The “Secret” to Successful Investing

 austerity measuresThe bulls have been good to us so far in 2012. The stock market continues to show optimism; the key stock indices are displaying a “golden cross, with the 50-day moving average (MA) above the 200-day MA. All of this buying bias is encouraging, but the light trading volume tells us to be careful, as there continues to be numerous threats that could drive fresh selling.

Bullish investor sentiment in the stock market continues to drive buying interest despite the technically overbought condition. The key focus remains Greece, which has agreed to the tougher austerity measures. You would, too, if you were asking for another $171 billion!

Growth in the eurozone contracted 0.3% in the fourth quarter and speculation is that a mild recession may surface. Earlier this week, Moody’s downgraded six eurozone countries, so there will likely be more issues down the road as Europe struggles with debt.

Some of you may be too focused on the improving economic renewal domestically, albeit the Industrial Production and Capacity Utilization readings for January were below estimates and short of the December readings. And, on the home front, the NAHB Housing Market Index improved; however, it remains well below the level considered healthy.

In the stock market, the S&P 500 is facing resistance at 1,350-1,360 and will need a strong catalyst to break higher towards 1,400. The bullish investor sentiment in the stock market continues to drive the positive bias in stocks, but I’m seeing some stalling on the charts. The bias is for higher gains, but the lack of strong trading volume is somewhat of a red flag.

You need to understand that being prudent is important for success in the stock market.

The reason why I want to briefly talk about risk management in the stock market is my sense that there are some of you who probably fail to incorporate some sort of risk management strategy. If you do, that’s fantastic and you are probably sleeping well at night.

When the price of a stock trends higher, you should always think about a potential exit strategy. This does not mean liquidating profitable trades; more like protecting your unrealized gains. Take the current stock market rally as an opportunity to take some profits.

If you have a price target for your stock, you can sell the stock when it reaches that target. Alternatively, if the gains are significant, you can take profits on a portion of the position and let the remaining portion ride. For instance, if a stock rises by 100%, you can liquidate 50% of the position and keep the remaining 50%. Under this simple strategy, you take some profits, but at the same time create a zero-cost trade, as you have recouped your initial investment. You can view the remaining 50% stake as risk capital.

Another stock market strategy that needs to be considered is the use of mental or physical stop-loss limits. But you need to be careful when the volatility increases and wild swings in the stock market materialize that could take you out of your position prematurely.

Stops should also be used when a stock is trending higher. These stops are referred to as “trailing stops” and are constantly adjusted as the price of the stock rises. Adopting trailing stops helps to protect your gains as the stock rises.

For those of you familiar with options, you can employ put options to help minimize the downside loss in the stock market. If you own mutual funds, you can buy the appropriate index put by determining the type of fund it is (e.g. small-cap, blue-chip, S&P 500, technology).

If your portfolio is 50% technology, 30% large-cap, and 20% small-cap, you can hedge the risk by allocating 50% to puts on the NASDAQ 100, 30% for S&P 500 puts and 20% for Russell 2000 or S&P 600 Small Cap puts. If you hold only a few large stock positions, you can simply buy corresponding stock puts to match.

The key to success in investing in the stock market is to know the risk and have an exit strategy.

Two of the most critical factors driving the success of a company are leadership and vision, which I discussed in Success Driven by Leadership: RIM vs. Apple.