Relative Price Strength by taking a stock’s price 1 year ago and its price
today, calculating the percent change and then comparing it to all other stocks over the
same time period. The result should be on a scale of 1 to 99 with 99 being the highest.
• If a stock’s relative strength falls, do not buy any more shares. If the stock price drops 8% below your purchase price, sell all of your shares. This way you protect yourself from
large losses.

Lesson 7. Know a stock by the company it keeps
• Always pick stocks from leading industry groups or sectors. The majority of past marketleaders were in the top industry groups and sectors.
• Historically, the drugs, medical, computer, communications, technology, software,
specialty retail, leisure, and entertainment groups have supplied more big winners than
most other groups.
• When Microsoft was an outstanding winner, so was PeopleSoft, Dell was doing well at
the time Compaq was too. Home Depot, Wal-Mart, and The Gap were all major retail
winners. The same time Schering-Plough and Bristol-Meyers Squibb were leading, so
were Warner Lambert and Pfizer. When buying stock, look at the group strength.
• The Industry Group Relative Strength Rating can help you identify stocks in top

Lesson 8. The importance of volume and sponsorship
• Institutional investors account for 75% of the buying of better quality stocks. When you’re selecting stocks, daily or weekly trading volume is how you measure demand.
• Volume is the actual number of shares traded daily and is available in most newspapers.
• Sponsorship is when large institutional investors buy into a stock.
Stocks never go up by accident. There must be large buying, typically from big investorslike mutual funds and pension funds.
• Use Accumulation/Distribution rating to find out if stocks are beingbought or sold by biginstitutional investors. It is available for every stock, every day and the Acc/Dist Ratingtracks the last 13 weeks of trading volume for a stock and tells you whether
it is underaccumulation (institutional buying) or distribution (institutional selling).
Provided on an Ato E rating system, an A or B means stock is being bought, a D or E means stock isbeing sold and should probably be avoided for the time being, while C
indicates a neutralamount of buying and selling.
• It’s important to know what stocks the best mutual funds are buyingand selling.
Sponsorship Rating helps you determine whether your stock has quality institutional

Lesson 9. How to buy at just the right moment
• In studying the greatest stock market winners over the past 45 years, there can be foundspecific base patterns. These bases were formed just before the stocks broke
out intohigh ground in price and went on to make big gains.
• The most common pattern is a “cup with a handle” named so because the chart shows aresemblance of the pattern to a coffee cup. The end of the handle signifies the buying
• The optimal buy point of any stock is its “pivot point” or the point at the end of a basingarea when the stock price is breaking out into new high ground.
• On the day the stock breaks out, volume should increase 50% above
its average.
• Buy a stock when it is breaking into new high ground. 98% of individual investors never
buy this way, and that’s why few will ever own big stock winners. The idea is not to “buy
low, sell high” but “buy high and sell higher”.
Increased volume from the prior day/week with the price moving up isgenerally a positivesign.
• Increased volume from the prior day/week with the price moving down is generally anegative sign.
• A decrease in price on decreased volume indicates no significant selling.

Lesson 10. How chart patterns lead to big profits
• Aside from the “cup with the handle” pattern, a “double bottom” or a “W” pattern on a
chart shows a potential good stock
before it advances in a huge way. American Power
Conversion’s 39-week pattern in 1990 resembled a letter W. The end point ofthe W or
Point G was the correct buy point at $22, the stock advanced 800% in the following 22
months from Point G.
• You want to buy a stock exactly at its pivot point as it breaks out of a sound pattern.
Don’t chase it up more than 5% past its pivot.
• Short bases of 1 to 4 weeks in duration are very risky and usually fail. Avoid them.
• Patterns that are abnormally wide or loose in overall appearance aremore risky. It is
safer to buy tighter, better-contained patterns with less wild price fluctuations.
• Stocks that shoot up straight from the bottom of a pattern into new highs without any pullbacks or handles are risky and frequently have sharp sell-offs.
• A base breakout with no real increase in volume should be avoided.
• Laggard bases. The last stock in a group to break out to a new high is weak and a
laggard and should be passed up.
• Handle areas that are too wide and loose (down 20% to 30%) or handles that wedge upalong their lows rather than drift down along the lows are faulty and frequently fail.
• After a stock has had a long advance, the fourth time the stock forms a base (“fourth
stage” base) is usually too obvious to everyone and will probably fail.
• When choosing stocks, look for “cup with the handle” patterns, “double bottom” patterns,and “flat base”.

Lesson 11. How to read stock charts like a pro
• Most successful stocks build a number of bases as they make their way up in price. Eachone creates a different “stage” base. Third and fourth stage bases are prone to failure.
• Chart price and volume action frequently can help you recognize whena stock has
reached its top and should be sold.
• Study chart patterns of past winning stocks. History always repeats itself in the market.
• Look for handles that from in the upper half of the base.
• A sound base should usually have more weeks where the price is up on greater-thanaverage volume than weeks down on greater-than-average volume.
Most big stock market leaders breaking out of a sound base will go up 20% in 8 weeks or less from the pivot point. Never sell a stock that does this in 4 weeks or less.

Lesson 12. How to gauge the stock market’s health
• For an individual investor investing in common stocks, the key stepsto follow are:
1. Develop buying selection rules that let you pick the best stocks and use charts todetermine the right time to buy.
2. Have a set of selling rules that tell you when to sell and nail down a profit, or cut
short a loss to avoid a possible larger loss.
3. Have a specific method to tell you when the general market averages are topping
and headed down, and when they’ve hit bottom and turned into a new uptrend.
When it comes to the stock market, remember:
• It’s better to get off the elevator on one of the floors on the way up than to ride it all the
way down.
• The general market is represented by leading market indices like theS&P 500, Dow
Jones Industrials, and the Nasdaq Composite. Tracking the general market is key
because most stocks follow the trend of the general market.
• Ignore personal opinions about the market. Study the day-to-day price and volume
changes in leading indices instead.
A typical bear market will decline 20% to 25% from its peak price. Anegative political or economic environment could cause a more severe decline.

Lesson 13. How to spot when the market hits a top
• Knowing when to buy or sell a stock is key.
• Because three out of four stocks, regardless of how “good” they are, will eventually followthe trend of the general market, it is important to learn how to spot when the market ishitting a top.
• After 4 or 5 days of distribution within a 2 to 3 week period, the general market will
normally turn down.
• Distribution is indicated by the index closing down on increased volume or a day’s attempted advance stalling on greater volume than the day before. At this time, review the stocks in your portfolio and look for individual selling signs that
indicate you should cut back or sell them.

Lesson 14. How to spot when the market bottoms
• Bear markets create fear and uncertainty. When stocks hit bottom andturn up to begin
the next bull market loaded with opportunities, most people simply don’t believe it.
• At some point on the way down, the indices will attempt to rebound or rally. A rally is anattempt by a stock or the general market to turn up and advance in price after a period ofdecline.
• Bear markets normally come in two or three waves, interrupted by several attempted
“false” rallies that usually fizzle out after one to three weeks and occasionally five to six
weeks or more.
• Eventually, one of the rallies will “follow-through”. A “follow-through” occurs when one ofthe indices closes up 1% or more with a jump in volume from the day before. This
confirmation will usually happen on the fourth to tenth day of the attemptedrally.
• The Dow, S&P 500, and Nasdaq indices, along with the IBD Mutual FundIndex are your
best sources for analyzing the market’s condition and determining if a top or bottom hasoccurred. Also, observing how leading stocks are acting can be another indicator of a
market top.
• Most technical market indicators are of little value. Psychological indicators like the Put-Call Ratio can help confirm changes in the market’s direction.

Lesson 15. Putting the stock-picking puzzle together
Once you determine that you are operating in an uptrending general market,
here are the factorsyou need to consider:
• Is the company’s current quarterly earnings per share up at least 25%?
• Are the percentage increases in profits accelerating compared to recent quarters?
• Does it have six to twelve quarters of significant earnings increases up 50%, 100%, even
200% or more?
• Is the next quarter’s consensus earnings estimate up a worthwhile amount?
• Have earnings in the past few quarters been higher than expected?
• If it’s a growth stock, is each of the last 3 years of earnings up an average of 25% or
more per year?
Is the company’s Earnings Per Share Rating 80 or higher?
If it’s a turnaround stock, does it have two quarters of strong earnings increases or onequarter that is up so much that the 12 months earnings per share are back to
their oldpeak?
• If 2 or more quarters have turned up, are the trailing 12-month earnings near or abovethe peak of the prior couple of years?
• How much are the consensus earnings estimates up for the next 2 years?
• Does the company have six to twelve quarters of strong sales growth?
• Has that growth rate accelerated in recent quarters?
• Is the current quarter’s after-tax profit margin at or close to itspeak?
• Has there been a general trend of profit-margin improvement over many quarters?
• Are the company’s margins among the best in its industry?
• Is the annual pre-tax profit margin 18% or more? (For retailers it’s alright to have lower
• Is the return on equity 20% to 505 or more and is its ROE among the very best in its
• Is its Sales+ Profit Margins + ROE Rating an A or B? That would place it among the top
40% of all stocks in terms of sales growth, pre-tax and after-tax profit margins, and returnon equity.
• Does the company’s management own the stock?
• Is the stock in a quality price range? Quality comes at 16$ to 150$ for Nasdaq stocks and20$ and above for NYSE stocks. Leaders like Cisco Systems, Wal-Mart, Microsoft,
PeopleSoft and Amgen broke out of their beginning chart bases many years agobetween
30$ and 50$ per share – before they had giant price advances. Price is a basic reflection
of quality.
• Is the stock part of a historically winning industry group such as retail, computers,
technology, drug and health care, or leisure and entertainment?
• Is it in one of the Top 5 groups? Check the “52-Week Highs and Lows” feature on the
Industry Groups page for the top 5 performing groups.
• What broad economic sector is the market favoring? Consumer or high-tech? Growth orcyclical? Defensive (food, utilities)? New or older more established companies?
• Does the company’s product save money, solve a problem, or savetime with new
• Is it a new drug or medical technique?
• Is it widely needed or liked?
• Is it a product that encourages repeat sales?
• Is the company’s backlog of unfilled orders expanding?
• At what percent capacity is the company operating?
• What is the company’s expected rate of future expansion?
• Have one or two of the smarter, better-performing mutual funds
bought the stockrecently? Better institutions do extensive research before buying.
• Do you really understand and believe in the company’s business? Have you seen or
used its product or service?
• Potential winners will have strong earnings and sales growth, increasing profit margins
and high return on equity (17% or more) and will be part of a leading industry group.
• Check Daily Graphs Online to spot which of your prospects are forming a sound patternand are under accumulation or professional buying. They must be near a
proper buypoint.
• Analyze the week-by-week price and volume action. Write down the price at which you
will begin buying the stock. After your initial purchase, identify a price area (maybe whenit goes up 2.5 to 3%) at which you will add a small amount as a follow-up buy if itcontinues to perform well.
• If the stock drops 8% below your exact initial buy point, protect yourself against a
possible larger loss by selling at the current market price.
• You want an increase of 50% or more in trading volume on the day youbegin buying withthe stock breaking out of a sound base.
• Is the chart pattern a “cup with a handle”, “double bottom” or “flat base”? If it is not any ofthese, it may be faulty and failure-prone.
• Is its Relative Price Strength Rating 80 or more? Is the relative strength line on the chart
in a definite uptrend?
• Keep adding to your best-performing stocks and reduce or sell your worst performing
• Check a long-term monthly chart to see if stock is also emerging outof a long-term baseover a number of years.

Lesson 16. How to find new investment ideas
• Scan “The Markets” summary for the prior day’s closing prices of the S&P 500 and the
Dow Jones Industrials, the Nasdaq and the NYSE volume, all can be found on the front
page of IBD
• “To the Point” gives the busy reader a quick, time-saving review of all key business newsof the day.
• Check out “The New America” page for new companies. Study How to use IBD
SmartSelect Corporate Ratings box found at the beginning of the main NYSE
andNasdaq stock tables.
Avoid companies where the EPS (Earnings per share) Rating and RS (Relative Price
Strength Rating) are less than 70.
The best companies should have at least aB on all
three ratings.
• Stick to stock purchases among leading groups or sectors by checkingtheir Industry
Group Relative Strength Rating.
• Sales + Profit Margins + ROE (SMR) Rating combines 4 fundamental measurements
(sales growth, before and after-tax profit margins, and return on equity) into one easy
• The Accumulation/Distribution Rating identifies whether a stock is under professional
buying or selling over the last 13 weeks. A = heavy buying, B = moderate, C = equal
amounts of buying and selling, D = moderate selling, E = heavy selling
• Look for stocks in the stock tables with boldfaced type. This indicates that a stock is up
1$ or more for the day or is making a new price high. This is a good starting point for
more research

Lesson 17. Growth vs. Value Investing
• There are two kinds of investors: growth stock investors and value investors.
• Growth stock investors seek companies that show consistent earnings and sales growth,usually 20% or more each year for the past 3 years or 5 years. Companies
such asSchering-Plough, Paychex, Cisco Systems, and Microsoft would be considered
growthstocks in the 1990s.
• Growth stocks have a high-quality, repeat-type product or service that generates superiorprofit margins and return on equity of at least 17% to 50%.
• Value investors search for stocks they believe to be undervalued. They evaluate a
company’s balance sheet and profit-and-loss statement, looking for hidden value like anunusually large amount of cash in the company or property carried on the books at cost,which is below the current market value, etc.
• Value investors look for a bargain and like to buy stocks with a low P/E ratio
(Price/earnings) or low price-to-book value. They look to buy a business
franchise at alow price. Value investors wait for the market to recognize their stock’s
value for it to goup in price. This takes a long time, and sometimes does not happen at all.
• Studies have shown the new market leaders had P/Es that significantly exceeded the restof the market (31 times the average) before they made their big advance.
• Mutual funds are a great investment as well. Pick strong performing funds from Investor’sBusiness Daily’s “Mutual Funds” page, and remember the key to success
with mutuals isto buy and hold forever.

Lesson 18. Don’t try to be a Jack-of-all-trades
• Keep it simple. Concentrate on a few good high-quality common US stocks. Domestic
stocks or mutual funds are best. The more types of investments you own, the harder it is
to keep track.
• You get what you pay for on the market. Low-priced stocks are usually cheap for a goodreason. They may be performing poorly.
• Options are risky because investors do not only have to be right about the direction of thestock but also about the time frame in which they believe the price will go up or down.
• Futures, due to their highly speculative nature, should be attemptedonly by people with
several years of successful investment experience.
• The US has the greatest stock market in the world. There are more than 10,000 commonstocks to choose from. If you can’t learn to profit investing in US stocks,
you aren’t likelyto profit in the commodity market or buying foreign stocks.
• Many foreign stocks are unstable due to their government’s history,corruption, and
unsound systems. Most individual investors do not know all they need to knowabout
foreign countries.

Lesson 19. What’s the right mix for your portfolio?
• Concentrate your eggs in fewer baskets, know them well and watch
them carefully.
• With $5,000 invested, you may own no more than 2 stocks.
• With $10,000 invested, 2 or 3 stocks is appropriate.
• With $25,000 invested, 3 to 4 stocks is appropriate.
• With $50,000, 4 to 5 stocks
• With $100,000 5 to 6 stocks
• It is not advisable to hold more than 20 stocks. You cannot keep track of all these
investments properly.
• Stagger your buying over time. Never buy all five stocks at once. Let your stocks make
some progress before you get 100% invested.
• Buy only half of your $20,000 position ($10,000) in one stock as your initial buy. If the
stock goes down in price, don’t buy any more. If it goes down 8% from your buy price,
sell all of the stock at once to cut your loss. If the stock moves up 2 to 3% in price from
your initial buy and if it still looks like it is performing well, follow upand buy $6,500 more.Buy another $3,500 worth if it makes another 2 to 3% advance, and then stop.
Sit backand give it time and room to grow.
If you already own the maximum number of stocks but want to add a new stock to yourportfolio, sell the least profitable stock to get money for the new one.

Lesson 20. Sell rules every investor should master
• Cut your losses short and do it early. We repeat the old 8% rule. If a stock falls 8% below
your purchase price, sell it.
Don’t sell and take a profit if your market leading stock is up 20% to 25% in only 2 or 3weeks. That’s a sign of real power, and you may be holding a big winner.
• Don’t let yourself lose money on a stock you had a reasonable profit in.
40% of stocks will pull back near the initial buy point, sometimes in big volume, for 1 or 2days. Don’t let this shake you out of your stock.
• 30% of market leaders will peak after many months of advance by having what is called a“climax top”. The stock will run up at a much faster rate than in prior weeks. Look for thestock’s greatest 1-day price advance since the beginning of the move up. This usually
means that everyone is excited about the stock, which makes its price rise dramatically.
Because the market often moves contrary to mass opinion, it is a good idea to sell your
stock when this happens.

Lesson 21. More sell rules every investor should master
• Sell a stock if the earnings per share shows a major deceleration ingrowth for two
quarters in a row.
• If your stock advances a significant distance over many months and has formed severalbases during the process, the fourth time the stock breaks out of a base (“
fourth stage”base) it probably should be sold.
• Sometimes you should sell a stock because it consistently moves up in price less than
another good stock you’re holding. The money can be used in the better performing

Lesson 22. How to make a million with mutuals
• A diversified US stock fund, whether growth or value, is your best choice.
• Never sell a domestic growth stock mutual fund. Hold it and watch ts growth compoundover the years ahead. If you need income, just set up a monthly or quarterly
withdrawalplan to take out 7 or 8% each year.
• Don’t buy too many funds. Extensive asset allocation will just dilute your overall returns.
• Compounding over long-term is the key to making a million in mutual

Lesson 23.
• Scan IBD’s Top 10 new stories and “The Markets” summary box, “To
the Point” and readonly the brief summaries you find important.
• Scan “The New America” for dynamic entrepreneurial companies with
new concepts andproducts, “Leaders & Success”, “Business & the Economy”, “Computers & Technology”.
• IBD is really a daily computer printout and evaluation of the entiremarket. It provides
relative scores, ratings, and special screens, based on extensive stock market research,
of the most relevant factors in winning stocks.
• IBD stock tables do 80% of your research for you in a lot less time.
Before selecting your stocks, you must be able to gauge the general market. “The BigPicture” on the “General Market & Sectors” page will show you what is going on in themarket now.

Lesson 24.
• The Internet is a convenient and time-saving research tool and can help you when you
know exactly what you’re looking for, but it can also overwhelm you and youcan easily
get lost in cyberspace if you are just randomly surfing for ideas and
looking for hugeamounts of data.
• Consider that information providers on the Internet are potentially


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