The power of rule-based investing for retail investors

Key indices at all-time highs; leading stocks making fresh highs; extended valuations. Should you take new equity positions? Conscience says NO, but somewhere deep in your heart, you feel the highs would get higher. Fear and greed pave way to various types of human biases. The majority of investors avoid taking new positions until they see further triggers. But why sit in the stands and watch the play unfold, when you can be a part of all the action?

Biases are faulty and convenient shortcuts taken by one’s mind, due to, incorrect information processing and emotions. The stock market captures the perception of millions of individuals in arriving at the price of a security. When biases creep into investment decision-making, they tend to have unfavourable pay-offs, which could pose a serious threat to one’s hard earned money.

A go-to solution is sticking to tested and proven investment rules. Novice or experienced, small or big, trader or investor; one answer to human investment biases is rules-based investing.

A rule-based system, created by sound research, is a very useful technique to make gains in the stock market, without letting the biases and noise to hamper your decision making. How often do you confidently believe in a stock, only to see the market disagree with you, and relentlessly pound it lower and lower? How often have you watched a stock flutter higher, only to sit on the sidelines, because somebody says its valuations are already rich? A rules-based system runs on facts and data, without emphasis on anyone’s opinion, which could be the source of various biases.

Rules may be self-defined and often differ from person to person. The first step in adapting to a set of rules is to identify one’s risk appetite and return requirements. Secondly, adopt rules which comprehensively factors in both fundamental and technical factors. Actively investing in one of the fastest growing economies is not as easy as it looks, with abundant pieces of investment advice being thrown at you. Investors should set simple triggers or rules, to which they have to stick by in order to prevail in such bull markets.

Setting strong buy rules in the foremost step in developing investment discipline. No aspect of the market environment can beat a strong fundamental story. Incorporating discipline based to fundamental screening is the root of a fruitful investment. However, along with the stock’s fundamentals, investors should look at technical indicators such as leading industry group rank, price and volume action of the stocks, institutional buyer demand, and chart patterns, among others.

After sorting “what to buy”, an investor should also focus on “when to buy”. Timing the buy is a widely ignored aspect in the investment world. Investors have a bias that markets can’t be timed. Often investors believe in buying low and selling high. Stocks should actually be bought after gauging price-volume action as it indicates market optimism and pessimism for the stocks.

Most common oversight seen in retail investors is the judgement to take sell calls. Investors are seen holding onto fundamentally strong stocks with poor price performance. Often investors let losses worsen, hurting overall portfolio performance. Markets go through a lot of biases when it comes to the selling aspect of a position. Failing to understand the cause and not acting on it timely will further deepen your losses. On the flip side, investors who stick to certain sell rules, irrespective of what their conviction says, will avoid a further downturn. These investors, as wisdom dictates will focus on the next big stock opportunity.

Investment discipline brought in by rules never leaves you in doubt of whether or not to go for it. Though there may be rare cases when rules fall flat, an experienced investor can subtly tweak the rules to suit the dynamic market conditions.

If you own a portfolio of stocks, you must learn to sell the worst performers first and keep the best a little longer. The most common trait found among successful investors is not just intelligence, experience, or luck, but it is primarily their discipline in taking investment calls.

STEADY STEPS

• The first step in adapting to a set of rules is to identify one’s risk appetite and return requirements
   
• Secondly, adopt rules which comprehensively factors in both fundamental and technical factors
   
• If you own a portfolio of stocks, you must learn to sell the worst performers first and keep the best a little longer

The writer is COO, William O'Neil India