GET INSTANT LIQUIDITY: Buy only the most actively traded ETFs for the smallest bid/ask spreads, most efficient executions, and best overall prices.
While this list of candidates may vary over time, an online search today would reveal the S&P 500 SPDR (SPY), Nasdaq 100 Trust (QQQ), Russell 2000 iShares (IWM), and Dow Diamonds Trust (DIA) as the most liquid ETFs for non-leveraged shares. And consider only the ProShares Ultra S&P 500 Fund (SSO) and the ProShares Ultra QQQ Fund (QLD) as the most liquid leveraged broad-based ETFs.
Note: The bid/ask spread is the difference in price between what an investor can buy a stock for and what he or she can sell that same stock for at a given moment. An investor pays slightly more to buy a stock than what they can sell it for at that particular time. The spread or difference in price is money that goes to the traders on the floor of the stock exchanges for their services.
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“In order to make a success trading in the stock market, the trader must have definite rules and follow them – Trade only in active stocks. Keep out of slow, dead ones.”
William D. Gann ~ Author of Truth of the Stock Tape (1923)
AVOID TOO MUCH LEVERAGE: The financial industry has filled the needs of excessive risk-takers with their new assortment of super-leveraged, triple action Exchange-Traded Funds. But for most independent amateur investors, these new funds only serve as a faster way to lose money and should, therefore, be avoided.
Many prominent market observers assert that these funds do not deliver what they promise to achieve in terms of price performance. In addition, the excessive risk in trading these funds will automatically result in punishing investors for the slightest errors in timing. Don’t get greedy and be content with using the better-known and less volatile ProShares Ultra Funds for the leveraged portion of your trading position.
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Note: Don’t be fooled by the high volume in some of these super-leveraged funds. While this may indicate a higher level of efficiency, it does nothing to make the overall nature of these trading vehicles less risky. Remember that the objective of the Wall Street Craps strategy is to make fast money with less risk, not more.
INCREASE YOUR LEVERAGE: Consider putting a sensible portion of your allotted funds into broad-based ProShares Ultra Funds in order to get more bang for your buck.
The ProShares Ultra Funds are designed to move at 200% of the index they mimic. While these funds have only a short track-record, their high volume implies that management has largely succeeded in delivering what they have promised. As a general guideline, an investor should start off doing about 80% of their trading in non-leveraged ETFs like the S&P 500 SPDR (SPY), Dow Jones Industrial Average SPDR (DIA), and the Nasdaq 100 Trust (QQQ).
For more leverage, consider trading only about 20% of your “play money” in leveraged ETFs such as the Proshares Ultra Dow 30 Fund (symbol: DDM), the ProShares Ultra S&P 500 Fund (symbol: SSO), the ProShares Ultra QQQ Fund (symbol: QLD), and/or the ProShares Ultra Russell 2000 Fund (symbol: UWM).
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Note: An experienced investor with a high risk tolerance can consider using up to 50% of their play money funds in leveraged broad-based Exchange-Traded Funds. But because of their high volatility, a trader in these funds must be ready to sell out quickly and avoid holding positions in these types of ETFs over any weekend or holiday.
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“All active and well distributed stocks of great American corporations generally rally and decline with the averages, but any individual stock may reflect conditions not applicable to the average price of any diversified list of stocks.”
Robert Rhea ~ Author of The Story of the Averages (1932)
COVER THE WHOLE BOARD: Buy only broad-based Exchange-Traded Funds for the highest probability of moving in the same direction as the general stock market. The idea is to analyze and calibrate the general market and then make highly correlated bets based on your evaluations.
This means to avoid buying Exchange-Traded Funds that represent limited sectors of the market, such as financials, technology, health care, gold, energy, industrials, or real estate. The temptation is always there to outsmart everyone with the perfect selection, even when it comes to ETFs. But in order to participate in a general upward move in the stock market, you must discipline yourself to buy only broad-based ETFs that mimic the price movements of the S&P 500, Dow Jones 30 Industrials, Nasdaq 100, and/or Russell 2000 indices.
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Note: This rule applies mostly to large-sized bets or investment positions. The gold-related ETF, which goes by the stock symbol of GLD, is my choice to dabbling in the area of precious metals because of its performance and liquidity.
DON’T PLAY YOUR FAVORITES: Don’t fall into the trap of picking popular favorites in the stock market. Falling in love with the story of an individual stock or market sector will keep you emotionally attached and, therefore, make it hard for you to ever let go and sell correctly.
For example, when I play at a Las Vegas Craps table, my tendency is to follow the numbers 6 and 8. When those numbers hit and I don’t have a bet on them, it causes me to say in anguish, “Darn, those are my numbers!” The same thing happens in the stock market when an investor has an emotional attachment to a particular stock, such as General Electric, Cisco, Ford, or Bank of America, or a market sector, such as gold, oil, or technology. This unreasonable but natural emotional attachment will get in your way of trading objectively. It will cause you to focus more on the performance of an individual stock or market sector than on the overall stock market.
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Note: There is a place for individual stocks and that is in the security assets portion of your asset allocation plan. It is here that you can accumulate a small position of your favorite stock as long as it is undervalued, oversold, and out of favor. It is regarded as a long-term holding and must only represent a tiny part of your overall diversification strategy.
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“Giving a stock a personality is a common, if human, error. Trouble follows when there is a divergence between image and reality.”
Robert Metz and George Stasen ~ Authors of “It’s A Sure Thing” (1993)
CONCENTRATE YOUR BETS: Buy shares of Exchange-Traded Funds instead of the stocks of individual companies. Narrow your investment selections down to four or less. This approach will take the emotion out of your investment selections, while providing wide diversification.
One of today’s most popular investment vehicles are the newly created Exchange-Traded Funds or ETFs. They’re similar to mutual funds but trade on the major exchanges in the same manner as common stocks. Buying Exchange-Traded Funds allows investors to effortlessly diversify their portfolio over several industries, countries, and asset classes. And since ETFs are traded on major exchanges, an investor can move in and out of positions without the trading restrictions imposed by traditional mutual funds. The investor also enjoys the same low commission rates that many online brokerage firms charge for stocks transactions.
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Note: An investor who owns ETFs instead of the stocks of individual companies can concentrate their bets, focus on the general market, and eliminate the endless hours of useless research that usually amount to no advantage at all.
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“Our policy is to concentrate holdings. We try to avoid buying a little of this and that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts.”
Warren Buffet
Letter to Berkshire Hathaway Shareholders (1978)
DON’T MAKE SUCKER BETS: It’s a “sucker bet” to waste your time, energy, and focus trying to find the next Apple, Google, Wal-Mart, or Microsoft. Realize that every stock has a story of “great potential” attached to it.
It is the story behind a stock that causes most amateur investors to subscribe to stock market newsletters and watch stock market TV shows on CNBC like Jim Cramer’s Mad Money for hot buying tips. The lure of “inside information” from investment experts causes people to buy the stocks that these authorities most strongly recommend. But in many cases, this practice leads average investors to concentrate their portfolios in too few companies or chase after spectacular gains in high-risk small-capitalized stocks.
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Note: The amateur investor as well as the amateur gambler falls prey to the allure of the big payoff. And in the case of stock market investing, the big payoff rarely occurs and results instead in consistent losses. The smart way to play the market is to aim for decent returns while focusing on managing risk.
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“I have probably purchased fifty ‘hot tips’ in my career, maybe even more. When I put them all together, I know I am a net loser.”
Charles Schwab ~ Founder of the Charles Schwab Corporation
SEEK WIDE DIVERSIFICATION : Don’t buy shares of individual companies. The portfolio risk is too high when you own the shares of too few companies.
The typical investor doesn’t have the time or inkling to trade a diversified portfolio of 25 stocks or more. What normally happens, instead, is that an amateur investor will have a handful of his or her favorite stocks in a portfolio. And as we learned from recent failures, owning large positions in such popular names as Merrill Lynch, Lehman Brothers, Enron, and Fannie Mae can destroy the value of concentrated stock portfolios just by themselves. The goal of the wise investor is to gain the benefit of diversifying your risk over several companies, without having to actually follow and trade too many individual stocks.
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Note: Lack of diversification is one of the most common mistakes that individual investors make. And it isn’t enough to only have 4 or 5 stocks representing different sectors of the market. In this case, you still only have 4 or 5 companies represented. If any one of those have any negative earnings or forecasting surprises, they will make a huge dent in your portfolio.
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“Portfolio diversification makes up for investor ignorance.”
Wall Street Adage
A SIMPLE GAMBLING ANALOGY:Choosing a stock to buy is like selecting where to place a bet at a Las Vegas Craps table. Every stock has its own risk and reward potential, just as there are different bets with varying mathematical odds and payouts in Craps.
The amateur Craps player will most likely place random bets of varying amounts on an assortment of numbers on the Craps table layout. He or she usually doesn’t have any kind of organized system for selecting their number(s) or controlling the size of their bets. His or her success or failure is dependent entirely on the roll of the dice.
On the other hand, the savvy Craps player fully understands the mathematical odds and plays accordingly. As a result, he or she knows what bets to consistently make and which ones to always avoid. You’ll rarely if ever see a savvy Craps player making careless large bets in the hope of snagging a lucky number. However, you will notice that savvy players know how to take full advantage when the table gets “hot” by being diversified on enough high-percentage numbers.
In a similar way, the amateur stock investor will dabble in an assortment of individual stocks – without a system for diversifying risk over enough companies and market sectors. Unless the amateur is lucky in his or her stock choices, he or she is likely to suffer greater losses in a downward trending market. The amateur will also receive smaller gains in an upward market cycle than a savvy individual or professional investor.
Like the savvy Craps player, smart investors know what to buy and what to avoid. They fully understand the risk and reward of each position that they take. And while they may have a few speculative individual choices in their portfolio, savvy investors find a way to be sufficiently diversified in order to full take advantage of hot streaks in the general stock market.
DON’T TRY TO PLAY THE PRO’S GAME: Professional stock investors (big-time hedge-fund, mutual fund, and private equity managers) are usually well-diversified over dozens of companies in several different industries. While potential returns are always a strong consideration in their evaluation processes, the accurate assessment of risk is equally important to them.
But it’s worth remembering that the professional stock investor who manages other people’s money as an occupation is really in the business of getting and keeping customers by having superior performance relative to their competition. They are also paid to maintain positions in the stock market and to spend most, if not all, of their new inflows of money on additional stock purchases. What the pros are not paid to do is hold their customers’ money in cash or cash equivalents for an extended period of time. And unfortunately for professional public investors, they have the added pressure of having to report their performance and stock positions on a regular quarterly basis.
On the other hand, individual investors are only in the business of satisfying their own needs on their own timetable. They’re not in competition for any customer money. An independent investor can learn how to buy stocks and manage risk like a professional, without having to report their actions and results to anyone outside themselves.
This means that as a savvy independent investor, you don’t have to spend most or all of your money on stocks in order to play the game. You have the option of holding large amounts of cash for any length of time, whenever the risk/reward ratio doesn’t appear attractive enough for you to invest.