Five Minute Investing（1）

Introduction 
If you are like most persons these days, no one needs to remind you that we live in a hectic society which stretches nearly everyone's schedule to the breaking point. This is why I have written Five Minute Investing. This is a book designed to help busy people perform consistently well with their stock investments. It is for the person who wants to aggressively manage his or her portfolio for maximum growth, yet not have it consume their life with time-consuming analysis and worry. 

Five Minute Investing focuses on the two main aspects of managing an aggressive stock portfolio: Stock picking and portfolio management. In other words, what to buy, when and how much to buy, and when to sell. 
Background 
If you have ever tried to make your own investment decisions over a period of time, chances are you spent most of your time wondering what you should do next. You also experienced how time-consuming and distracting that can be. Once you have studied and thoroughly comprehended the concepts in this book, you should never again agonize over which stocks to buy, or how much to buy, or when to sell them. Peace of mind comes from having a plan that will take care of you no matter what conditions prevail. Any portfolio of stocks can be managed effectively and without worry if you carefully follow the strategies laid out in this book. As powerful as it is, this strategy can truly be implemented in five minutes a day or less. You need not think about it beyond those five minutes. As you use and gain confidence in Five Minute Investor techniques, you will find that you think about your stock investments only during those five minutes, not worrying about them all day long as some people do. 
The average person thinks that the key to success in the stock market hinges on the ability to pick which stocks will do well. This is only partially correct because even a stock portfolio which is packed with tomorrow's winners can turn out to be a disaster, if managed incorrectly. If there is only one thing that you retain from this book, let it be this: strategy and advance planning are at least as important as stock-picking. The main premise of Five Minute Investing is that without a well-conceived plan, the psychological makeup of most individuals will lead them to make emotional, and mostly bad, decisions. So the emphasis in the book will be on making nearly no subjective decisions. This book gives the average investor a plan to use for managing both the individual stocks in his/her portfolio, and the portfolio as a whole. It is the best blend of risk, reward, and time commitment of any strategy I have seen or used. 
While the subject of stock-picking has been addressed in many writings, the one in Five Minute Investing requires little or no time in reading annual reports, financial analysis, and the usual host of activities that most investors commonly associate with picking stocks. Because some of the ideas are unorthodox and run counter to popular belief, it may take some faith on your part to accept them until you see that they work under real-life market conditions. I have devoted the first few chapters of this book to addressing myths and misconceptions, because if you are going to change your investment results, you must first change your way of thinking. These first chapters lay the conceptual groundwork for the strategy and stock-picking criteria developed later in the book. Please check at the door any preconceived ideas about how to be successful in the stock market and try to keep an open mind. 
Five Minute Investing requires a longer-term commitment to the stock market. This is a book on stock trading, but not a book on short-term stock trading. That is, stocks are eventually sold but we attempt to hold onto a position for as long as possible - hopefully many years. Most books tend to focus on either how to pick stocks or how to trade them once you've picked them. Often, they are collections of subjective rules of thumb which require years of investment experience before the techniques can be applied with any degree of confidence. This book, on the other hand, will give you a simple, unambiguous method for not only picking winning stocks but also for managing your portfolio. 
The Reverse Scale Strategy - the portfolio management technique which is developed in Chapter 7 - will work with virtually any type of stock portfolio, but it gives you your maximum advantage when applied to growth stocks. Using the stock-picking approach suggested later in the book will result in your portfolio being packed with timely, high-potential stocks and these stocks can easily be selected in a half-hour or less. 
The term "growth stock" is sometimes taken to mean "stocks of small companies," but that is not what I mean by the term. My definition of a growth stock is a company that is growing rapidly in market value. There have been long periods of time when the return on larger companies has outstripped the returns on small companies. There have also been many periods of time when the opposite has been true. So, both large and small companies can be growth stocks in their season. Whichever the case may be at any given time, the stock-picking section of Five Minute Investing will lead you to them. 
Finally, in every case I have tried to avoid the use of confusing financial and stock-market jargon commonly found in books on this subject. My personal feeling is that these types of terms are not well understood by the public and make the world of stock investing seem like alchemy. The emphasis here is on keeping things simple. Because of the simplicity of this strategy, no computers are required for implementation of anything in this book. This will not be the most complicated or scholarly book on stock investing you have ever read, but it will be one of the simplest and most practical. Simplest is best, especially if simple works. Why complicate things unnecessarily? 
Summary of Objectives 
To summarize, this book is designed to show you a plan for investing that is simple yet complete - one that I have used with a high degree of success for years. Five Minute Investing will allow you to successfully navigate the two main chords of stock investing - stock selection and portfolio management, and also: 
• Understand what you are doing and why you are doing it. 
• Have no need for market gurus, full-service stockbrokers, newsletters, advisors, and the like. 
• Avoid the most common mistakes and fallacies of investing. 
• Be able to sleep at night, because your risks will be tailored to fit your level of risk tolerance and confidence level. 
• Have confidence that you will never enter into a trade without having an exit plan that covers every possible outcome of that trade. 
• Enable a busy person to manage an aggressive stock portfolio in five minutes per day with the peace of mind that comes from having a plan. 

Chapter 1: Replacing Stock Market Myths  In the Introduction to Five Minute Investing, I mentioned that the ideas and approaches developed in this book would be unorthodox. In this chapter, I hope to point out and correct a few of the popular myths that abound in regard to stock investing. There are many more that exist, of course, but I've attempted to identify and address the most destructive ones. Please study this chapter carefully, and feel free to test any of the assertions I make in the laboratory of the market. Debunking these myths and replacing them with concepts that are closer to the truth is foundational to understanding the rest of the book.  Myth #1: The stock market is a form of gambling  Perhaps at the heart of many other stock market myths is the idea that investing in stocks is a form of gambling. Remarkably, I recently heard someone who was introduced as an "economist" say as much on a national radio news broadcast! As of this writing (1995), some of this myth has been dispelled by the relatively steady returns enjoyed by investors is recent years, versus the up and down markets experienced during the 1970s. Still, many folks consider stock investing to be fundamentally different than investing in bonds, certificates of deposit, and other more-predictable investments.  To understand why stock investing is inherently different than gambling, first we need to review what common stocks are. In the most basic terms, a share of common stock entitles the owner of that share to a fraction of what is left over after all other stakeholders in a business have been paid. So, the firm takes in revenue from customers in return for the firm's product, and with that revenue pays for raw materials, employee wages, energy, supplies, and pays interest on borrowed funds. Whatever is left over, if anything, belongs to the holders of the firm's stock, who are essentially the owners of the firm. Depending on business conditions and how well the company is managed, the amount left over for the shareholders can be very large, very small, or even negative.  It is obvious that the common shareholders see more variability (risk) in what they take home than bondholders, raw material suppliers, employees or anyone else involved in the operation of the firm. The common shareholder stands last in line to be paid, and because of this additional risk the shareholder demands a higher expected return than does the bondholder. In the stock market, investors are constantly trying to assess what will be left over for the shareholders both now and in the future. This is why stock prices fluctuate - because the outlook for business conditions are always changing, and what will be left over for the owners of a particular firm is always changing too. But, one thing is for sure: common shareholders expect their returns to be volatile, but they also expect them to be positive and permanent over the long run - and higher than the return on bonds, treasury bills, or other less risky investments. That is, the shareholders don't expect to give up all their gains - despite the fluctuations in value, the returns at some point become permanent. For as long as common stocks have existed (hundreds of years), this expectation has been met: Stocks have had their ups and downs, but have trended steadily higher in value over the years. And, they have increased in value at a faster pace, on average, than dollars invested in more predictable vehicles such as bonds or treasury bills.  It is this steady upward progression in the value of stocks that sets them apart from gambling in a major way. You could buy a set of stocks, and hold them for the rest of your life. Although they would fluctuate in value over your lifetime, chances are they would greatly increase in value during that period of time. However, no other person would have lost money simply because your portfolio of stocks gained in value. This is not true with gambling. In gambling, every dollar won is a dollar lost by someone else. It must be this way because gambling produces nothing, creates nothing, and therefore can only return to a winner what it took from a loser. The value of common stocks increases without taking wealth away from anyone; in fact when the stock prices increase, the amount of aggregate wealth increases for society as a whole. This is because common stockholders do produce something: They postpone the consumption of goods (ie, they save some portion of their income ) in order to supply the seed capital needed to buy production equipment and produce goods. They get the ball rolling, so to speak, for firms wishing to produce goods.  Here is another fact which highlights the vast differences between gambling and stock investing: When gambling, the longer you stay at the gaming tables, the more likely you are to walk away a loser. In the stock market, the longer you stay at it the better chance you have of coming away a winner. In fact, if you buy and hold a well-diversified portfolio of stocks, you are virtually assured of making money eventually. Of course, many people do lose money in stocks, but only because they fritter their capital away with excessive or ill-founded trading strategies.  Every stock investor needs to know why investing and gambling are two totally different pursuits. Once you realize this, it will give you confidence in pursuing a long-term plan for investing and will make you less prone to the destructive forces of fear and greed.  So, the two facts to retain regarding myth #1 are as follows:  Gambling transfers wealth from a winner to a loser because it produces nothing. Investing increases overall wealth because the capital invested in stocks provides the initial funding for firms which exist for the purpose to producing goods and services.  The value of stocks trends steadily upward over time. They do not seesaw back and forth in the same range forever. In the aggregate, stock investors demand and receive a return that is substantial and permanent.  Myth #2: Stock Market Predictions are the Key to Successful Investing  One of the greatest popular myths about investing in stocks is that in order to be successful, you must be able to predict the stock market's movements. Why do people assume this? For some, it is because they do not understand that stocks give a positive and substantial return over time - they falsely assume that stocks bounce around in the same range forever, and they therefore conclude they must predict movements in order to be able to sell at the top of the range and buy at the bottom of the range. For others, the desire to predict is borne out of human nature, which puts a premium on certainty. We love to know what will happen in advance. Hence, it is usually assumed by the beginning investor that to be successful, one must first become an expert at forecasting future market trends. Experienced investors know, in fact, that nothing could be further from the truth.  Some icons of Wall Street love to advance the cause of market predicting, because they are paid to predict these movements. Others simply humor their clients who are looking for market projections because they know that it is easier to give them a projection than to try to correct the clients' thinking. For instance, nearly every retail brokerage firm has a chief economist or market strategist whose main responsibility is to predict the climate for stocks. A large number of books, advisory services, and such that are sold focus themselves almost exclusively on prediction of how the stock market in general will perform in the future. But in truth, the best way to make money in the stock market is to avoid approaches that rely on market predictions. This will most likely seem an odd or even a absurd statement to some, perhaps most. Yet, any serious review of the results of market gurus over a long period of time reveals a track record that is no better (usually worse than) a simple buy-and-hold strategy.  Don't misunderstand me: There is no doubt that if a person could accurately predict the short-term fluctuations of the stock market, that person could far exceed the return of someone who simply bought a basket of stocks and sat on them. However, the one fatal problem with this is that there has never been a single person who has figured out how to do it. Nearly all market advisors claim to be able to call the market's every turn, but in fact every credible study ever done on the subject has proven that these claims are invariably false. By far, most market prognosticators significantly underperform the market, despite their universal claims to the contrary. Given the large number of market gurus that now exist, the laws of statistics dictate that some of them must beat the market, out of pure luck if nothing else. However, they lack the ability to repeat this performance from one time period to another, and the group of market beaters will usually be a different group every time period that is sampled. If you could predict which guru would be right for the next year, you would be in good shape. But, of course, it's just as hard to predict which guru (or which dart board) will be right for the coming year as it is to accurately predict market conditions. Finally, even if we are generous and assume that there is some market forecaster out there who has the holy grail of market prediction, our chances of being able to sort him out from those who simply got lucky are pretty slim.  As of this writing, the market prognosticators who are most successful over the past ten to fifteen years are those who have been perpetually bullish. Although we all get bearish once in a while, we do best when we keep our bearish feelings from affecting our actions. Therefore, I recommend that you feel free to have your opinions about where the market is heading, but always invest as though the market is going higher. Over the long run, you will be better off than if you had jumped in and out of the market. Of course, you have to exercise some caution in having an optimistic viewpoint; the best policy is to only invest money that you can afford to be patient with if the market stalls or backtracks. If you take out a huge mortgage on your home with the expectation of investing it for a quick payoff, you are tempting fate and your emotions of fear will almost certainly cause you to fail.  If results are any indication, the conclusion must be that market forecasting is prone to failure. One of the purposes of this book is to free you from the compulsion we all seem to have to predict future market trends.  An alternative mindset to the prediction game  If we are not going to spend our energies wondering where the market is going, then how can we succeed in the stock market?  The key is to develop a method which will react to events as they occur, and will ensure that our returns are as good or better than the returns on the general market, whatever those market returns may be in the future. We can essentially ignore what "the market" is doing - or especially what it is forecasted to do in the future. We own our particular set of stocks, not "the market." What we really need is a method which concentrates on how our stocks are actually doing, as opposed to how they will do in the future. We own our portfolio of stocks. The Reverse Scale Strategy is such a method and will be developed later in this book once its theoretical underpinnings are explained.  If you just can't help yourself...  As most investors eventually learn, market prognosticators are notoriously inaccurate. If you already know the futility of market forecasting but feel that you simply must predict the market, I will reveal at this time how you can be as good as the best market gurus in predicting the market: When you get up each and every morning for the rest of your life, make this astonishing prediction: "The market will be up today." If you make that your prediction every single day you will be as accurate as some of the best people in the field of economics, having achieved a long-run accuracy of about 60%. Despite people's fears of bear markets, the market spends most of its time advancing, not declining.  In the long run, a good investment strategy that doesn't rely on prediction will beat a market forecasting strategy.  Myth #3: What goes up must come down  The statement "what goes up must come down" is certainly true in the natural world, and it's often assumed to be true in the world of investing as well. I will attempt to convince you that this assumption will lead you to make some pretty significant strategic errors in your investing.  If you refer to the conclusion from Myth #1, you will see that in the aggregate, stocks trend upward over time and at some point, they advance to the point where they will never again return to their previous levels. As we have noted previously, stock investors demand a permanent return on their investments, just as investors in other types of assets demand a permanent return on theirs. A good high-profile example of this is the Dow Jones Industrial Average, which is now at about 5,000. In the 1930s, it was around 50. I do not expect to ever see it at 50 again. So, from here the Dow may dive to 3,000 or it may continue advancing, but there is a certain point below which it will never again dip. So, certainly the gains enjoyed by shareholders up to Dow 2,000 or so may be considered "permanent." At some time in the future, the gains up to Dow 5,000 will also become permanent as the market will at some point dip to the 5,000 level for the last time. Naturally, there is no way to tell when that will occur.  Certainly, some individual stocks do go up rapidly, then give back the entire gain just as rapidly. All seasoned investors have had this disappointing experience. However disappointing it may be to have a good profit going and then see it evaporate, do not let this bitter experience lead you to believe in taking profits too quickly. If you do, it will cost you the really big gains, in the long run.  If you think about it, the fact that the entire stock market marches higher, often never to return, then there must of necessity be some individual stocks that also advance without returning to their previous lower price levels. In fact, this is the case more often than not. Even so, the average person commonly expresses the belief that when they have a profit going they should take the money and run - often leaving a lot of money on the table when they do.  Of course, the grain of truth in this myth is the fact that any stock trend consists of a series of advances and retreats, resulting in a net increase over time. So if you are going to believe the statement "what goes up must come down," then keep in mind that it often happens that a stock moves way, way up, and then comes down just a little. Think of it this way: If a stock increases tenfold in value and then undergoes a 20% correction, we are still ahead by eight-fold.  Given enough time, stocks of individual companies often make substantial price progress over time, and sometimes with no major pullbacks in price. As an example, following is a listing of stocks whose prices increased remarkably over a period of recent years:  Stock Price Move Time Period Percentage Gain  Fastenal $7/8 to $38 1987-95 4,242%  Linear Technology $2 1/8 to $38 1989-95 1,688%  Jupiter National $3 1/2 to $27 1991-93 671%  Mid-Atlantic Medical Services $2 3/8 to $27 1991-94 1,078%  Micron Technology $3 to $95 1992-95 3,066%  There are many, many others. Obviously, these are the types of stocks you want to find and hold onto. You won't find them often, naturally, but eventually you will find them if you use the stock selection criteria in Chapter 4.  It's educational to note that all the above listed stocks spent a lot of time on the daily new-highs list while they were increasing in value. The new-highs list is published daily in most financial newspapers. It is a list of stocks which traded above their previous high price for the past 52 weeks.  Linear Technology, as an example, hit a new 52-week high on 1/3/90, at $2 3/4. It topped out (so far as of this writing) at $45 5/8 on 11/9/95. There were 1,491 trading days between those two dates, during which Linear Tech appeared on the new-highs list 157 times, meaning it made it onto the new-highs list about once every two weeks, on average. During those 1,491 trading days, Linear Technology did not appear on the 52-week-lows list even once. Yet, incredibly, many people go to the new-lows list when prospecting for stocks! They ignore the new-highs list, assuming that the stocks listed there are "too high." In so doing, they decrease their chances of finding the next Linear Technology from pretty good to almost nonexistent.  Just because a stock has had a large increase in price does not mean it cannot increase further. Stocks which are hitting new highs often continue making additional new highs in price.  Following is a chart of Linear Technology's price trend from 1989 to 1995:  With this chart in front of you, it is an excellent time to rid yourself of another popular strategy often heard on financial talk-shows and in investment newsletters, namely: "Buy good stocks on pullbacks." As you can see from the chart of Linear Technology, many of the best-performing stocks do not have significant pullbacks while they are increasing in value. So, by waiting for a good stock to pull back, you will most likely doom yourself to sitting on the sidelines while a stock makes a tremendous move upward, without you. When it finally does have the pullback you've been waiting for, that may be the beginning of the stock's demise.  Once a good performing stock has been identified, don't wait for a pullback in price before taking your position. In the long run, this will cost you more in profits than it saves in losses.  Myth #4: What goes down must come back up; or Buy low, sell high.  This myth is the granddaddy of them all. In the subject of investing, probably no more destructive misconception has ever been conceived than the idea of buying low and selling high. Whatever the reason for its appeal and widespread popularity, no myth is more pervasive among amateur investors. The emotional appeal of this myth leads investors to commit many of the most grievous errors listed in Chapter 2 on the most common investor mistakes.  Stocks make all price movements in trends. Sometimes these movements are small, sometimes huge. Given enough time, most stocks eventually have some large price trends which develop. Although most people know this, few take the time to realize the implications of it. As will be covered later in this book, one of the most common investor mistakes is to buy stocks that are "down" in price. The common assumption is that if a stock has gone from 40 to 10, it is somehow more likely to get to 40 again than is a stock that has gone from 4 to 10. They are both at 10, but the majority of novice investors assume the stock that is "down" in price will be a better bet than one that is trending upward. This is exactly the opposite of the truth!  If you are to succeed in the stock market, you simply must eradicate from your mind the appeal of buying declining stocks!  Think about this: If a stock is destined to go from 5 to 100, it of necessity must pass through 6, 7, 8, 9, 30, 50, 80 etc. to get there. It does not have to (necessarily) pass through 4, 3, 2 or 1 on its way to 100. This is why picking stocks that are trending upward in price gives you a better chance of finding timely, winning stocks than buying stocks in a declining phase. Why then, do most beginning investors tend to choose stocks that have declined in price, rather than choose ones that are at all-time highs? Simply put, because they "feel" safer buying a stock that once sold for a higher price. This false sense of security has led many investors to the poorhouse over the years.  Most investors will find it useful to study a long-term chart book in order to get a feel for how stocks make large price moves. Some good references for doing this are Long-term Values, published by William O'Neill and Co, and the Value Line Investment Survey. As you study these long-term charts, note just how many stocks have made 300-1000% moves. You will find that such moves are not at all uncommon, and some of them happen in an almost uninterrupted manner. Sometimes, stocks will even make more stunning moves of 2000-3000% over longer periods of time. It is inevitable that any stock in an uptrend will have periods of correction (short-term pullbacks in price), but most often there are some long trends where pullbacks do not exceed 30% of the stock's peak price.  Study the price chart of a stock that has had a large (four to ten-fold) increase in price and note carefully just how many times this stock made a new all-time or at least a 52-week price high. From this you should learn that someone who is afraid to buy (or hold onto) stocks making new highs would automatically guarantee that they will never reap the benefits of large price moves. And yet, it is only by owning these very strong stocks that the true profit potential of stock investing is realized. By studying the way in which price trends occur, you will give yourself confidence to hold onto your winners rather than succumbing to the temptation to sell your winners to 'lock in' profits. This is why trading strategy (or the way you manage your stock picks) is just as important as which stocks you pick.  It is impossible to reap big profits from the stock market unless you are willing to buy and hold onto stocks that are making new all-time highs in price. Further, stocks that are at new price highs tend to do better than those making new price lows.  Eventually, everyone finds stocks that will ultimately turn out to be big winners - but not everyone ends up profiting from them. It is your trading strategy that will determine whether or not you reap the benefits of the winners you find.  Valuation measures  If you are to make really big money in the stock market, resign yourself to the fact that just about everything you buy, if you are buying stocks correctly, will seem too high priced by just about any traditional measure of valuation. This is because traditional measures of a stock's value generally are of little usefulness in circumstances where earnings are growing very quickly. Use of these measures as stock selection criteria often misleads investors into buying stocks that are declining in price. For instance, Price/Earnings (P/E) ratios are a commonly misused measure of a stock's attractiveness as an investment. Many investors try to buy stocks that are selling for very low P/E ratios, meaning that the stock is selling for a low price relative to the previous year's earnings. They believe that if the stock is selling at a low P/E ratio, then the stock must increase in value. This approach to selecting stocks is flawed because it assumes all companies have roughly the same future earnings growth prospects. However, the reality is that companies have vastly different outlooks for growing earnings and that is why the market rightly assigns a low P/E ratio to some stocks and a high one to others. There are companies which grow earnings at 2 to 3% per year for years and years on end. There are also companies which grow earnings at 20 to 30% per year over many years. It is absurd to assume, as proponents of a low-P/E ratio strategy do, that a company which is positioned for high growth should be priced the same as a stodgy company in a shrinking industry.  Another popular but flawed concept which leads investors into buying stocks which are declining is the practice of purchasing stocks which are selling for a low price relative to "book value." Book value is calculated by taking the value of the assets owned by the firm and subtracting out any debts the firm may have. There are three problems associated with using this calculation as a investment screening parameter:  1. Book values as calculated by accountants often bear no resemblance to the real value of assets on the balance sheet.  2. Firms which are selling for a low price relative to book value are selling for a low price for a very good reason: these firms invariably are earning a very low return on their assets. After all, the value of a firm's assets really do not matter; what matters most is what the firm can earn on those assets for their shareholders. A person looking for low prices relative to book value forgets that most firms which are earning substandard amounts on their assets generally keep on earning low rates of return.  3. Much of the earning power of a firm is determined not by physical or financial assets, but instead by the abilities of the people working for the firm (human capital) and by the position of the firm in the market it serves. Book values capture none of this and thus ignore completely the most critical assets which a firm possesses.  It is best to avoid stocks that are declining in price, even if they have financial measures which appear to make them good values.  Stocks that appear to be cheap by financial measures and are falling in price tend to keep falling, and what seems too expensive and is rising in price tends to keep on rising. Chapter 2: Things to Avoid  Building upon the last chapter, we are now ready to explore and face the mistakes that nearly every beginning investor makes. Do not skip over this or any other part of the book because you need to be aware of these mistakes. Otherwise, you may spend years learning these lessons the hard way. Practicing these errors versus not practicing them makes a very large difference in your rate of return, not just a small difference. Generally, in fact, it will make the difference between a large positive rate of return and a large negative rate of return. Obviously, there is a relationship between the investor myths of the last chapter and the errors reviewed here. Each of these mistakes is traceable to the myths. As was said earlier in the book, if you are to change your investment results, you must first change your thinking. If you have read and understood what's been written so far, you are well on your way to doing this.  Mistake #1: Not having an exit plan before buying  No matter how well or poorly founded, every stock selection strategy produces both losers and winners. In the case of both losers and winners, the reason for selling a stock is always the same: To preserve capital and allow you to redeploy it to more profitable investments. The relevant question is, "how to determine the right time to sell?"  The time when you can think most clearly about why you would eventually sell a stock is before it is purchased. Before you buy anything, you have no emotional attachment to it, which means you can make totally rational decisions. Once you own something, you tend to get either greedy or scared. These emotions lead to a desire to preserve profits, leading to prematurely cutting off an ascending price trend.  How not having an exit plan hurts your performance  Big losses are one thing which destroys most investor's performance, and these are almost always a direct result of the investor failing to plan, before entering a trade, how he will exit it. Since the potential gains from a stock are always higher than the potential losses (100% loss potential versus unlimited upside potential), an even bigger source of under-performance is selling too soon when you do find a great winner.  An exit plan is one thing that experienced investors/traders always have before initiating a position. The reason is simple: you must have a plan and stick to it, or else every decision you make will be emotional, not rational. Worse yet, the larger the position is, the less rational your decision-making will be. Therefore it is vital to make all decisions up front, before you are scared (if the position happens to go down), or greedy (if it soars). Emotional decisions almost always are poor ones, leading to large losses and small gains.  The pitfalls of trying to manage a stock portfolio without a plan are many and varied. The advice of friends, stockbrokers, market advisors, and the like are all likely to have a magnifying effect on the natural elements of fear and greed that are present in every investor. These influences can cause someone who does not have a well-thought-out plan to abandon profitable positions and hang on to losing ones. This is exactly why the majority of amateur investors under-perform the market: they do not have a plan. As the saying goes, "when you fail to plan, you plan to fail." This saying is as true in the stock market as it is in any other aspect of life.  With emotions running rampant from a loss or a large gain, it is virtually impossible to make a good decision. This is precisely the point at which most investors fail: They have no preconceived plan for exiting a stock before they buy it. As a result, when they hear a tip or rumor on a stock they get so excited that they forget to ask themselves what they will do if it turns sour, or if it soars, what will be their plan for letting the profit ride? If the investor who doesn't plan ahead also happens to believe some of the myths presented in Chapter 1 then his/her chances of making a good decision are almost nil. If you are a decision-maker of any kind, you no doubt realize that making decisions based on wrong assumptions renders your chances of success to be minuscule. For this reason, the need for an exit plan based on sound theory before a stock purchase cannot be overemphasized. Unfortunately, most investors don't want to think about planning ahead, (especially for adverse possibilities) when they are buying a stock - they put the selling criteria decision off until it is unavoidable, and usually too late.  An exit plan must be identified for every investment before the investment is made. This plan should cover all possible outcomes of the trade, both profit and loss.  Mistake #2: Plunging too much into a stock all at once  Another common error committed by many investors is plunging. This means that the investor makes two mistakes: First, they purchase entirely too large a position in a single stock. Secondly, they do it all at once. The real problem with doing this is that the investor puts themselves in a perfect position for their emotional decision-making to run wild. Typically what happens is the following: First, the plunger takes a huge position. Then, his stock either begins declining or increasing. In either outcome, the emotions of plunging work against the poor investor. For if the stock declines, the plunger will either get scared and sell out with a loss that is a sickening percentage of his capital, or hold on in hopes of an increase in value (which may well never happen). If the stock increases in value, the investor will often have a large dollar gain that is hard to resist cashing in. In this latter case, the investor makes the mistake of cutting his winnings short. In short, plunging leads to cutting your potential gains short and letting your losses keep mounting...exactly the opposite of what you should be trying to accomplish.  Almost always, the plunger lacks an exit plan for the purchase before buying. If the plunger had thought about an exit plan beforehand, he probably would have realized the potential pitfalls and would have taken a more appropriately-sized position.  Plunging can work occasionally if one is fortunate enough to select a stock that immediately increases in value and never looks back. However, in most cases the plunger has such a large percentage of his capital riding on a single stock that the emotions of greed and fear work against him in a major way. The normal fluctuations of stock prices have an exaggerated effect on the plunger's emotions by virtue of the huge amount of capital represented by the position.  Taking too large of a position leads to emotional involvement which leads in turn to poor decisions. It also exposes you to the potential for lots of damage from one bad trade. Diversify - don't bet the farm.  Mistake 3: Failing to cut losses  A certain percentage of stocks you choose will show themselves to be losers. Count on this fact. These losers must be dealt with in some way in order to limit their impact on your overall performance. Once a stock starts to decline it can become a vicious cycle, leading to even more declines. As unbelievable as it seems to the novice investor, the more and longer a stock declines the more it is apt to continue declining, or continue going sideways.  Even if a stock does come back, it will likely take a long, long time to do so, and time is money. For this reason, it is important to stop the bleeding once it becomes apparent that you have chosen a loser. Here as elsewhere, the actions of most investors are opposite the logical course of action. Most hold on to their losers, hoping against hope that the stock will someday pull itself together. Some also hold on because they can't face up to the fact that they made a mistake. They reason (poorly) that as long as they don't sell, then they haven't really lost anything. This is a error because the value of their stock is the current market price, not what they paid for it - but their rationalization helps them feel better about themselves. The driving force behind this type of thinking is dealt with in Chapter 3.  The other compelling reason for selling losers is the concept of opportunity cost, that is, the money you could have made by redeploying your capital to a more promising investment. Often, the opportunity cost of holding a losing stock is far greater than the loss on the stock itself. Let's say we have $10,000 invested in a particular issue and it declines to where it is worth only $8,000. There are two reasons to consider selling the stock in this example. First, the stock is clearly in a downtrend, and like most trends, the decline is most likely to continue. If it does, the decision to sell may save us as much as $8,000, the current market value of our stock.  The second reason for considering cutting our loss short is that by redeploying the $8,000 into a stock that is trending upward, we increase our chances of making up the $2,000 loss more quickly than if we'd continued to hold the losing stock, waiting for it to come back. The distinct possibility exists that we could make up the $2,000 loss and make an additional $8,000 profit by redeploying our capital from the declining stock to the ascending one. All the while, the original purchase may still be languishing far below where we dumped it. While there are no guarantees that the ascending stock will continue ascending, it is a much better bet statistically than the declining one. In the stock market, going with the long-term statistics is a key to long-term success.  Beware of the common compulsion to hold onto your losers. If you do succumb to this temptation, your portfolio may still be profitable (as long as you also do not sell your winners), but it will not be as profitable as it could be.  Mistake #4: Selling too soon  Another error that cuts seriously into many investors results is the error of selling a winning stock too soon. Though it might seem that this is a relatively minor problem, it actually is a very serious error because it robs you of your really big profits. I believe it is a bigger mistake than failing to cut your losses, because in a properly diversified portfolio the potential profit from any one stock is far more than the potential loss. That's simply another way of saying that the most you can lose on a single stock is 100% of what is invested, but the potential gain from every stock is unlimited. If your objective is to make as much money as you can, then you must put yourself into a position to hold onto really big winners when they come your way. If you have a strategy that emphasizes taking the money and running every time you get a double or triple, then you are seriously shortchanging yourself.  Think big  I believe the reason most investors fail to hold onto winners long enough is that they simply do not realize how big a move can sometimes be realized. They wrongly assume that if a stock has doubled or tripled then that is about the best they can hope for. However, investors who take the time to study the history of stock trends know better. Sometimes a stock that has doubled will go on to make another tenfold increase from there. It can (usually does) take years for this type of move to occur, but over a several year time frame your chances of finding a huge upward trend is far better than you'd think. Again, the best way to convince yourself of this is to get a long-term stock chart publication and start studying it.  Price Objectives  Another insidious reason for investors selling too soon is the use of price objectives. This is when you buy a stock and set a price that you will sell at if and when the stock makes it to the target price. These target prices are usually arrived at as a certain percentage above the entry price, or else are based on some analyst's assessment of the 'value' of the stock.  However arrived at, I feel that the use of target selling prices is a seriously flawed practice. One of the enigmas of the stock market is the tendency for what seems overvalued to keep going higher still, and what seems reasonably valued or cheap to keep on retreating. The reason is that when a company's earnings are (or are about to start) growing rapidly, the price of the stock may be high relative to the current earnings, but only a few times the next year's actual earnings, if next year's earnings could be known. The stock may even be selling for many times the earnings estimate for next year, because it takes time for good trends to be recognized and assimilated by stock analysts. Thus, stock analysts' earnings estimates for coming years tend to lag when something good is brewing, just as they often lag when bad things are in the works. The thing to remember about this is that the aggregate consensus of all market participants (as reflected in the stock's price trend) tends to be more accurate and more timely than published earnings estimates.  If you study stock trends I believe you will come to the conclusion that the trend of a stock is a more accurate indicator of when to sell than are calculated estimates of a stock's alue.' Why then are price objectives used? The reason they are so popular is because of the need for retail brokerage houses and newsletter writers to give some sort of selling advice to large numbers of retail clients. Through the use of price objectives, the task of giving advice to large numbers of people is made manageable for the advice-giver. However, it seldom results in the best possible outcome for the client. This is a good reason to become your own investment advisor and portfolio manager. The use of price selling targets mostly results in you capping your profits, as you cannot possibly make more of a profit than that which is reflected in the target price. Finally, it should be obvious to all that capping your profits is not a good thing. If you employ a strategy which cuts your losses but also caps your gains, by definition you'll be worse off than if you had bought your stocks and done nothing but sit on them forever.  Don't try to guess how far a stock can move up. If you do not give your stocks a lot of room to move upward, you will guarantee that your stock market profits will be below average.  Mistake #5: Choosing stocks that are in a downtrend  Buying stocks which are in a downward price spiral is the most common mistake among novice investors. In order to profit from such a strategy, you need to be right about two things at once : First, that the stock's slide will end (a surprising number never do until they become worthless), and secondly, the timing of when (and at what price) the stock's slide will end. Your chances of being right about both things are slim.  The typical scenario for this particular mistake is an inexperienced investor scouring the stock pages looking for stocks near their 52-week lows, since this information is readily available. The novice wrongly assumes that if a stock is near its low for the year then it must be "low" and therefore in an opportune position to be bought. As we have seen, the hapless bottom-fisher finds out after it is too late just how easy it is for such a stock to keep on making new (and even lower) 52-week lows.  As an aside, it's interesting to note that it's fairly common that a stock which is today making a new 52-week high has as its 52-week low a price that was a 52-week high. Chapter 3: Know Yourself  As you have probably seen by now, the emotions and predisposition's we are all imbued with tend to work against us in the world of aggressive investing. Often to succeed in this business we need to develop the ability to do exactly the opposite of what our emotions are telling us. To do this effectively, it is necessary to ferret out the real reasons why we are investing in the first place. While make money' is likely the obvious reason, in reality there are myriad reasons why we try our hand at stocks. These range all the way from the money objective, to wanting to feel good about ourselves, to garnering the respect of others. These are at least as strong as the money factor, and when you think about it, money is usually the means for achieving something else - like respect, etc. Only misers want money alone. From a practical standpoint, we are all a mixture of these reasons and more. Therefore, if we are to succeed, it may be helpful to know what our own true motivations are. Whatever your reasons for wanting to succeed at stocks, you simply must learn to keep your ego in check because it is the one thing that will lead you to make the wrong moves. I cannot psychoanalyze you, but I offer this chapter as a means for you to psychoanalyze yourself.  My way of illustrating the motivations of investors will be to study the two basic types of investors. One of these is an extremely humble fellow, who does not care much about whether he is viewed as smart or ignorant by his acquaintances, but he does what he needs to do in order to optimize his investment results. The other is a proud person who cares primarily about his image in his own mind and in the minds of others. Swallowing his pride to increase his investment results is out of the question for him.  There is a little bit of both persons in each and every one of us. Before you embark on any investment approach it is best to search yourself to see which elements are present in yourself and attempt to root out the attributes of the ego-driven investor and bolster the characteristics of the results-oriented investor.  The ego-driven Investor  The ego-driven investor sees investing as something exciting. He mostly does it as a way to garner the admiration of others. He may also see it as entertainment. He is constantly talking about this or that great deal, imagining that others will stand in awe of his prowess and immense wisdom. In reality, he most likely does not really make too much money in the stock market, a fact which he hides from the outside world by any means possible.  Worst of all for the ego-driven type, he never gets any better at his investing. To admit he has been doing something wrong, even to himself, is more than his sensitive ego can take. Since the aura of being an investment wizard is simply a way for him to gain affirmation from others, he really doesn't care too much whether the results are there as long as he can still stay in the game and keep talking about his smart deals at cocktail parties. Of course, he conveniently forgets the bad ones and keeps turning over in his mind his best deals and how smart he must be. He certainly never does a post-mortem on any of his losing trades to figure out just why they were losers. He simply blames the loss on his broker, the company's management, or stock manipulators. He can't ask anyone what he may have done wrong, since to admit he's made a mistake to someone else goes directly against the grain of his objectives - to appear wise to others.  One way in which our friend Mr. Ego deals with losses is by stubbornly holding on to his losing trades, no matter how bad they get. He reasons that until he sells, he hasn't really lost anything, so why sell? Never mind that his broker sends him statements every month telling him that his account value has dwindled - he really has lost money -whether or not he admits it or not. In this way he assures himself that he can never really redeploy what's left of his capital into something more promising.  The ego-driven investor doesn't enjoy buying a stock that has already doubled in value, even if it could increase another 1,000% from there. The idea that someone else was "smarter" than him and bought at a lower price is more than he can bear thinking about. On the other hand, he dearly loves to buy stocks that are in a downtrend because there is a chance that he will be the one who will buy the stock at its low for the year. Imagine what bragging rights that would give him! Of course, most of the time he buys these types of stocks and they just keep going down, down, down. But that's OK, as these deals are unknown to anyone in his circle of friends. The prospect of that unlikely but alluring "buying the bottom" scenario keeps him coming back for more - losses, that is.  Even when he does get lucky and happens to stumble into a winner, Mr. Ego is his own worst enemy. He waits until the stock hits a new high for the year and then promptly sells out to lock in his profit. Of course, this stock was in an uptrend and keeps right on sailing far above where he exited. That's OK by Mr. Ego, though: he now has a profit that can be exaggerated the next time he sees his friends. Will they ever be impressed!  Thus, the ego-driven investor's strategy is complete: he always holds onto his losing stocks and when something starts to go right, he bails out faithfully. He has plenty to talk about at parties, but there is no way he can ever make a decent profit. The real tragedy is owed to the fact that since he blames others for all of his problems, he will never get any better.  The results-oriented Investor  The results-oriented investor seldom talks with others about his investment results. Really, he is too busy trying to make his results better. He is never too proud to buy a stock that is making new highs, realizing that those who are buying the stock most likely know far more than he does - and a winning company is more likely to keep on winning than a losing company is. The fact that someone else was smarter and bought at a lower price does not worry him; it is against his nature even to have such a thought occur to him. He is far too focused on trying to pick stocks that are performing well to entertain these types of thoughts. He compares his performance against others' performance only as a means of learning and getting better.  When the results-oriented investor finds himself with a stock that is zooming ahead, he holds on, letting the stock continue to do well for him. Conversely, when a stock stumbles badly enough that his predetermined plan says it is time to exit, he acts in an unhesitating manner. He follows his plan for buying and selling whether that means selling at a gain or at a loss. He also never sells a stock as it is making a new high, since his concern is not in selling the top but rather in letting his winning positions run their course. He does not mind selling a stock after it has retreated 50% in value, if being patient through price corrections is what allows him to capture the occasional 1000% gain.  One big difference between the results-oriented investor and the egoist is what he does with losses. While Mr. Ego blames others and learns nothing, the results-oriented chap studies in great detail how his loss occurred, and eventually figures out the fallacies in his thinking and/or system. Therefore he always gets better and better at what he is doing. He even keeps a notebook on each loss and records what he could have done better.  Don't forget why you are investing: To make money. If you have any other reason for investing, find another pastime. Chapter 4: Stock Picking  Stock investing is something that has been made out to be far more complicated than it needs to be. There are far more complicated approaches to stock-picking than those presented in this chapter, but the guidelines presented here will result in 95% of the results of those approaches with only 5% of the time, effort, and confusion. Since the name of this book is Five Minute Investing, I have chosen to build these guidelines in such a way as to minimize your time commitment while helping you avoid the investor mistakes outlined in previous sections.  1) Look for positive price momentum  Most investors search diligently for companies where some good situation is developing - and rightfully so. They do this by asking brokers, looking for stories in the press, etc., but few stop to realize that the stock market itself gives them a list of such companies every day in the form of the new 52-week highs list. Most likely it's because they have believed some of the misconceptions dealt with in Chapter 1 and wrongly felt that if something appeared on the new-highs list, it's too late to buy. Actually, nothing could be further from the truth.  The simplest, best way to assemble a list of potential high performers is to refer to this new 52-week highs list included in just about every financial newspaper. I highly advocate that investors begin their stock picking expeditions by referring to this list. Remember that companies on the new-highs list do not get there because a certain financial reporter likes them, or because the government thinks they are good for society, or because a brokerage firm will get a hefty commission if the stock appears there. Stock market investors themselves who are knowledgeable about the company in question put them on the list by voting with their own hard-earned dollars, bidding the price up to new highs. Stocks do not appear on it unless there is something in fact really good and tangible happening with the company's prospects. Furthermore, few good situations develop in one day; they develop over many weeks, months, or years. So, many of the uptrends evidenced in the new highs list will most probably continue on for some time. Not all will, but as long as our strategy allows for weeding out those stocks that do not continue increasing in price we will probably be all right. This part will be dealt with later in the book.  Ask yourself the following two questions:  1. How often does a company make a new price high when something good isn't happening?  2. How often does a company where something really good is happening fail to trade close to or at a new high price?  I believe the answer to both of these questions is seldom. All trends eventually come to an end and stocks can go from making new highs to making new lows with breathtaking rapidity. But even in that extreme case, if you utilize the Reverse Scale Strategy introduced in Chapter 7, you may be able to react before major damage is done to your portfolio value. If something very good or bad starts to happen to a company's earnings trend, it will most likely start to show up in the trend of the stock long before you will read about it in the press - or hear about it from your broker. But the stocks that show positive momentum by appearing on the new-highs list have a excellent chance of continuing their trends. In a nutshell, the new-highs list technique isn't infallible, but then neither is the stock-picking advice of your broker.  I believe you are almost always better off picking your own investment ideas because you will know why you picked them. Also, you will be more aware of what is happening in the market since you won't have delegated responsibility for your money to someone else - someone who most likely has hundreds of individual accounts to oversee. It is your money and the more personal attention you can give to it, the better off you will be. Certainly, unless you are very wealthy, you can give more attention to your portfolio than can a broker or advisor. However, it may be best to let your advisor manage the majority of your money, while you try the strategies in this book with your true risk capital.  Finally, if you do not believe that the stocks on the new-highs list tend to outperform others, pick a group of ten stocks from the new highs list and a group from the new-lows list. Track how each group performs over the next few months. Unless you happened to pick a very unusual time period, you will see that the new-highs as a group seriously outpace the new-lows group. If you are into instant gratification, you could also go to the library and pick a random list from a year or two ago and see how they have done since then. If you do, be sure you account for stock splits that may have occurred in the last year, since there may well be some where that has happened - especially among the stocks which appeared on the new-highs list. I highly encourage anyone to perform this simple and unambiguous experiment.  Your performance can be further enhanced by not only choosing stocks making new 52-week highs, but better yet pick stocks that are at all time new highs in price. This will take a little more work for you because you will not find such a list in the newspaper. The best way to distinguish between issues making new 52-week and those making new all time highs is by looking at a long-term chart book. Obviously, any stock making a new all-time high will also be on the new 52-week high list, so begin your search with the 52-week high list.  2) Diversify between industry groups  Because stocks within an industry tend to move more or less in lockstep, make an attempt to diversify your portfolio between at least three industry groups. This will help to reduce some of the risk in your portfolio and having your money spread over several industries will help even out more of the ups and downs in your account value than if you had everything in one industry. Whether you are investing in stocks, fine art, certificates of deposit, bonds, or whatever, the first rule of investing is: Diversify.  3) Beware of stodgy stocks  When selecting stocks, beware of picking those stocks that move very little whether the market is good or bad. These are generally referred to as "defensive" stocks because they are held by those wanting to defend themselves against the possibility of a bear market. These conservative picks tend to underperform the market over the long run, making them a poor substitute for issues with real growth potential. Especially during market downturns, defensive issues hold up well, giving the illusion that there are good things happening to their underlying businesses. In reality, they hold up well mostly because investors flock to them for safety. When the market turns better, these types of companies tend to simply sit still while the rest of the market charges ahead.  So, it is best to avoid defensive stocks lest you get left behind when a bull market appears. Issues considered to be defensive include utility companies, gold stocks, food companies, oils, real estate investment trusts, and closed-end mutual funds. Closed-end mutual funds are mutual funds which have a fixed number of shares outstanding and trade just like a stock on an exchange. While they can sometimes post large increases in price, for the most part they sputter along and do not often have the potential for large increases in price.  While there have been times when each of these groups has done very well, for the most part they are a waste of time for those who are willing to take a little more risk in order to make a lot more money. So it is best to exclude defensive stocks, at least from the aggressive portion of your portfolio.  4) Weed out takeover situations  I would generally recommend that you look over recent news items around a company before you make a final decision to buy its stock. The reason I say this is that some of the stocks on the new-highs list are stocks of companies which are involved in real or rumored merger or buyout situations. They are generally a small minority of the stocks on the new-highs list, but be aware that this possibility exists. Takeovers and buyouts are unnatural, all-at-once events which are highly speculative and thus do not lend themselves to prudent investing. Once a firm is known to be a potential takeover target the price is dominated not by the company's market position or products, but rather by the development of the buyout offer. Also, most of the potential for further price advances is gone once the initial "pop" from the buyout has occurred.  For purposes of this book, try to avoid buying stocks which have become known to be the target of a buyout. Buyouts, when they occur, are big news and are generally well-known. The easiest way I have found to spot companies where a takeover has occurred is by looking at the price chart. Takeovers are almost always evidenced by a one-day increase in the price of the target company's stock of between 20% and 100%. If you see that type of pattern, dig deeper. There is an excellent chance that this company is in a buyout situation and should therefore be avoided.  5) Check out the Chart  Before you buy a stock, take a look at its price chart for the past year or two. This will give you a snapshot of the stock's personality from a volatility standpoint. I like to avoid stocks which have high week-to-week volatility and instead prefer ones which have a tendency for a cleaner trend. If a stock has a very volatile price pattern, then it generally means the company has no clear advantage in the marketplace for its product, services, etc., versus the competition. Since there are many companies out there which do have a clear, sustainable advantage in their particular market, I generally opt to purchase these instead. As an extreme example, following is a chart of a stock which has shown a very volatile price pattern in the past year:  I would probably not buy HEI Inc. at this point due to its highly erratic price pattern with no clear, discernible trend. The stock is also a long way from hitting a new all-time high, although it's not too far from making a 52-week high. Because of its poor trend in combination with the degree of up and down fluctuation in its price, I would definitely avoid this issue at this time.  As an example of a stock which shows an excellent trend pattern and low volatility, study this chart of Amgen, Inc. As you can see, the stock is making a new all-time high combined and is moving more steadily upward than many other stocks. I would tend to favor a stock with this type of price chart.  As a rule of thumb, the lower-priced a stock is, the more tendency it has to be volatile in its trend pattern. This is a good reason to avoid low-priced stocks and is one of the main reasons I insist on buying stocks that are above $15 per share.  In addition to volatility, the chart can also give you a clue to other important facts about the stock, such as if it's in the midst of a takeover situation (characterized by a large one-day move and a relatively stable price pattern thereafter), or whether it's a new issue. New issues sometimes appear on the 52-week highs list not because they are particularly strong stocks, but simply because they do not have much trading history behind them. It is best to know about these things and I can think of no faster way of finding out than by looking at the stock's chart.  There are several ways to obtain a chart of a company's recent price history. By far the best and cheapest way these days is by computer, but there are many published chart services as well. Mansfield Charts and Daily Graphs are good choices. Standard and Poor's also publishes a compact book of stock charts which give two years' price history on many stocks.  Keep in mind that no matter how you get your chart information, you only need it when initially selecting a stock for purchase with Five Minute Investing. As you will see later in the book, you do not need to lug a computer or chart book around with you in order to manage your portfolio. Charts are only useful for getting a quick feel for the stock's trend, volatility, and as a tip-off for weeding out takeovers and new issues. In Five Minute Investing, they are not necessary for day-to-day management of your portfolio.  6) Other Criteria  Other than what's already been mentioned, are there other criteria which are simple but can help you narrow your stock picks down to a more succinct list? Yes, and I will try to give a brief overview of them here. You can then choose how many of these criteria you would like to use. No matter how few you choose to use, as long as you apply the first four sections of this chapter you will not go too far wrong. These items should be considered "finesse points" that can be used to narrow your choices down to a select few.  1. Earnings Growth.  One way to further narrow your list of potential stocks is to focus on those that are reporting high rates of earnings growth. Do not think that because a company is presently generating rapid earnings growth that it cannot continue to do so well into the future. It often takes years or even decades for competition to nullify such a company's competitive edge in the products or services it provides, and it is this competitive edge that allows the rapid growth in sales and earnings. So, pay close attention to the earnings trend of your potential stock selections. Where can you get this information? It can be gotten from any number of publications including Standard and Poor's and also the Value Line Investment Survey. So far, though, the easiest place to find summary information on earnings growth is Investor's Business Daily. IBD has earnings per share rankings for every stock in the market, every day. For this reason, it is superior to the other sources of information because all the information can be found in one place, and in a similar format so that each company's earnings growth number can be directly compared to every other company. IBD categorizes earnings growth on a percentile basis, called the Earnings Per Share ranking. This number ranges between 1 and 99, with 99 being the most positive. All else being equal, try to pick issues which have the highest earnings growth, because these are the companies which have a demonstrated edge in their particular market.  2. Market Capitalization.  Market capitalization is another thing you will want to pay attention to. Market capitalization is simply the total market value of all the company's outstanding shares, or total shares multiplied by the price per share of the company's stock. I generally like to avoid the very biggest capitalization stocks, say those with capitalization's over $5 billion (in 1995 dollars) or so. This number will change over time, since the definition of a "big" company is constantly increasing.  Why take market capitalization into account when picking stocks? The larger the base of earnings a company is working from, the less likely they are to be able to grow earnings at a sustainable clip of 30% or more - and the less likely we are to be rewarded with a windfall profit. So, try to stick with the smaller-company stocks appearing on the new-highs list.  3. Buy the Price Performers.  Try to choose stocks that have performed well versus other stocks in the market, from a price standpoint. Simply put, choose the stocks that have run up most in value. This approach goes directly against human nature, but by adding this to your list of criteria you will greatly increase your chances of finding a phenomenal winner. You can determine how well a stock is doing by looking at it's current price versus its 52-week low (not high). The higher it is in percentage terms versus its low point, the better. Or, an easier way is to use Investor's Business Daily because it provides Relative Strength rankings on every stock, every day. If you are using Investor's Business Daily, also try to choose stocks with a relative strength ranking that is high. Like the EPS ranking mentioned earlier, this runs from 1 to 99, with 99 being the most favorable and meaning that the stock is moving upward in price better than 99% of the stocks in the market. I like to focus on stocks exhibiting a relative strength ranking of 90 or better. If you do not have a subscription to IBD, make sure you at least pick up a newsstand issue whenever you are picking new stocks to invest in, as by now you can see how much time and effort it can save you in gathering information. I consider this publication to be well worth the price of an annual subscription.  4. Share Price.  Finally, try to limit your purchases to stocks sporting a share price at or above $15/share. By so doing you will enhance your chances of investing in stocks with good trending potential. Low-price stocks tend to have very choppy trading patterns and are much more subject to false trend reversals. I actually prefer to invest in stocks priced in the $30 to $50 price range, as I find they are often well-established enough to have a high success rate, but if they are smaller capitalization issues they also are small enough to have nice growth potential.  Short-term timing  Many investors let short-term timing considerations overwhelm their choice of which stocks to buy. I believe this is an error, and also greatly complicates their stock-picking criteria. People become so confused by what is happening with short-term oscillators, moving averages, chart formations, and other mumbo-jumbo that these things begin to dominate all other considerations. In this book I want to totally de-emphasize short-term timing and focus on the big picture: Long-term results.  The simple reason for my philosophy is, I would rather buy a stock that is overextended and may have a relatively small short-term pullback in price but on its way to a 1,000% gain than one that is not at all extended but on its way to only a 50% gain. In fact, on weekends I often look at the largest percentage price gainers for the week and I strongly consider those stocks for purchase. I am not afraid to buy a stock just because it is moving decisively upward. I believe that if you use the Reverse Scale Strategy as developed later in this book, you will accumulate your positions gradually enough that you will not need to worry about whether a stock is overextended, underextended, or other short-term timing concepts. Therefore, you can keep your stock-picking techniques as simple as what is presented in this chapter.  Fundamental Analysis  You may have noticed that there is nothing in this chapter regarding how to perform fundamental analysis of industries, companies within that industry, financial analysis of earnings statements and balance sheets, etc. Perhaps you expected any book on stock picking to include these topics, but Five Minute Investing does not. The simple reason for this is that if the market is saying that a certain company's earnings are expected to grow (evidenced by an accelerating upward stock trend), why should we find reason to dispute what the market is saying? As long as we have a loss-cutting mechanism in place, we do not need to use fundamental analysis to validate what the market already has told us about the future earnings of the company. The opinion of the aggregate marketplace has far more credibility in my eyes than does the opinion of any fundamental analyst, no matter how good. So I will always go with the opinion of the market, as opposed to anyone else's opinion, including my own. To me, anyone who tells me that a stock which is moving up shouldn't be moving up, has by definition missed something in his analysis.  To make my point on the futility of fundamental analysis for the average investor, think of how you would determine if the grass in your lawn was growing quickly. Wouldn't you just measure the grass today, wait a few days, then measure it again and subtract? If you did this and discovered that the grass was growing quickly, would you then go out and conduct a survey of the temperature, rainfall and hours of sunlight per day to validate that the conditions for growing grass are indeed good? Of course not! You would rightly conclude that the conditions for grass growth are good based solely on the fact that the grass is growing. Even if you did cook up some formula to predict grass growth based on environmental conditions, would you trust your formula more than your direct measurement of the grass's actual growth? If your formula said that grass shouldn't be growing and yet it was growing, would you stop mowing your lawn? Again, to do so would be preposterous. You would have to conclude that something is wrong with your formula.  Unfortunately, common sense of this sort does not get applied in the stock market by many people. Even though we can directly measure through a stock's price trend what the company's growth prospects must be, there is always someone there to try to make us lose sight of that simple fact by pointing to his "analysis." You can be sure that for every fantastically bullish trend, there is some analyst somewhere saying why it shouldn't be happening all along the way. The best you can do is to not listen to such opinions, and, again, go back to the market as your one source of advice.  A final word: Buy Quality  Whether you are investing in stocks, art, coins, or real estate, it is my opinion that it is always best to buy the highest quality you can possibly afford. Any review of the return on rare coins or masterpieces of fine art will quickly reveal that the best returns on investment have been enjoyed by those who bought the rarest and highest-priced items. The same principle is true in stock investing. Do not be afraid to pay a high price relative to earnings, book value, or sales. In fact, I would ignore such items. I recommend that you buy the stocks which are moving up persistently in price, and don't concern yourself that these stocks tend to cost a little bit more than some more boring issues. History shows that the premium paid for high-quality items of any kind is generally worth the extra money.  When picking stocks for investment, apply these criteria:  1. Restrict your stock-picking to stocks making new 52-week highs.  2. Diversify between at least three different industry groups.  3. Weed out defensive stocks and those involved in buyout situations.  4. Don't be afraid to pay up for quality.  Chapter 5: How to Evaluate a Trading Strategy  Characteristics to look for in any investing system  Obviously, there are many strategies that can be used in stock investing, but there are certain characteristics to look for in any plan for investing. Before we can develop a strategy for investing, we need to have a set of criteria by which to judge if it is a good plan or not.  Building upon our previous discussions about common investor mistakes and stock-market myths, I offer the following eight criteria as the means by which to judge an investment plan - any investment plan. The degree to which a strategy stacks up well against these criteria determines its desirability. The very best strategies will satisfy the following eight requirements:  1. Lets gains run their course, cuts losses short.  This is a necessary element for any good plan of investing, especially the part about letting gains run to their full potential. As long as a portfolio is well-diversified, you can probably afford to make the mistake of holding onto your losers, but you absolutely must not make the error of prematurely cashing in your winners. Since we expect our gains over long periods of time to exceed 100% of our initial investment, the amount of damage that can be done by cutting our winning stocks short far surpasses the damage we can do by failing to cut losses. However, for optimal performance it is best to both cut losses and ride winners as long as possible.  2. Much has been written about what the ideal point is for cutting losses. Some say it is 10%, that is, that you should never lose more than 10% on a stock trade. Others say you should never lose more than 8%. I have found that cutting losses this short leads to excessive trading and excessive losses, and does not allow a good stock enough room for normal day-to-day fluctuations. When cutting losses to 8% or 10%, it is extremely easy to get bumped out of a stock only to have it recover and begin soaring again without your being on board.  For this reason I prefer to take a radically different view of loss-cutting. I aim never to lose more than 3 % of my total account value on a single stock trade. As an example, I might set my stop-loss point back 30% from my purchase point and invest no more than 10% of my account's assets into a single stock. Therefore, I will not sell the stock unless it gets into serious trouble and falls 30%. If the worst happens and the stock does lose 30% of its value, I will have lost only 3% of my account's assets on the trade since I only invested 10% of my accounts assets into the stock. So, 10% times 30% equals 3%. I believe that this approach to loss-cutting is far superior to arbitrary rules which require cutting losses too short. If you can aim to lose no more than 3% of your cash on any one trade, it will take a long string of uninterrupted losers in order to seriously deplete your trading capital. Of course, there is nothing magical about the 3% number, but the point is to keep your possible losses from any one trade to a very small amount. Even in a market dip, it is improbable that all of your positions will drop to your sell point.  3. Gradual entry into major positions, as long as the position continues to be profitable.  It is inevitable that any system which attempts to let gains run will eventually build some large positions in a few stocks as the stocks grow in value. That is the good way to develop a large position. Also, it is OK to build a position by adding to the position as it advances in value; in fact, most professionals continually add to their stock holdings as the price moves in their favor. In this way, they maximize the potential reward for holding a particular stock or basket of stocks.  However, some approaches cause an investor to plunge a large amount of his capital into and out of the market all at one time. This is the type of approach which must be avoided at all costs. It is risky to enter any market all at once because it maximizes your ability to lose a lot of money in a hurry. One poor timing decision can result in a loss of a large percentage of your capital, and these drawdowns in capital really hurt you. A 33% loss of your capital requires a 50% gain on the remaining capital just to get to the break-even point. It is also unnecessary to take such daredevil risks because most trends last long enough that there is plenty of time to get on board and a lot of money can still be made by entering a trend in several installments as it is developing.  4. Minimal chance of a large loss from any one position.  This is an adjunct to #2, as the gradual entry into a position is a means for minimizing the chance of loss from a single bad decision. Again, it cannot be emphasized too much that massive drawdowns in your capital are to be avoided at all costs. Any plan of attack should score well in the area of keeping our eggs in many baskets as opposed to one; and we should not have a large percentage of our assets in a single stock unless our average purchase price is far below the current market price. If we do well at that, we can sustain a large one-day drop in the price of a stock without losing much, if any, of our original investment.  5. Clear, predetermined criteria for initiating, adding to, or liquidating a position.  In the heat of battle when you are dealing with your hard-earned money, the instructions from your system must be as clear as crystal. If not, you will find yourself making judgment calls that relieve your short-term stress, and yet are poor long-term decisions. Precise and unambiguous signals and marching orders are the best way to head off the effects of euphoria and fear. You may still feel these emotions, but as long as your system is sound and you adhere to it fastidiously, everything will turn out well.  6. Sells a stock once it begins to underperform.  While we want to make sure we have a means for riding a stock's trend for as long as it can go, when it becomes clear that the trend is beginning to profoundly weaken or even reverse, we need to have a system which allows for selling the stock so we can redeploy capital to greener pastures.  7. Maximum dollars invested in biggest winners.  If a strategy allows us to build a large position in an issue that is lagging or even losing money for us, there is something seriously wrong with that strategy. The common complaint one hears from many stock market participants is that they wish they hadn't invested so much in XYZ Company and they wish they had invested more in ABC Co. This mis-allocation of assets is usually accomplished via some of the common investor mistakes in Chapter 2, especially the mistakes of adding to a losing position, or plunging. A successful system needs to ensure that our biggest investments are in our best stocks, not in our worst.  8. Minimum dollars invested in losers/underperformers.  This is the converse of #7. It is interesting to note that the only ways you can accomplish having too much invested in a loser is to either plunge into it all at once and fail to cut your loss, or add to a losing position once it is established as a loser. Both of these are deadly mistakes and any system we develop must preclude us from committing these sins.  9. Not time consuming to maintain.  This is important because throughout this book I assume that the reader's time is his most valuable asset, and probably in short supply as well.  When an investment plan is not really a plan  Occasionally, one will hear statements such as "sell a stock once its earnings growth slows," or "hold a stock as long as its product looks good." Often, these types of statements are hawked as rules for investment. I want to make a point that these types of statements are not really plans at all, in and of themselves. They are far too subjective for the very tangible world of the stock market, where stocks are given a specific price every minute of every trading day. In order to be useful for decision-making by us mere mortals, the system used must tell the investor exactly when to buy or sell, and how much to buy or sell. How can you spot that precise moment when a company's product turns from good to bad, or when a company's earnings have "slowed?" Chances are, you can't. Since a stock's price generally reflects such events long before they actually happen, these subjective sorts of approaches tend to be a day late and a dollar short unless you are incredibly well-connected to the company in question. Even if you were well-connected, then you could be trading on inside information, which is against Federal law.  It is conceivable that if you could develop some non-subjective criteria about how to tell when a firm's product or earnings are losing their edge, you might possibly be able to develop a true (non-subjective) system around it. Even if you could do it, it would be different for every industry, making it very time-consuming to implement. Therefore, this type of approach is not very practical for the average person and definitely violates our requirement that our strategy not be time-consuming to maintain. There is a difference between subjective rules of thumb for trading, and a non-subjective system for trading. Learn to recognize the difference and you will be several steps ahead of the majority of investors.  Chapter 6: The World's Worst Trading Strategy  The next step down our road to investment success involves briefly reviewing the worst stock trading strategy I can imagine, a simple strategy known as Scale Trading. Why would we want to learn about the worst strategy? Because once we know the worst possible strategy, one that is destined to maximize losses over the long run, then we can reverse its ideas to craft a strategy which does just the opposite - it will be destined to produce some tremendous long-term gains. This is precisely how I came to develop the Reverse Scale Strategy introduced in the next chapter, which has served me very well and will also serve you well if you adhere to it. I want you to not only know what the strategy is but also to understand how it was developed and why it works.  I want to mention that the comments in this chapter focus on scale trading as applied to stocks only. Scale trading can be a viable strategy when applied to commodity futures, mostly because commodities have inherent value meaning that they cannot decline to zero value. But even then, it requires a lot of capital and advance planning to be successful. Individual stocks can and do become worthless on occasion, which is one of the main reasons why scale trading is such an unfit approach for stock investing. Scale Trading  Other than the fact that it is simple, this strategy has no redeeming value. It is the manifestation of all the most devastating investor mistakes. While it can produce small profits over short periods of time, eventually it always leads to the poorhouse when applied to individual stocks. Scale trading is not a very popular or widespread strategy except among extreme neophytes, as anyone using it will not last very long in the stock market. I like to think of it as the financial equivalent of bungee-jumping: It's exciting, risky, takes a lot of guts, and occasionally, the cord snaps! Nevertheless it is useful to study this method because often much can be learned by studying a truly bad approach to anything and then reversing its concepts.  Scale trading can be applied to a single stock, or a portfolio of stocks with equally disastrous results.  It is accomplished by taking an initial position and then adding to it in predetermined increments as the position declines in value, and selling those purchases as they increase in value. For instance, the investor might buy 20 shares of stock at $50/share (for $1,000) and decide to buy another $1,000 worth of stock if the price declines by 20%. If the price increases from $50 before declining to $40, he will sell his 20 shares (purchased at $50) for $60/share, for a profit of $200 less commissions. So, another 25 shares are added at $40 with the idea of selling those acquired at $40 if the price then increases to $50, and so on. The purchase and sale levels for this particular situation are shown in the following table:  Scale Trade from 50, 20% declining purchase increments.  Price Level Amount Invested This Purchase Shares bought This Purchase Cumulative $ Invested Cumulative Shares Owned Cumulative Value of Shares Cumulative Cost/Share Total Profit/(loss)  50 $1,000 20 $1,000 20 $1,000 $50.00 $0  40 $1,000 25 $2,000 45 $1,800 $44.44 ($200)  32 $992 31 $2,992 76 $2,432 $39.37 ($560)  25 5/8 $998 39 $3,990 115 $2,944 $34.70 ($1,046)  20 1/2 $1,004 49 $4,994 164 $3,359 $30.45 ($1,635)  16 3/8 $999 61 $5,993 225 $3,686 $26.64 ($2,307)  13 1/8 $996 76 $6,989 301 $3,945 $23.22 ($3,044)  10 1/2 $996 95 $7,986 396 $4,152 $20.17 ($3,833)  8 3/8 $998 119 $8,984 515 $4,320 $17.44 ($4,664)  6 3/4 $1,000 149 $9,984 664 $4,456 $15.04 ($5,528)  5 3/8 $999 186 $10,982 850 $4,563 $12.92 ($6,419)  4 1/4 $1,001 233 $11,983 1083 $4,651 $11.06 ($7,332)  The scale trader is hoping to profit by, for example, selling any shares acquired at 32 on a subsequent rise to 40, any shares purchased at 20 1/2 would be sold at 25 5/8, and so on until the stock advances to 60, at which point the scale trader sells off the last of his shares - those purchased at 50.  There is no limit to the amount of times that a stock can oscillate between any two or more of the price levels. Each time this happens the trader pockets another $200 profit, excluding the effect of commissions.  It seems like a foolproof approach to the neophyte trader, but let's trace what happens with this trading method through a hypothetical situation. As indicated, our trader makes up the chart as shown above, and takes his position of 20 shares purchased at a price of $50/share. Let's say the price then slips to $40, and a subsequent 25 shares are purchased at that price. From there, the price increases to $55, meaning that the 25 shares acquired at 40 are sold when the price reaches $50, netting a profit before commissions of $200. At this point, 20 shares acquired at $50 are still in his inventory. However, he doesn't get to sell those shares, as the price drops from $55 all the way down to $30 - so 25 shares are purchased at $40, and another 31 shares at $32 before increasing again to $40. The shares purchased at $32 are sold for $40 for another $200 profit. Fantastic: He has so far generated a $400 realized profit and never had more than $3,000 invested at any point. The only negative so far is that it took four months to do this, but $400 profit on a $3,000 investment over four months is not bad. So far, so good.  From $40, the price then takes another dive down to $15. Shares are purchased at $32, $25 5/8, $20 1/2, and $16 3/8. Then the price runs up to $30 before retreating back to 25 5/8. Quite a windfall for our trader as he sells the shares acquired at $16 3/8 for $20 1/2, and the ones scooped up at $20 1/2 for $25 5/8. From this, he nets out another $400, bringing his total trading profits to $800. True, he has a $1,046 unrealized loss bringing his net profit to a negative $246, but he reasons that when the price goes back up to $60 he will have completed his trade and sold out every single position for a profit. At this time, though, he narrowly misses selling his shares acquired for $25 5/8 at 32, since the price topped out this time at $30.  Next, the unexpected happens. The company that our scale-trading friend is trading reports that it is under Federal investigation concerning false financial reporting. The next day, the stock opens a few points lower and just keeps on dropping until it hits $10 3/8, its closing price for the day. Though shaken by the news, our friend is disciplined about his system and buys slugs of the stock right on schedule at $25 5/8, $20 1/2, $16 3/8, $13 1/8, and $10 1/2. He is getting a little worried because he is eight months into this trade and he has an $800 realized gain and a $3,833 unrealized loss so far. He also is realizing that so far he has nothing to show for his nearly $8,000 investment except a net loss. He starts to wake up at night wondering what will happen to his position, since although he realized that this could happen, he never thought that it actually would happen.  Unfortunately for our friend, in the following months the investigation reveals that the company does actually have some fraudulent practices. This requires that the balance sheet and income statements for some previous years are revised to reflect the effects of the management misstatement and cover-up. The experienced (though crooked) management of the company is ousted for their sins and replaced. So the price of the stock works its way lower and eventually levels out between $4 and $5 per share, and it languishes in the low single digits for the next five years. Our scale trading friend has a $6,000 to $7,000 unrealized loss in addition to his $800 trading gain, and ten or eleven thousand dollars invested in the stock he still holds. Once in a while over the next few years he may get a $200 trading gain as the stock bounces around, but these pale in relation to what he has invested and what he could have earned even from a passbook savings account. On top of this, he also has to live with the worry for the next five years that the stock will further decline, causing him to either give up his strategy completely or invest even more money. Now he realizes that so much time has passed that even if the stock rises back up to $60 someday, his annual rate of return for the amount invested will be minuscule.  It is scary to realize what can happen when you get caught up into a flawed strategy such as scale trading. This little story might sound extreme, but I assure you that every single day someone gets the bright idea to do exactly what our poor friend in the story did. Thinking they have discovered a money machine, they begin scale trading and the rest is simply a matter of time. The trader in the story was disciplined - he held to his system against all odds, but he still got mired into a terrible mess. The lesson to be learned is that to be successful, you not only have to be disciplined, but the theory on which your system or method is based must be correct as well. A bad theory well implemented still results in a loss.  Of course, not every scale trade results in a disaster, in fact most of them probably result in a profit sooner or later. But the potential for profit is small considering the time, worry, and capital invested. The typical pattern with scale trades is a series of small profits followed by one gigantic and inevitable loss.  Some folks even apply the scale trading technique to several different stocks at the same time. This does nothing but compress the amount of time it takes to lock on to a stock that just keeps declining and declining in value - it may even become totally worthless and enter bankruptcy proceedings. Or, almost as bad, it may decline from $50 all the way down to $10/share and sit there for a long time. Perhaps it will sit there for years or even decades while the poor trader sits trapped in his losing position earning little or nothing on his money. You can rest assured that anyone who uses this approach consistently in the stock market will meet this demise fairly early-on in the process. The fatal assumption made by the scale-trading theory is "what goes down must come up," and as we have discussed earlier, this simply is not the case with stocks.  In the example above, if the price of the stock declines to slightly above $1/share, the hapless scale-trader will own stock with a market value of $4,900 in which he has $17,900 invested - a loss of $13,000. If the company goes bankrupt, the numbers would be worthless stock and at a sickening loss of at least $17,900 (if he had sense enough to stop buying once the stock fell below $1/share). This is after starting with only $1,000, and the usual case is that the neophyte feels his strategy is so foolproof that he starts with $5,000 or some other large amount. The only saving grace is that people tend to pursue this strategy when they are young, foolish, and have little money to lose. So if our novice scale trader started with a $10,000 initial position at $50/share instead of the $1,000 position in the example, he likely won't lose the entire $170,900 we might expect him to lose. This is because unless he inherited his money, he probably won't have that much to lose.  The positives of scale trading are:  1. It is simple and not subjective.  2. It can generate lots of small gains in choppy market conditions.  The negatives of scale trading are:  1. When applied to a portfolio of stocks, the stocks which do worst suck up the most capital as more and more purchases are made while it declines. All capital is automatically allocated to the worst-performing stocks in the portfolio while the best stocks are sold off. The result is at best a disastrous underperformance versus the market or at the worst a total loss of capital. If a scale trader uses margin (borrows money from the broker to buy even more stock), the trader may, under the right conditions, creatively find a way to lose even more money than he has. The biggest problem is that scale trading cuts the trader's gains and lets his losses run, just the opposite of what you want to do.  2. It is impossible to plan how much capital it will take to execute the strategy since you never know how far down a stock will go before it recovers - if it does recover. There are an infinite number of 50% declines between any positive number and zero, therefore an infinite number of purchases you would need to make to fully execute the strategy. Few people I know have unlimited capital.  3. Eventually, everyone who practices scale trading encounters a stock that declines precipitously and then goes bankrupt. The losses from such an occurrence are huge. There have been a plethora of seemingly rock-solid companies over the years that have ended up in bankruptcy court.  4. The scale trader never gets the full benefit of a favorable trend since he is always selling his winners and buying more of his losers.  5. Even when a scale trade is successful, the amount of profit to be had is very small relative to the amount invested and especially relative to the risk of catastrophic loss.  6. When a scale-trader finds himself locked into a large losing position, he can't even get the tax benefit of a write-off, since his strategy makes no provision for him to sell out his position. Of course, if a bankruptcy should occur, then he can write off the entire amount!  Obviously, scale trading is not a strategy to pursue unless you want to guarantee yourself substandard returns peppered with an occasional financial disaster. In the next chapter we will take this lemon of a method and make lemonade. By reversing the scale trader's tactics, we will construct the Reverse Scale Strategy, which will give us some moderately large gains, some small losses, and some huge gains which will make it all worthwhile. Better yet, the rules of this strategy will be as forthright and unambiguous as in the scale trading method.