Trading Rules to Live By

In the dawn of my Wall Street career, I took a class in "Risk Management" at the New York Institute of Finance (by the way, I highly recommend these courses to expand your professional expertise; even if you don't live in the New York City area, they have distance learning programs).

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The class was taught at that time by the head of foreign exchange trading at Chase Manhattan, although the risk management strategies applied to any financial product. She recommended that we novices get in the habit of keeping a log of why we entered a trade, conditions that prevailed at the time of the trade and when we closed out the position, as well as whether the trade made a profit or loss. In addition, she told us to jot down notes about strategies and ideas that we learned from more experienced traders or through our own research. She made the point that our memories were more fallible than we knew. The only way to develop a disciplined approach to trading was by revisiting our successes and failures while the markets were closed, modifying our strategies based on a hard record of experience.

To this day, I keep a steno pad on my desk. I don't have to track individual trades anymore -- we have computer systems which do that for me -- but a couple of times a month, I'll recognize a pattern and commit details to my trader's log. For example, I discovered a series of short- term indicators that could reliably tell me when to commit new cash to the stock market. The rules for applying these indicators evolve over time as markets continue to evolve. By referring back to the trader's log, I have the information I need to improve their application.

Here's an example of a rule I developed from last year's Internet fiasco. In 2000, many experienced investors could see that certain dot-coms were woefully overpriced, but their skepticism was brushed aside by soaring stock prices. At a certain point though, I noticed that individual sectors (e.g., business-to-consumer, net infrastructure, etc.) broke down even though the overall Internet indices were still rising.

I had already noted that part of the huge rise was due to demand chasing a relatively small supply of stock, but I couldn't account for the end of the individual rallies. At a certain point, however, I had the revelation that individual stocks broke down about one month before insider lockup expired. As a substantial supply of additional stock reached the markets, demand evaporated and prices cratered just as classic supply/demand theory predicts.

So my new rule is: The next time investors make a mania out of a certain stock sector, keep an eye on the overall stock supply and sell out of anything where the float is about to increase dramatically. You might think this won't happen soon, but investor manias happen fairly frequently (remember the Y2K mania of 1998 or the Iomega (IOM - commentary - Cramer's Take) mania of 1996? I do because I noted it all down in my log).

Here's a summary of the rules that generally guide my investing (bear in mind that I run a fairly conservative firm with an average five-year holding period for companies in our portfolios). These rules developed out of 15 years of trading logs, additional research and an MBA.

For Companies

All other things being equal, choose the company with the largest market share in its industry.

A company with a fair product and a good marketing plan beats a company with a good product and a fair marketing plan.

A company with no or negative earnings is significantly riskier than a company with positive earnings, especially over a five-year time period or longer.

A company with negative cash flow is significantly riskier than a company with positive cash flow.

A company whose financial ratios are better in aggregate than its industry group and the S&P 500 merits investigation (examples: price-to-earnings ratio less than averages, forward growth rate higher than P/E ratio, price-to-sales ratio less than average).

Companies with "strategic niches" have less risk than companies in commodity businesses.

A company with five years of expanding operating margins is usually a winner.

For Industries

A star company in a declining industry is riskier than an average company is a rising industry.

All industries go through a cycle of innovation, expansion and maturation. The biggest risks are during the innovation stage, and the biggest stock market profits come during the expansion stage.

Different industries perform differently during the economic cycle (e.g., a financial company performs best early in an expansion, a manufacturer in the middle of an expansion, a commodity supplier late in an expansion).

A portfolio diversified by industry is less risky than a portfolio concentrated by industry. However, focusing on a handful of top-performing industry groups is the simplest way to produce returns in excess of the S&P 500.

For the Stock Market

True bear markets result from the Federal Reserve raising rates or the outbreak of war.

Long-term growth in the S&P 500 is 10%-12% annually. Reversion to the mean suggests that periods of above average growth will be followed by periods of below average growth.

Stock prices lead the economy by one to two years. The least risk is in investing during a recession; the most risk is in investing after several years of expansion.

A stock trading at a 52-week high may well go higher; a stock trading at 52-week low may well go lower.

Beware the fourth quarter.

Beware the preannouncements cycle (four weeks preceding regular earnings announcements).

Fundamental factors rule long-term stock price movements; technical factors rule short-term stock price movements.

For Portfolios

Taxes and holding periods matter -- a low-turnover portfolio beats a high-turnover portfolio, all other things being equal.

Trading costs matter -- given commissions and trading spreads, the average portfolio has to generate an extra 1% in return just to match the S&P 500.

A minimum of 30 equally weighted positions substantially reduces company-specific risk in a portfolio. Diversification beyond 50 equally weighted positions does not further reduce company-specific risk.

A portfolio composed of less-correlated stocks is less risky than a portfolio of highly correlated stocks (e.g., a portfolio composed of a bank, a car manufacturer and an oil company is less risky than a portfolio composed of three banks).

Employee stock and stock option plans require special diligence.

Beware leverage.

For Selling

Sell decisions are much harder than buy decisions.

In a diversified portfolio, sell one-half of any position that exceeds 10% of the portfolio.

Sell any company that fails to meet analysts' expectations for two quarters in a row.

Sell any company that restates historic earnings.

Consider selling any company that falls below its 200-day moving average.

Sell any company whose "niche" product becomes commoditized.

In tech stocks, sell any company whose products are superseded by newer technology.

Beware the "paradigm shift."

William Eng, a successful trader with 30 years experience and several books under his belt, wrote a terrific primer for short-term traders -- Trading Rules: Strategies for Success. When I first read this book in 1990, I photocopied his 50 rules and taped them to the blotter on my desk. The book is still in print and can be bought on Amazon.

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David Edwards is a portfolio manager and president of Heron Capital Management, Inc., a New York investment management firm. At the time of publication, his firm was long Amazon, though positions may change at any time. Edwards appreciates your feedback at [e-mail].

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