The stock market’s average return is 10 per cent annually — better than you can find in a bank account or bonds. So why do so many people fail to earn that 10 per cent, despite investing in the stock market?
The reason according to expert investors is either many don’t stay invested long enough, or they sell their investments at the wrong time. So, what we can learn from this is – timing the market is key to making the most profits.
Timing is key
Timing the market is key to making the most profits.
Many sell their stocks before they peak, others hold on to them in the hopes of a recovery. This begs the question—how do you determine when is the right time to sell?
When investors begin to believe the investment will begin losing value, they tend to take the profit they know they have rather than a loss. So it’s vital to understand how to time the market.
For those cricket or baseball lovers, here is a common sport reference to help you understand the art to timing your stock market investments to perfection.
You do not need to hit sixes (in cricket) or home runs (in baseball) to win the game. Focus on running singles or getting base hits – Same applies to the investing game!
Though contrary to human nature, the best way to sell a stock is while it's on the way up, still advancing and looking strong to everyone.
"The secret is to hop off the elevator on one of the floors on the way up and not ride it back down, again,” said renowned stockbroker and entrepreneur William J. O'Neil.
So, what veteran investors often recommend is – after a significant advance of 20 to 25 per cent, sell into strength. This way, you won't be caught in heart-breaking 20 to 40 per cent corrections that can hit market gainers.
The Rule of 72
This simple calculation shows how effective following the 20-25 per cent profit-taking rule can be.
For example, if you invest money at a 10 per cent return, you will double your money every 7.2 years. (72/10 = 7.2). And if you invest at a 9 per cent return, you will double your money every 8 years. (72/9 = 8). Similarly, if you invest at an 8 per cent return, you will double your money every 9 years. (72/8 = 9).
The rule of 72 essentially states that the amount of time required to double your money can be estimated by dividing 72 by your rate of return.
If you manage to get three stocks that posted 24 per cent gains — and re-invest your profits each time — you will nearly double your money.
TIP: It's much easier to get three 20-25 per cent gains out of different stocks than it is to get a 100 per cent profit out of one stock. Those smaller gains still lead to big overall profits.
Here is the table below to illustrate how this works:
In other words, if you had invested in an index fund that tracks the S&P 500 in 1994 and you never withdrew the money, you would have average returns of 8.52 per cent per year.
At that rate, you should expect to double your money about every 8.45 years (72/8.52).
It's also important to understand that the market often takes wild swings in any given particular year and does not simply grow at the average rate.
During the 25 years from 1994 through 2018, the market gave returns as high as 34 per cent in 1995 but declined by as much as 38 per cent in 2008.
Now let’s explore a question that would have crossed most of your minds at this stage. Why particularly 25 per cent and what is the significance of booking profits when stock rise as much?
But to understand that clearly, one should first familiarise oneself with a few concepts – like ‘breakouts’, ‘fakeouts’ and ‘basing’ – which we will now explore by learning how one can use stock charts to make profits.
How to use stock charts to win big?
• Understanding ‘Breakouts’ and ‘Fakeouts’
Before we go into a set of pointers that can enable a trader to make profits, it is vital to know what a market ‘breakout’ is. Here is the technical definition.
“A breakout is a stock price moving outside a defined support or resistance level with increased volume. A breakout trader enters a long position after the stock price breaks above resistance or enters a short position after the stock breaks below support.” Sounds complex? Let’s break it down.
Every stock’s price movement is known to have an unseen barrier that has come about as a result of technical analysis of the stock market.
Once the stock trades beyond the price barrier (breakout), volatility tends to increase and prices usually trend in the breakout's direction.
The reason breakouts are such an important trading strategy is because these setups are the starting point for future volatility increases, large price swings and, in many circumstances, major price trends.
Regardless of the timeframe, breakout trading is a great strategy. Whether you use intraday, daily, or weekly charts, the concepts are universal. You can apply this strategy to day trading, swing trading, or any style of trading.
When trading breakouts, it is important to consider the underlying stock's support and resistance levels. The more times a stock price has touched these areas, the more valid these levels are and the more important they become.
Support is a price level where a downtrend can be expected to pause due to a concentration of demand. As the price of assets or securities drops, demand for the shares increases, thus forming the support line. Meanwhile, resistance zones arise due to a sell-off when prices increase.
Once prices are set to close above a resistance level, an investor will establish a bullish position. When prices are set to close below a support level, an investor will take on a bearish position.
Which is why entry points (for an investor to take an investment position in a stock) are fairly black and white when it comes to establishing positions on a breakout.
At the same time, the longer these support and resistance levels have been in play, the better the outcome when the stock price finally breaks out.
Now coming to what are fake-outs.
Fake-out is simply a term used in technical stock market analysis to refer to a situation in which a trader enters into a buy or sell position in anticipation of a future price movement, but the signal or movement never develops and the asset moves in the opposite direction.
To determine the difference between a breakout and a fake-out, wait for confirmation.
For example, fake-outs occur when prices open beyond a support or resistance level, but by the end of the day, they wind up moving back within a prior trading range.
If an investor acts too quickly or without confirmation, there is no guarantee that prices will continue into new territory.
Many investors look for above-average volume as confirmation or wait toward the close of a trading period to determine whether prices will sustain the levels they've broken out of.
Understanding ‘Bases’ or ‘Basing’ is crucial too
Basing is again a term used by technical market analysts that refers to a consolidation in the price of a security, usually after a downward trend or downtrend, before it sets out on a bullish phase (that encourages regular buying). The resulting price or chart pattern looks flat, or slightly rounded.
In other words, a base is when the market is taking a break.
Some securities, like stocks, can form a base that lasts for several years before the trend reverses.
And that typically happens around the same time the general market upward trend begins to slip into a correction.
That's why following the 20 to 25 per cent sell rule can help you lock in your profits before the stock begins to sell off and forms a new chart pattern.
(So now this answers our earlier question of what makes 25 per cent an ideal return percentage to book profits.)
TIP: Generally it has been observed after a company's stock chart forms two such bases and beyond, the stock's movement becomes unreliable and advisors recommend a 'sell' at such stages of basing.
And furthermore, when the market rebounds, the cycle begins all over again: Stocks break out of the bases they formed during the past correction and move higher.
(Which is also why it is always recommended that to buy stocks at the right time, one needs to stay in sync with the market cycle.)
The big money is made in the early stages of a new uptrend. And to capture those gains, you need to do your homework during a correction and identify stocks forming the telltale bases that precede a new price move.
Technical market analysts have found that typically, growth stocks tend to advance up to 25 per cent after breaking out of a proper base, then decline and set up new bases, and in some cases resume their advances
So in most cases, you're better off locking in your gains to avoid watching your profits disappear as the stock corrects.
And you can potentially compound those gains by shifting that money into other stocks that are just starting a price run.
By following this disciplined approach, you'll regularly nail down the kind of solid gains that lead to large, overall profits in your portfolio.
Checklist for traders to make profits
Now, expanding on the previous guideline to sell at a 20-25 per cent return, and while making use of the terminologies and concepts we just learnt – here is a checklist to help get a better grasp of nailing down the best time to buy and sell when trading in real time.
If the stock's 20 per cent gain comes in the first two or three weeks after the breakout, then it is advised to be held at least eight weeks — unless any major sell signals or a severely negative change in general market trend.
TIP: Such stocks that often get a fast start are an indicator of being a market winner. You don't want to sell such a stock too early.
If a market winner took longer to reach the 20 per cent mark but has three quarters of earnings growth acceleration in a row, you might want to hold the stock — given its strong earnings growth potential (or any stock with strong underlying fundamentals).
If the 20 per cent gain came slowly and from a second-stage base or later, you should sell. The reason for that is most big winners correct after a 20 per cent to 25 per cent gain. It has been historically proven that a third-stage base is prone to fail. So, why hold for that?
Most big winners correct after a 20 per cent to 25 per cent gain. It's been historically proven.
If the gain came in an erratic fashion, sell. It doesn't matter if the stock or the general market is to blame. Such a stock is likely to move against you quickly.
If you've taken several 7 to 8 per cent losses and have no stock up 20 to 25 per cent, consider taking smaller profits to erase the losses. Then you would want to step back and study your buys and sells to determine the reason you are losing.