First Steps: Step Four - Planning an Investment Strategy

Have you ever wondered why some people appear to be good investors while others seem to always lose money in the market? It's a question asked by many investors - both those who are new to buying shares and those who have been investing for some time.

It is often easy to attribute other people's investment success to factors like luck or opportunistic timing. It is equally easy to blame your own poor investments on the market, your broker, or the person who gave you a bad tip.

Unfortunately many of these beliefs are unfounded. The one thing that often separates good investors from bad is an investment plan.

An investment plan is essential for all types of investors, including those putting money into the sharemarket. You wouldn't just tell a builder to build you a house and leave it up to them to make decisions like how much to spend, what kind of time frame you have, or what the house should look like. The same follows for building wealth. You need to think about things like your financial goals, how much you want to spend, how much you are prepared to lose, and so on.

Many New Zealand and Australian individual investors have bought shares in companies for reasons that they cannot themselves explain. Buying shares because your colleague gave you a tip or because you read something in the newspaper is commonplace among many investors. The same investor typically has no idea when they intend to sell, or how they were going to make money from the investment. Most remarkable of all is that many people feel that because they are "in for the long-term," that they do not require any sort of plan.

There are three steps to every investment in the share market. First you must decide what to buy. Next, you must monitor your investment. Finally, you must decide when to sell. Most people have no problem with stage one and can buy shares with reasonable confidence, but the next two steps are trickier.

Let's first consider the different reasons why you might decide to buy a share. You are obviously interested in making money in some way, and so the first thing to ask is, "how will this share make me money?"

This can typically happen in two ways. Firstly, the market value of the share that you bought could increase and you could sell the shares for a profit, also called a "capital gain". The second way that investors in New Zealand and Australia can make money from investing is by sharing in the profits that a company makes. This is paid out as a dividend.

Dividend payments are not as certain as they once were in local markets because a number of companies have followed the American lead of reinvesting profits to build up their business. This has changed the way many individual investors choose which shares to buy. However there are still plenty of New Zealand and Australian companies that that do pay regular dividends and many people invest in these companies to receive income from these payments.

When you invest in a company to earn a share of the profits through dividends it is called "investing for yield", and it is possibly the easiest type of investment to plan. You can choose which share to purchase by looking at the historical dividend yield and projected dividend payments.

For example, you might decide to buy a share that has an historical yield of 10% and a projected yield for the next two years of 15%. This would satisfy the first stage of your plan - deciding what to buy. You will then have to monitor the company to make sure their dividends stay in line with your expectations. Your reasons for buying the share will also give you the knowledge you need to know when it is time to sell. In this example, you bought because you wanted to receive between 10% and 15% per year in dividend payments. If these payments were to dramatically reduce, or stop altogether, then you would know that it is time to sell. If you always remember why you bought the shares, you should have a better idea of when you should sell them.

In later articles we will discuss the strategy of investing for dividend yield in greater detail. Unfortunately it is not as simple as just looking for a high yielding share and buying blindly. A 10% yield is useless if the value of the share drops by 20% and therefore it is important to use additional methods to reduce the risk of a decline in price.

As we have shown in the example above, it is important to keep in mind why you bought a share to help you decide when to sell. This basic principle can be applied to nearly every method of share investment. For example you might decide to buy a share based on a growth strategy. You might look at factors such as the projected earnings and market share of a company and would therefore sell that share if the company failed to meet its earnings targets, or lost a large portion of its market share. Too many investors are given advice to buy a share and then fail to track the share using the same criteria. This can be a failing of an advisor as well as an investor.

Short-term "technical traders" require a very strict investment plan. Technical traders are people who buy and sell shares in the market based on a technical analysis of what is happening to the share price. They buy shares for short-term capital gain and rely on their discipline to ensure that losses are controlled and profits monitored and taken. Traders use selling methods that directly relate to why the share was purchased. For example, if a share was bought because it has broken in to a new "trend", then it is sold when that trend stops and the price begins to fall.

The next few articles will discuss specific investing strategies in more detail. It is essential that a plan is developed for whatever investment strategy you currently use, or decide to use in the future. Perhaps you might want to consider your current investments and ask yourself if you can remember why you bought the shares, and under what conditions you will sell them. As the saying goes, if you don't know where you are headed, how will you know when you get there?

This article was written by Nick McCaw from Intelligent Investing