Four Principles to Smart Investing

This article is published with permission from InvestmentU.com.

At the beginning of every year (and often at the beginning of each quarter) I like to write out the many investment principles that guide me. I rewrite them because there may be new principles to add or changes to the old ones.

Today I thought I’d share four of my main short-term trading principles from a technical standpoint. It’s a different spin on the long-term strategies often discussed in Investment U.

1. Relative strength investing is the cornerstone of my success

If Security A advances by more than Security B, then it’s showing positive relative strength. If Security A declines, but by less than Security B, it’s still showing positive relative strength.

It’s important to understand that relative strength is used to reduce risk of loss as well as increase upside potential.

Relative strength is about being in the right global market. For example, many believe that “The Bernanke Put” — basically, the Fed’s monetary policy during the Bernanke years — is the reason the U.S. equity market was the strongest in the world last year. Therefore, during that time, our bullish positions would be based primarily on U.S. equities. When global markets decline, it’s best to have bearish positions on non-U.S. equities.

Relative strength is about finding the best way to invest in something. If you want to own the broad U.S. equities market, do you stand to make more or risk less by investing in:

A. Large-Cap Growth Stocks ($10 billion-plus market cap)

B. Large-Cap Value Stocks ($10 billion-plus market cap)

C. Mid-Cap Growth Stocks ($2 billion to $10 billion market cap)

D. Mid-Cap Value Stocks ($2 billion to $10 billion market cap)

E. Small-Cap Growth Stocks ($300 million to $2 billion market cap)

F. Small-Cap Value Stocks ($300 million to $2 billion market cap)

Relative strength is about finding the right sectors of the stock market. There are 42 broad sectors. Some people mistakenly believe a bull market causes all sectors’ stock prices to advance. They say “a rising tide lifts all boats.”

Not true.

The reality is that each sector is like its own little stock market within the broad market. One clean energy sector ETF, Guggenheim Solar (NYSE: TAN), was up 132% last year while the gold mining sector ETF, Market Vectors Gold Minors (NYSE: GDX), was down more than 50%. The steel sector ETF, Market Vectors Steel (NYSE: SLX), was up less than 1%.

To attempt to outperform the broad market benchmark on a short-term basis, diversify — but only among the top four or five sectors. The longer your time horizon, the wider your diversification.

2. I employ the use of options to get the most out of my trades

Securities don’t only advance or decline. They can advance at sharply different rates, or remain flat. Options strategies exist that are well-suited to all such scenarios, and I’ll be discussing these at greater length in future columns.

3. The positions I take are bullish and bearish

There are times when I am one or the other, and then there are times when I’m both. For example, when U.S. equities are outperforming emerging market equities by a large margin, I might have equal dollars in bullish positions on four of the strongest U.S. sector ETFs and in bearish positions in four emerging market ETFs.

4. At times, the direction of my investment account will have little if any market correlation

Most people are programmed to think “up market good, down market bad.” But as I’ve said, I’m not too concerned with the direction of any financial market broadly. Instead, I focus on finding situations with the highest probability of success.

This can be a great feeling if the market you are familiar with is in decline and you are one of the few who is profiting from the event or avoiding the decline somehow. But on the flip side, if your investments are in decline while the market you’re familiar with is advancing and most people you know are celebrating, it can be frustrating, to say the least.

I encourage people who use hedging strategies to take a long-term view. Without question, the account will go through advancing periods and declining periods. Because hedging isn’t a common methodology, don’t expect it to share common times of success.

These principles are among the most important I’ve ever learned — and it took me some time and mistakes to really learn them over the course of my career.

I hope, by sharing them with you, that I can cut some time off of your journey.

Chris Rowe is a member of the Investment U Research team.

The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.