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Five Lessons to Master before the Next Bull Market

June 2009

Bond Certificate

Many active investors enjoy stock picking and “playing” the markets, but no investor can consider himself educated until he has lived through at least one full bull and bear market. Much of the fun happens in bull markets, but most of the learning happens when the bear starts growling.

If you buy individual stocks or narrow “sector funds,” here are five skills that you can start to master now and put into practice whenever the next great bull market arrives.

  1. Be wary of your own emotional highs. Yes, it will happen again. You’ll start feeling good about your investments. Confident. Happy. Remember how good you felt in 1998 or 2006? When you start to admire your buys or (even more alarmingly) boast about them to your friends, it's generally a great time to think about taking profits. When everyone is talking about gold funds, or the latest hot emerging market exchange traded fund (ETF) it is time to start locking in some gains. I’ve learned over the years that when I open my statements and feel that lovely warm sense of satisfaction, it’s a sell signal. Conversely, when you feel worst about your investments it’s generally time to stay in the market, or even be a buyer.
  2. Portfolio structure can help you keep things in control. Track your family’s investment portfolio with tools such as Morningstar. Unless you have many years of investment experience and spend at least four to five hours per week managing your investments, never have more than 10–15% of your investment holdings in individual stocks or narrow sector funds (such as funds that invest in gold, or Chinese companies, or technology stocks). View this slice of your investment portfolio as the speculative portion of your investment portfolio. In contrast, the remaining 85–90% of your investments should be invested in “core” funds that invest very broadly in a well- designed mix of US and overseas stocks and bonds.
  3. Treat speculative holdings differently from core investments.With core investments it’s best to take a buy-and-hold approach, with regular rebalancing. That is not a wise strategy with your more speculative investments (individual stocks and narrow sector funds). Keep a close watch on your speculative investments and be willing to trade them actively. Avoid having more than ten individual stocks or narrow sector funds; holding dozens of different stocks and sector funds is a distraction and adds nothing to your overall investment performance. No individual stock or narrow sector fund should be allowed to grow to much over 10% of your total investment portfolio without your taking some profits (this can easily happen if you have options or stock in the company that employs you). Regularly recycle profits from speculative holdings into the “core” portion of your portfolio to keep the speculative piece from getting too big and increasing your risk. Be honest with yourself: review your trading history regularly and if you find yourself consistently losing money on this part of your investment portfolio move the money out of speculative investments and into core funds.
  4. Never let a loss on a stock or sector bet grow beyond 7–10%. It’s hard to take losses, especially in bull markets when it’s easy to think that the next powerful market surge will bail you out of your losing position. Wrong idea. You will do better over the long haul if you cut your losses rigorously in bull markets. There is no knowing when the bull will turn into a bear and make your 10% loss into a minus–80% disaster. When you first buy a stock, subtract 7% from your buy point and post that “target” next to your computer. If a stock hits that target “stop-loss” price, sell it right away. You can also enter a standing “stop-loss order” on a stock with your broker. You'll have to renew the order regularly, but it's a good way to protect yourself from losses—especially when you are flying off to Hawaii for vacation. A stop-loss order can also be used to protect profits or prevent loss in exchange traded funds, but generally cannot be used to protect conventional open-ended mutual funds.
  5. Master the art of profit taking. To learn how to take profits in a market-sensitive way, it pays to learn the basics of stock charting. Visit www.investors.com, the home of Investors Business Daily, for some of the best educational materials on technical analysis. Great stocks and major sector moves will often happen in stages, with a powerful initial move of say, 25%, followed by a short period of “consolidation” when the stock or sector pauses for a few months and then takes off like a rocket and posts another 20% gain over a few months. The longer this trend lasts, the more nervous you should get. Nervousness is, of course, exactly the opposite of the emotion most people feel. Typically investors grow more and more complaisant the higher their investments’ market value climbs. Fight this emotional response. Pay attention in profit taking to the length of time the stock has been moving in one direction. Most sector or stock moves last only about one to three years(every now and then you’ll get a four year move, but it’s rare). If a stock or a sector has staged major (10%–15%+) advances over a one- to three-year time frame, it's probably getting close to the end of the run, and it’s time to take profits.

At Responsible Investing, we can help you learn how to master key money management skills. To learn more about our affordable classes and independent advisory and coaching services click here.

Responsible Investing is an independent financial coaching and investment advisory firm, registered with the Commonwealth of Massachusetts.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Outside sources used in this article are believed but not guaranteed to be accurate. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.