Guest Author - Guido Deboeck

Those who have been reading articles on this site already know that Investors Business Daily (IBD), the financial newspaper pioneered by William O’Neil, is an essential tool for learning and making progress in investing.

One of the dominant features of IBD, shown daily on the Investor Education page, is “IBD’s 20 rules for Investment Success”. The introduction to those rules states that “these are based on detailed models of all the most successful stocks from 1880 to 2005”. These rules represent the cumulative experience of O’Neil and his team over many years. As far as I know there is howeveer no published data on the models or patterns that O’Neil used to suggest these rules...

“Investment success” can mean different things to different people. The success that O’Neil and his team of portfolio managers achieve may not be the success you can achieve! Working as a portfolio manager or trader for someone else, managing someone else’s money, is totally different from managing your own, or investing your family’s assets. People behave differently if they work for a bonus rather than invest their own money.

The main objective of this article is to provide a simpler, more intuitive, easier to learn set of rules for investing and achieving your investment results.

Let’s start by reducing the number of rules and putting some order in the set. Twenty rules are a lot to remember. Most people find it easier to remember ten rather than twenty rules. After all there are only Ten Commandments; why should investment success require more?

Here are my ten rules for achieving investment results starting with the most important rule of all. It assumes that you first learn to determine what is the direction of the market. Rule 1 suggests that you invest ONLY when the market is in an uptrend, meaning “you have the ball “(see my article on market direction). Reading key sections such as "The Big Picture" in IBD on a daily basis may obviously facilitate this.

Next, we focus on what to buy. Rule 2 suggests that you consider only companies with solid earnings growth over the past three years, with recent quarterly earnings growth well above that of their peers, who have strong sales growth, who have management ownership, and increasing institutional participation. If you have IBD and look on the Investor Education page you immediately notice that this rule pulls together several IBD criteria for picking stocks. Today, with Daily Graphs OnLine, an excellent IBD service, all this information can be found in one chart. Most of it can also be found in the newspaper itself when you browse the highlighted stocks.

Rule 3 is about when to buy. To start learn to read charts, learn to recognize patterns in charts, and learn to identify buy points. Rule 3 suggests to buy stocks only when they are at their buy point or within 3-5% from their buy point; and never to buy them when their price exceeds more than 5% from their ideal buy point.

Rule 4 is about what to hold. Stocks that are in your portfolio need to perform. What would be the point of holding onto stocks that don’t? If a stock performs well, it becomes a candidate for accumulation, meaning more shares of that stock would be added. If a stock increases fast you quickly endup with a decent return, then you may hold that stock longer. Other stocks who move site ways are candidates for elimination. Hence Rule 4 suggests evaluate individual stock performance constantly to determine which to hold long, which to hold for a shorter period, which to eliminate quickly.

The rule that is the most difficult of all is when to sell. Rule 5 suggests based on O’Neil to sell any stock that drops 7% to 8% below the original purchase price. Clearly this is not a natural thing to do: you invested in a stock because you researched it thoroughly and you bought it at the right time, nevertheless it moves against you and proves you wrong. It will always be cheaper to accept you were wrong than to try to prove the market wrong by holding on to a stock whose price is going down.

Rule 6 expands on Rule 3 but fits after Rule 5 because we talked about prices going down. Rule 6 suggests that you do not buy stocks because they are way down, no bottom fishing; that you avoid stocks that are cheap, avoid buying stocks because they have high dividends, low price-earning ratios or other oversimplified criteria. This rule also suggests to avoid buying on the basis of rumors or advice provide by others (family, friends, dentists, hair dressers, taxi cab driver…)

The next rule does not appear in the IBD’s 20 Rules because the focus of IBD is on stock picking not on portfolio and risk management. Rule 7 suggests that whatever amount you have to invest you divide it approximately equally between 5 to 7 stocks. If you have less than $50,000 to invest maybe you should divide it between 3 to 5 stocks only. If you have over $100,000 to invest, stick to the five to seven split. Once you know the amount to put in each stock (for example, if you have $50,000 to invest and choose to keep 5 stocks, then each holding would be no more than $10,000), then calculate the number of shares this allows for each stock you plan to buy (e.g. if a stock is at $35 then buy no more than 285 shares of this stock if your limit is $10,000).

Rule 8 tells you how to accumulate stocks. If the ask price of stock XYZ that you have researched thoroughly is $35 then you buy no more than 285 shares of XYZ. Rule 8 suggests that you would do this in stages: start with buying, say, 140 shares, after the stock performs well (i.e. is up 2-3 %) add 75 shares and later when you have 5% return or higher add another 70 shares.

Rule 9 is the inverse of rule 8. When a stock in your portfolio goes down -- it breaks through its 10 day moving average-- then it is time to sell half of your shares; when it goes further down sell another half of your holdings; and when it reaches its 50 day moving average you should be out.

Finally, Rule 10 suggests that on a regular basis you evaluate how you are doing. O’Neil talks about an annual post-analysis of all your buys and sells but that is really not frequent enough in the rapid moving financial environment. Rule 10 suggests that at least on a monthly basis you compute the rate of return of your portfolio (or that you keep this updated in an Excel spreadsheet) and compare it with standard indices. If you match the performance of the indices you are doing OK as an investor (lots and lots of professional managers do not even achieve that much), if you are doing better or significantly better than the market indices then you are doing more than OK. If unfortunately your portfolio is not matching the returns of the indices then you need to reflect, revisit the above rules, and become more disciplined in applying them.

As an exercise you can compare my ten rules for achieving investment results with the original IBD 20 Rules for Investment Success . You will find that mine put greater emphasis on portfolio and risk management while keeping the essence of stock picking. I left some out, bundled others, and have added rules that O’Neil does not have. Knowing very well that O’Neil strongly objects to any thinkering with his rules, there may nevertheless be some value added from streamlining, structuring, and complementing the O'Neil investment rules, based on our own experiences. We all can learn from each other.

If you have any comments or suggestions on the above please raise them in the Investing Forum.