In yesterday's Digest, we continued with our "technology" series from Matt McCall, editor of Early Stage Investor.
In it, Matt has been discussing the extraordinary investment opportunity in front of us today thanks to a wave of technological advancements coming our way.
Yesterday, we looked at five questions to ask yourself in order to help you find tomorrow's big winners.
Today, we pick back up with an often-overlooked topic -- after you've found these potential winners, what's the best way to buy them? We're talking the nitty-gritty details here ... limit orders, market orders, position-sizing -- all the nuts-and-bolts of adding these high-fliers to your portfolio. It's important stuff that most early stage investors don't consider.
I'll let Matt take it from here. Enjoy.
Jeff Remsburg
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How to Buy Early-Stage Companies Like a Pro
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Yesterday, we discussed five valuable questions to ask yourself as you comb through potential early stage investments. Today, let's say you've found a handful of quality investments and you're ready to buy. What now?
We'll build our wealth investing in smaller companies that go on to become bigger companies -- and their share prices get a lot bigger, too. As I mentioned, it's a venture capital-like approach, which is why the potential upside is so big. Because we'll be owning smaller companies, from time to time we may need to be a little more strategic in how we buy and sell. We do that through limit orders.
Smaller companies are sometimes not as liquid as bigger stocks, meaning they have fewer shares that trade on the open market. When that is the case, the stock's price can move quickly if tons of investors try to buy or sell a stock around the same time. Part of it is simple supply and demand. The price goes up when investors are buying. Part of it is also the market makers, or specialists as they are called. These are the people that facilitate the transactions between buyers and sellers. They will see the increased number of buy orders hitting and mark the price up. That's how they make their money, and they don't need to take any of ours.
Limit orders are the way we protect ourselves. We specify the maximum we are willing to pay for a stock we are buying, and we specify the minimum we are willing to take for a stock we are selling. That way we buy or sell on our terms and not somebody else's.
These are easy to set with your broker, and they are especially important when it comes to lower priced stocks. For example, if you wanted to buy a stock that is trading for $2.75 and a flurry of buy orders runs it up to $3 or higher, that's already a 10% difference, which is the market's average gain for an entire year.
In the end, strategic use of limit orders can impact your returns on a trade more than you might think. Add that up across multiple trades and over time and the extra money you have in your account can be significant.
How to Size Your Positions Like a Pro
All too often, investors get excited about a company's prospects, think about all the money they'll make, and buy some stock. They don't spend two seconds thinking about an absolutely critical component of investment success.
That component is called "position sizing."
Position sizing is the part of your investment strategy that determines how much of your portfolio you place into a given stock, ETF, mutual fund, or bond.
For example, suppose an investor has a $100,000 account. If he buys $3,000 worth of stock in a company, his position size would be 3% of his capital. If he buys $10,000 worth of stock, his position size is 10% of his capital.
Position sizing is MUCH more important to your investment success than any one single stock position.
Smart position sizing is one of the important ways investors can protect themselves from what's called a "catastrophic loss."
A catastrophic loss is a loss that erases a big chunk of your investment account. It's the kind of loss that can end a career ... and even a marriage.
The catastrophic loss typically occurs when an investor takes a much larger position size than she should. She'll find a stock that she is very excited about, start thinking of all the profits she could make, and then make a giant bet.
She'll place 30%, 40%, 50% or even more of her account in that one stock. If that stock plummets in value, the account takes a huge hit.
The obvious damage from a catastrophic loss is financial. If an investor with a $100,000 account suffers a catastrophic 75% loss, he is left with $25,000. It takes most people years to make back that kind of money from their job.
The less obvious damage a catastrophic loss can inflict is mental trauma. It's crushing to know that you blew a big portion of your wealth with such a dumb move.
People can get knocked out of the investing game forever.
To avoid catastrophic losses, your first line of defense is to size your positions correctly. Most experienced investors will tell you to never put more than 4% of your portfolio into any one stock.
Others will tell you to never put in more than 5%.
When investing in volatile, early stage companies position sizes should be smaller ... like half a percent of your portfolio ... or 1% of your portfolio.
This concept is critically important to your success, so I'll state it again for emphasis: When you invest in early-stage companies, they have a higher failure rate than established businesses.
That's why it's critical to size your positions intelligently. A good rule of thumb is to never put more than 1% of your portfolio into an early-stage company.
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How to Be Right Just 33% of the Time and Still Make a Fortune
To the average investor, a 33% "win rate" on stock buys is a depressing thought.
Having a high "win rate" -- like "8 out of 10 stock picks are winners" -- is important to average investors.
However, the best venture capitalists and professional traders don't place any emphasis on "win rate." They know that with a good strategy, you can be right just 33% of the time and make a fortune in stocks.
Early-stage stocks are among the riskiest securities on the market. They are more volatile and have higher failure rates than established businesses like Walmart and Coke. That's just the nature of the game ... and that's why the payoffs in early-stage investments can be so huge.
Because early-stage companies can produce such gigantic capital gains -- and because they have higher failure rates than established businesses -- it's vital to understand a key money management principle used by the best venture capitalists.
As an early-stage investor, you're not going to achieve success on 100% of your investments. You probably won't achieve success 75% of the time ... or 66% of the time.
And that's fine.
When you invest like a venture capitalist, you can be right just 33% of the time and still make HUGE returns.
Some simple math shows us how it works ...
Let's look at a hypothetical investment example.
On December 1st, you structure a "venture capital" portfolio of 12 promising businesses. You hold them for a year. The returns of these 12 stocks are listed below.
In this example, four went up and eight went down. You were right 33% of the time. But because you hit just a few big winners, you made a great average return of 40% across the 12 positions.
Over the past 60 years, the legendary trader George Soros has made more than $20 billion in the financial markets. Soros is a genius at knowing how government actions affect markets. He's skilled at finding industries poised to boom. But there's a simple mindset that's more responsible for Soros' success than either of those things. Soros once summed it up like this:
"It's not whether you're right or wrong that's important, but how much money you Soros didn't focus on how often he was right. He focused on making his successes big and meaningful ... and making sure his mistakes were small and manageable. That's what we need to do as well.
I get how people feel the need to be right. I like to be right as much as anyone. In my early years as a stock broker, I had a boss once ask me "do you want to be right or rich?" I did not answer him, but I knew immediately what the correct answer was. I try to reduce my downside risk as much as possible. But the simple fact is that early-stage companies carry risk. I know I'm not going to be right 100% of the time.
The good news is, when you make sure to win a lot when you're right, and only lose a little when you are wrong, you can be right just 33% or 50% of the time ... and still make huge profits in early stage companies.
Okay, that's it for today. I'll be back next week to wrap up our series. We'll be talking about a basket approach, not checking market prices every day, and coffee cans. Confused? Join me next week and I'll explain.
In the meantime, if you'd like to learn more about my Early Stage Investor service where I follow the big money created by these tech advances, click here.
See you tomorrow,
Matt McCall
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