Rules-Based Investing Essential for Stock Investors

by Scott O'Neil

The trait most common among successful investors is not intelligence, experience or intuition. It’s discipline.

Disciplined investors actively use a set of proven rules that protect them and guide them through the ups and downs of the stock market. Those ups and downs can stir up costly emotions. Fear and greed (fed by the “noise” of numerous opinions) drive untimely buys and sells. Pride leads us to rationalize losses, and hope makes us hold on to stocks that can demolish a portfolio. Not only do rules prevent disaster, they represent a consistent approach to making profits and taking better control of your portfolio.

Control is the opposite of what most investors have felt this past decade. Since 2000, owning stocks, for all of us, has felt like being in the ring for 12 rounds with Mike Tyson. Your stock gets hit with bad news or an analyst downgrade, and then, just when you’re getting up off of the mat, another earnings season is upon you. Meanwhile, that great fundamental story doesn’t seem to be lifting the stock’s price; you’re still down on the position. Worse, you hear a choir of opinions singing the praises of buying on the dips, saying “what a great value XYZ Corp. is at current prices,” so you buy more. Then one morning you log in to check your account, and your equity is down another 15% or 20% on the year. Just try combating the full range of emotions that enter the picture now. Your retirement is at stake, and you still haven’t recouped losses from the 2000 bear market or maybe the 2008 bear market. Your thoughts get understandably bleak. “I can’t get a break … nothing is working.” Unfortunately, many individual investors are in these shoes right now.

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Scott O'Neil is president of MarketSmith, Incorporated and a portfolio manager with the O'Neil companies.


Percy from Illinois posted over 2 years ago:

The only way to have made money in the US stock market in the last eleven years was to time it using a good trend-following system. Even a crude market timing strategy such as an 80 day simple moving average trendline crossover of the S&P500 index would have done far better than a buy and hold approach. In other words buy a listed indexed fund when the index moves above the trendline and sell it when it falls below that line.

We are in a secular bear market that started in 2000 and may last for many years more. Only by riding the market's uptrends and avoiding its downtrends can one make capital gains in a sideways or downwards swinging market.

For instance check out; an Australian trend-following site for the emperical evidence to support such an approach.

Emory from Nevada posted over 2 years ago:

All rules are out since the government, banks, fed, etc. have begun manipulating the market.

Let's face it, the individual investor is screwed.

Allen from Oklahoma posted over 2 years ago:

We've all probably heard about the 6-10% loss cutting rule, but I've always had a tendancy to hold my winners perhaps too long. Problem is, you can't use a simple set of rules to apply towards all positions. If one had sold out after having a 20-25% gain on Apple, I'd bet they'd be kicking themselves.

James from Ohio posted over 2 years ago:

This is a very good article. I offer these observations about it and some additional thoughts.

1 - The author says “…. investors must develop a set of criteria ….” and “stick to them.” I’d take it a step further. Write down your criteria. Make a list of criteria for buying and another list for selling. Why? I suspect that most investors are like I was when I first developed and started using strategies. I didn’t write them down and what I discovered happening was that I (almost unconsciously) changed the strategy as I used it. “Discipline” is achieved by using the same strategy over and over again. If you keep changing it, down the road, you won’t know what worked well and what worked poorly.

2 - Once you develop and write down a strategy, back-test it (or at least forward-test it with paper transactions). You wouldn’t use a strategy that produced poor results in the past, would you?

3 – While the author initially endorses “disciple”, he indicates that his team’s decisions as to how many stocks to own depends on (a) how many stocks they want to own and (b) his team’s “comfort” level. Also, in his “Portfolio Management Rules” section, he says an investor needs to assess the “personality” of each stock. It strikes me that “comfort” and “personality” rules are likely to be pretty soft.

4 – It gets somewhat lost in the detail of the article, but the approach that the author says his team uses starts with ‘Fundamentals Analysis’ and stock screens and then they use ‘Technical Analysis’ to determine when to buy and sell.

5 - Fundamental analysis is virtually irrelevant when it comes to investing in mutual funds and ETFs, which is what I suspect may investors do. With mutual funds, an investor has delegated the analysis and decision making to the mutual fund manager. With ETF’s the fundamentals data is either extremely hard to obtain and update or doesn’t exist.

6 – The problem I’ve observed with most stock screens I’ve read about is that they only tell you which stocks currently meet the criteria. They don’t tell you what kind of investment results you would have made by investing in those stocks which met the criteria a year ago (or two years ago). (That’s a form of back-testing.) Certainly, some screening software (notably, AAII's Stock Investor Pro) can do this, but it takes a fair amount of additional effort to set it up.

7 – In his “Buy Rules” section, the author says stocks that are trending up for several weeks will pull back at some point (that’s a BGOTO!) and stocks that are trending down have a high probability of continuing down before coming back. While I can’t deny this, I’d like to see the supporting evidence.

8 – The author stated that the detail rules provided in the article apply to his “growth” investment methodology. I’d like to know what his rules are to decide to use a “growth” versus “value” versus some other methodology.

9 – While "timing the market" has somewhat gone out of fashion in many investing circles, the author clearly states that is what he does which he says has enabled him to make gains well above the average and avoid big losses.

Jim Grant
Solon, Ohio

Per from Illinois posted over 2 years ago:

As far as I am concerned, owning individual stocks is not suitable for individual investors. As for equity mutual funds, they have been no bargain either.
Fixed income, (domestic, foreign,EM)has outperformed most equity fund combinations and with only a fraction of the volatility.

Herb from California posted over 2 years ago:

Buy and hold can result in steady gains over the long term - I've done it for years. I don't claim to be Warren Buffett, but I use his strategy. You need to find solid companies that have a proven track record of performance, those with a "wide moat" and a history of dividend payments and growth. A good starting point is to look at the "Dividend Aristocrats" of the S & P (just Google the phrase. You need to do a little study, but its not that hard. Be sure you understand what the company produces and if they do it well.

Robert from Arizona posted over 2 years ago:

If "all the charts and indicators" you mentioned were pointing to the 2008 decline and those who were aware of these trends got out safely.
When one analyzes the mass of losses racked up by "professional" investors with very familiar firms and brokerages, and realizes that less than 1% of professional traders did not incur losses, many of which were well over 30% declines.
If the "pros" either did not follow your advice or had alternate strategies, then do you think it reasonable to assume that the "average" or even "sophisticated" investor was "able to get out safely"?
I found this article "entertaining" and extremely naive.
With respect to your comment (which I believe to be true) that all bear markets end sometime.....the damage done by the literal collapse of the investment banks and resulting losses to thousands of citizens will most likely take many, many years to be recovered and if we have a "new bull market" in the near future, most investors will not have enought funds to invest.

Larry from New York posted over 2 years ago:

Scott O'Neil is the son of William O'Neil founder of Investor's Business Daily (IBD) which for a retail investor is way better than the Wall Street Journal. William O'Neil also authored the book "How to Make Money In Stocks" which is in it's 4th or later edition. The system spoken of works if you follow it, but the secret to it is to only buy "leaders in the market" or what institutional buyers are buying and to watch when they stop buying and start selling. My advice is to look into it, the book is less than $20 and to look into a "Meetup" group near you on that is a IBD sponsored group. Hopefully you'll find one near by. Attend 4 -5 meetings and if they are run right it may change your thoughts and your personally taking charge of your own investing decisions on individual stocks. It really runs parallel with AAII on fundamentals but goes further on charting and technicals for when to buy and sell.

Patrick from New Hampshire posted over 2 years ago:

While I agree with the theme and most of the statements made in the article, my overall impression is that the article is long on generalities and very, very short on specifics. Other than the statement about limiting losses to no more than 8%, there was little else in the article. While Mr. O'Neil is certainly a very successful investor, he gave no information about what buy and sell rules that he uses. I am sure that he would not give away the store by giving all the specifics of his investing strategy but he could have provided a few more specific examples. Overall, the article was interesting and entertaining but had a very low investor-education value.

Raymond from North Carolina posted about 1 year ago:

Subscribe to IBD and you will learn all the rules and so much more. Go to your local library and check it out in the newspaper section.

Michael from New York posted about 1 year ago:

I like the article. The premise is rules lead to better investment decisions. My experiences bears this out. I doubt the author could specify criteria. Risk tolerance differs among investors. Criteria would logically be different for different portfolio strategies. The value added by investors must be in the development, application and modification of rules.

Ron from Ohio posted about 1 year ago:

I will speak based on my record since 2006. Except for last year when I made only about 8%, I have averaged between 11 and 23% gains,without a losing year. I developed a set of rules in 2006 before that my gains and losses were all over the map. The rules I have is when the SP-500 breaks its 50 week exponential moving average, I close all stock positions, tighten my stop losses, and go to cash and/or maybe bonds depends on the interest environment. I never lose more than 10% on any investment period. If you are down 10% you are wrong. Sell. I like to stocks that are growing in both revenues and profits, but I only buy when the price is between the 13 and 26 day exponential moving averages( Alex Elder's Rules) and the stock has at least a 10 point possible gain (Martha Stokes rules). I believe in buy high and sell higher. I move my stop loss up as the chart indicates, realizing I will never make the last dollar. I never ever average down. I did it once for Pfizer and lost a lot. That was how I learned the 10% loss rule, a hard painful and expensive lesson. Anyway, that's my 2 cents worth

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