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Unholy grails: profitability rules when the bear's in there

A lot of investors think the sharemarket is about finding good companies, and a lot of traditional value-based broker research simply focuses on that: on which stock to buy and on finding good companies.

A lot of investors think the sharemarket is about finding good companies, and a lot of traditional value-based broker research simply focuses on that: on which stock to buy and on finding good companies.

After a 33-year bull market, this process is quite developed, with a list of good-value, low-risk companies with sound balance sheets and high returns on equity now just a click away.

But with respect to the many decades of value-focused research that hasn't changed format since Benjamin Graham first put pen to paper, it is not enough - not in a bear market. In this market, "good" companies are going down in price and no one is making money on that information alone.

We have to do better than just identify good companies. Making money in this market is about risk and sentiment and that means timing the buying and selling of specific stocks over any time frame - not just the long term.

Palming off the responsibility for when to buy good companies with the line "you can't time the market" and evading the responsibility with the declaration that "one day, the value will be reflected in the share price" is a cop-out.

The truth is, share prices are just as likely to lead changes in value as value is to lead changes in the share price. But the value-based approach only plays one side of the equation and implicitly asks you to rely on the assumption that the value is right and the share price wrong.

That's some assumption, especially in a market in which value is being eroded daily by deteriorating trends in so many sectors of the global and domestic economies. More likely than not, the value calculation is wrong, rather than the share price, because the assumptions in the calculation are changing for the worse every day. No wonder so many stocks look like a "buy" - the valuations are too high.

In a high-risk bear market we have to do better than just buy good companies and wait for the value to appear. Making money in this market is about timing your buying and timing your selling. Here's how to do it in fewer than 400 words.

Pick up a copy of Nick Radge's book Unholy Grails, published this year.

He will tell you that while most beginners think success depends on their "win percentage" - the number of winning trades they make versus the number of losing trades - what really matters is your win-loss ratio, which is how much you make on a winning trade versus how much you lose on a losing one.

For instance, you can lose 80 per cent of the time (in other words, eight out of 10 trades lose money), but if you can contain the losses and let your profits run, you will still be profitable overall, as long as you make more than four times as much on those two good trades as you lose on your eight losing trades.

To quote Radge: "How much you win when you win and how much you lose when you lose is far more important than how often you win." Logical stuff. The aim is profitability and you don't need to be a divine stock picker to achieve it. In fact, you can be a bad one, as long as you can make more on your wins than you lose on your losses. Here's how you do that.

Three steps, in order of priority:

1. Control losses (by using stop-loss orders).

2. Let your profits run (by using a trailing stop-loss mechanism that lifts the stop-loss as the price rises, allowing unlimited gains).

3. Pick trades. Enter trades with as high a probability of winning as possible. On the arguments above, this is a subordinate priority to the other two.

The bottom line is you need to focus more on managing the trade after you buy than on what to buy before you buy. Identifying good companies is still important, but until a bull market returns, it is a secondary consideration.

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