Whatever your long-term investment aims, it’s essential to have a trading plan to help you stick to the straight and narrow.
Successful investors stick firmly to a chosen strategy, refining it as they go along with knowledge gleaned from successful – and unsuccessful – trades. In fact, the unsuccessful ones can often teach us far more.
That is not to say that in a year’s time, or two years, or five years, you shouldn’t revisit your trading plan and ask whether it is still right for you. In fact, carrying out a periodic reassessment at predetermined times should be part of your plan.
What you mustn’t do is jump from one strategy to the next on a whim, or just because you’ve had a few setbacks.
Any investment needs to measured over a fixed period of time, at least six months to a year, preferably longer.
It’s important to remember no trading plan is going to be 100% successful – you just need to make sure you are getting more winners than losers, and if not, you need to analyse why.
Firstly it’s important to establish your risk appetite – it’s a fundamental part of your trading plan.
Are you risk averse, just seeking to make a modest but steady return on a ‘safe’ stock or fund, in the absence of good savings rates at banks and building societies?
Or are you perhaps more of an adventurer, prepared to take a higher risk of losses in pursuit of double-digit returns?
Or you might prefer a middle course, putting a small amount of your investment pot into higher risk investments, but hedging that risk by putting your remaining cash in those steady earners.
One way of looking at your investment risk options is by creating a pyramid sliced into three layers. At the base are your safest investments – savings accounts, ISAs, government bonds, corporate bonds from big blue-chip companies, and so on.
In the middle slice you have investments that are still fairly safe, but more volatile – though equally, likely to earn you a bigger return. These will include mutual funds, closed-ended funds such as investment trusts, shares in big-name, blue-chip companies such as Apple, Microsoft and McDonald’s in the US Dow 30, and Astra Zeneca, Unilever and easyJet in the UK’s FTSE 100. Interestingly, Amazon, Facebook and Google aren’t in the Dow 30 as too many high-value stocks would distort the average – but all can be regarded as blue-chips.
In the top slice you have the riskiest investments. Currency trades, CFDs on currency and stock movements (see below), and other short-term trading techniques.
The shape of the pyramid – tall and thin or fat and wide – will depend on your own personal risk preferences.
The next big question is timescale, which is closely tied to risk. Are you looking for a short-term investment? Perhaps you’ve been left a £10,000 bequest and want to make the most of it rather than leave it in a building society account earning a meagre 2% interest.
You weren’t expecting it, so you can afford to be adventurous in a bid to make the most of that cash.
Alternatively, you could be looking to self-invest some of your pension pot, rather than simply keep it in your workplace scheme. In that situation, you would most certainly be looking at a much longer time horizon, and investing in a fund (or funds) where you are unlikely to get any nasty surprises.
Risk management procedure and personal strengths
As well as risk aversion, it’s also important to establish your other personal strengths and weaknesses.
You need a cool, calm head for investing of any kind, but it’s critical for short-term investing. Be honest with yourself – if you think there’s a chance you might panic or be tempted to gamble, than stick to longer term investing.
Play to your strengths. If you have a particularly good knowledge of certain types of stocks – say tech companies – then it might make sense to focus your strategy on that.
Do you follow the news and keep your finger on the political pulse, either in your own country or overseas? If so, then you may be well-placed to ride currency pairs (forex) – speculating on whether a currency is going to rise or fall.
Bear in mind, however, that currency movements are always highly volatile, and screening out the noise can be tricky. But big events such as the Brexit referendum, or Macron’s resounding election win in France, will always produce a strong response.
Once you’ve established the basics, it’s time to start setting some targets. How much of your cash are you going to allocate to each of those pyramid slices?
If you’re running active positions at the riskier end of the spectrum, how many trades are you prepared to have open at any one time – and how much are you willing to risk losing?
In these situations it’s worth setting a maximum loss limit – the most you are prepared to lose in one hit (see the 2% rule below).
Another factor to take into consideration is your trading style. This governs your overall approach to trading: are you planning to make trades based on external factors – the news, essentially? This is known as fundamental analysis. Here you will be making decisions about trades based on a number of events such as:
- Central bank forecasts
- Economic analyses from global bodies such as the International Monetary Fund (IMF)
- Official government growth and employment figures – in the UK released by the Office for National Statistics
- Geopolitical factors such as government stability, military tensions or economic sanctions imposed on a country
The other approach is known as technical analysis, and takes a more mathematical approach to trading:
- Analysing patterns of behaviour in stocks or currency (forex) movements;
- Making decisions to trade based on predetermined theories or formulae such as momentum investing, averaging down or the Martingale theory.
Momentum investing, for example, involves riding the coattails of a rapidly rising or falling stock.
Analysts have established a so-called momentum effect where share prices tend to keep trending up or down for a period of time before changing direction. The trend can continue for anywhere between three months and a year.
The underlying cause is psychological – investors don’t want to miss out on a trend, so they pile in, or out, reinforcing the direction of movement and sending prices even further up or down.
A classic example of this is the phenomenal price rise of Bitcoin in 2017, from just under $900 at the beginning of January to nearly $19,000 in December – but while the momentum was mostly upwards, there were also some unexpected and horrendous falls.
Such strategies can bring rich rewards – but they can also lead to big losses.
If you are looking at making regular technical trades, you will probably want to use a trading system that allows you to buy and sell contracts for difference (CFDs).