Create a stock investing strategy in 3 steps

An investing strategy aims to guide confident, effective trading decisions. Without a strategy in place, investors are more likely to overtrade, let emotions take over, or inadvertently change their risk profiles. Any of those outcomes can limit long-term growth potential.

Whether your objective is generating gains or income, having a defined approach provides the best chance of success in the stock market. Fortunately, you do not have to be an investing whiz to create a strategy that works for you.

You can develop a solid, personalized investing framework in three steps.

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Risk tolerance describes how much volatility you will accept within your investment portfolio. Your appetite for, or aversion to, risk should influence every aspect of your investing strategy.

Note, too, that risk and reward work together in investing. Higher-risk assets have greater growth potential, and lower-risk assets have lesser growth potential. The relative risk and reward of investing in stocks versus cash demonstrates this.

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Since risk tolerance is a foundational element of your strategy, it is wise to define it in writing. With that documentation, it should be easier to review and validate your approach periodically. If your risk appetite has not changed, your strategy is likely still on point. Or, if your defined risk tolerance no longer suits you, it is probably time for a strategy overhaul.

The simplest way to clarify your risk tolerance is to consider portfolio-decline scenarios. Could you handle a 10% dip in your investing account? What about 50%?

Your maximum capacity for unrealized losses can indicate where you fall on the risk tolerance spectrum. You incur an unrealized loss when a stock you own declines in value. Losses are realized only when you sell a stock for less than you paid for it.

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An example of what your risk tolerance spectrum might look like:

• If 10% is your limit, you are risk averse.

• If you can accept dips in the 20% range, you have a moderate risk appetite.

• If you can accept dips of 30% or more, you are risk-tolerant.

With a higher risk tolerance, you can comfortably own stocks that have greater growth potential — stocks like Nvidia, for example. Ayako Yoshioka, portfolio consulting director at independent asset manager Wealth Enhancement Group, notes that Nvidia stock (NVDA) has gone through multiple periods when it’s down more than 50%. The stock, therefore, provides a useful thought experiment for investors. If a stock you own loses half its value, would you panic and sell or be willing to wait for a recovery?

Asset allocation is the composition of your portfolio across different types of assets. Setting asset allocation targets helps you manage risk according to your tolerance.

For example, conservative investors might target 50% exposure to stocks and 50% exposure to bonds. In this mix, the stocks provide growth potential along with volatility. The bonds provide stability in repayment value and income.

A portfolio with a higher percentage of stock could deliver larger gains but with more risk. That is why aggressive investors who can handle risk prefer heavier stock exposure, up to 90%.

You can also break your targeted stock exposure down into smaller categories, such as growth stocks, value stocks, small caps, mid-caps, large caps, and international stocks.

You might also cap your relative exposure to any single stock. This is particularly important for volatile growth stocks, which can reprice quickly and dramatically. Holding each stock to, say, 5% or less of your portfolio keeps you from being too reliant on any one position.

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Your allocation targets guide your initial portfolio construction and ongoing trading decisions. For example:

1. As a stock price appreciates, that position’s holding value becomes a larger percentage of your portfolio. The position could eventually exceed your single-stock exposure cap. That would be a cue to sell some of your shares to reduce your exposure and take profits.

2. A dip in price could leave you with room to increase your position. If you still believe the stock has an upside when that happens, it may be time to buy.

Michael Kodari, CEO of wealth manager KOSEC Securities, recommends setting target buy and sell prices to manage risk.

Target buy prices can be based on formal or informal estimates of the company’s intrinsic value. Formal methods to establish value include dividend discount method (DDM) and discounted free cash flow (DCF) analysis.

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DDM quantifies a company’s value by estimating future dividends and adjusting that income to the present value. DCF follows a similar logic but discounts the company’s projected free cash flow rather than dividends. Informal methods for establishing value include peer and historical comparisons.

Note that many investors set their desired buy price lower than their value estimation. This provides a margin of safety from further stock price declines.

Setting target sell prices can be more straightforward. You can base these on unrealized gain percentages or whatever price would cause the stock to exceed your allocation targets. For example, you may want to take profits when the stock price rises 20% above your buy price.

Other data points that can inform your triggers include:

1. Relative strength index (RSI). RSI is an indicator of momentum that measures the speed and size of recent stock price changes. An RSI of 70 or higher indicates the stock could be overbought and ready for a price correction. An RSI of 30 or less implies the stock is oversold, which can create a bargain price point.

2. Valuation ratios. Price-to-sales and price-to-earnings ratios quantify how expensive the stock is relative to its revenue and earnings, respectively. These ratios are most meaningful when compared to peers and the company’s historical values.

3. Analyst ratings and price targets. Analysts have in-depth knowledge of the companies they cover. They are not infallible, but analysts can quickly identify how recent developments affect a stock’s outlook. If you’re questioning the outlook of a stock, try reviewing what analysts have to say as a starting point.

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A solid investing strategy can transform your investing from guesswork to a productive methodology. Use it to ground your decision making — especially on headline-grabbing stocks like Nvidia or Tesla (TSLA) — for a surer path to wealth creation.