The stock market is a constantly changing beast that loves to cause the greatest pain to the largest number of participants possible. What I mean by that is if the majority of investors are positioned bearishly, the market will likely head higher and force them to cover. Conversely, those that are overly bullish near the top are likely to have their own pound of flesh taken by a turning of the tide lower.
So how do you protect yourself from entering the market at an inopportune time?
The reality is that no one knows what is going to happen from one day to the next. This is especially true in the age of lightning fast information exchange and globally interconnected markets. The overnight headline risk alone is something that you can’t foresee or control. Once you succumb to that reality, you can focus on the finer points of your portfolio that you can control – i.e. position size, stop losses, asset allocation, etc…
The Big Picture
Whenever you are looking to establish a new position in stocks, bonds or commodities, it always helps to take a moment to step back and evaluate the big picture. Ask yourself these questions:
- What trends are in play that reinforces my decision to enter this position?
- What adverse factors could force me to sell or adjust my investment thesis?
- How does this investment react to macro forces such as interest rates, volatility, or forex changes?
- What does the short-term momentum picture look like? i.e. has this investment gone up or down for the last 8 days straight?
- How does this investment comingle with other positions in my portfolio and how will it alter my existing asset allocation?
The answers to these questions will ultimately help determine if the investment is suitable for your portfolio and at a potential entry location. Keep in mind that a counterintuitive mindset will help you immensely when picking an opportune spot to trade. You probably won’t catch it perfectly, but you can greatly enhance your chances of a successful outcome by paying attention to the big picture.
For instance, if the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) has been on a two-week straight run and the CBOE VOLATILITY S&P 500 (INDEXCBOE:VIX) is hitting new short-term lows, it may best to wait for a lower risk setup. Keep in mind that it will never look “perfect”, but patience can be your ally when waiting for a small pullback to purchase.
Position size is another important factor when entering a new trade. You should initially determine how large you want an investment to be in the context of your total portfolio and set a roadmap for how you will get to that full allocation.
For some, this means going all in on one trade to maximize your exposure. However, if possible, I like to break up trades into multiple parts in order to have greater control over the final outcome. Transaction-free ETFs are perfect for this strategy because they allow you to purchase even tiny amounts without the drag of incremental trading costs.
Breaking your trade up into two or three parts will allow you to use any additional weakness to lower your cost basis. Conversely, if the investment starts running away from you on the upside, at least you have some initial exposure to ride the trend higher. This strategy works particularly well when purchasing near the highs or when volatility ramps up.
Asset allocation may play another important part in timing an entry point into the market. Aggressive traders are likely comfortable with a higher number of transactions and sitting on cash for extended periods of time. However, those with a more long-term mindset may be inclined to hold on to positions regardless of the short-term outcome.
One strategy may involve pairing two asset classes together in order to reduce your risk profile. Adding to a high risk position in stocks alongside a high quality position in bonds may help cushion any bouts of unexpected volatility. Like multi-step trading, this strategy will reduce your overall gains if the stock moves higher, but will also help preserve your capital if conditions deteriorate.
Another time tested risk management strategy is to set stop losses on your investments to ensure they don’t fall below a pre-set level. This can also be used in reverse as well – to set predetermined buy points for new positions if certain conditions are met.
The advantage to this strategy is controlling risk with a defined exit or entry plan thateliminates emotional decision making. Nevertheless, stop losses can also lead to quick whipsaws that find you exiting a position right before it swings back higher again. That is the tradeoff you assume when opting to preserve capital and ensure you only have small losses rather than big drawdowns that are difficult to recover from.
The Bottom Line
Many investors will choose to ignore these tips and proceed headlong into the fray. However, with some simple planning and situational awareness, you can be better prepared to make proactive rather than reactive investment decisions. As always, having a straight forward plan and implementing it decisively will produce superior investment results.
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