Building core investment platform

Investing is great way to obtain financial freedom. However, reverse is true as well, investing in a project/company that does not do well can lead to loss and great psychological pain

My aim in this article is to streamline a process so that we can have a good decision-making process before making an investment. Each part contains lots of detail. However, aim of this article is to have a strong platform that we can build on.

So, let’s start the process.
I will be using abbreviation so that it is easy to remember things.

I will start investment platform with the abbreviation PML. PML stands for Psychology, Money management, and Logic. We will delve into these below.

1. Psychology: Psychology includes greed and fear which drives the prices up and down. Many people focus on fundamental, technical analysis before making investment, and ignore psychology and money management part. You need to have patience and discipline of monk to succeed has investor. If you have to give importance on these PMT factors on percentage basis, then Technique part would only get around 30%. Psychology and Money management would get more than 2/3rd percentage point.
   Human being are emotional creature by nature. Markets are driven by human emotions. This is extremely common phenomenon. Human beings are driven by short term gain or pleasure. All of us want to see quick gains. That tendency leads us to herd mentality. When something is going up our rational mind is lost and in seeking quick gains we join the crowd without thinking about long term prospects. As a rationale investor, we need to have discipline to analyze what will be long term consequences.

2. Money management: RAP ( Risk and Profit Management) rule.

   (a) Risk management: Risk management is extremely important. First rule in any investment is protect your capital.
   When we see exciting technology, innovations, project we tend to visualize all the profits we can make from the investment, without thinking about risk. First question we need to ask before any investment is not how much profit I’m going to make, but what is the risk if the project/innovation does not pan out as expected. Market involves different group of participants each having their own viewpoint. Market can remain irrational for long period of time. There are multitude of risks involved that we cannot imagine like what if CEO is fired, regulations, political risks etc.
   That’s why we need to have a stop point. Stop point is where you would stop and get out of your investment. Stop discipline is extremely important.
   Example: Say you come up with a company/project where you thought that it will be great to invest. However, due to bad news the price starts falling, then you need to defined price level where you would say, okay I thought the company would do great but did not pan out as I expected, and then get out of the position. If things change or fundamental changes, then you can always buy back, sometimes in even lower price.
   General rule of thumb for stop loss is at price level of strong support/resistance. Also, general rule is 0.5-2% of your total capital is total loss per investment.

   (b) Profit management: This is other critical component of Money management. We need to have systematic way of taking profit. We have seen a lot of times our investment to do well initially, only to later fall below the price you have bought and then sell it at loss. Market ebbs and flows. Market sentiments change from bullish to bearish due to various macroeconomic and micro economic factors.
   You can have different systems for taking profit, one such example is as below:
   Selling 1/3rd or 1/2 of your position when it reaches 2X your risk, and then letting others run. In this way, you would have covered your loss incase market decides to turn against you.
   Example: Say your risk is about 3 dollars per equity, then when you have gained 6 dollars per equity then you sell 1/3rd to half your positions, and let others run.

1. Logic: Logic is your method of choice for evaluation before making decision about investment. Logic includes macroeconomic evaluation, Fundamental analysis, and Technical analysis. Each one has their own advantages, and disadvantages. I suggest using all three of them before investment. I call it Fusion Analysis.
   Each component here has lot of things to cover which is beyond the scope of this article. Again, my aim in this article is to build a platform where we can build things on.

(a) Macroeconomic factors: GIRC (GI pronounced like in GIRL)
Macroeconomic factors primarily include economic growth (G), inflation (I), interest rates (R), and credit cycles (C). We need to understand at which cycle of economy we are in . There are four phases of economic cycle. Expansion, peak, recession and trough. Different industries/sector do well in particular phase of cycle. For example, tech and utilities does well in early to mid-expansion phase, while commodities do well in late expansion or peak phase. Higher inflation is good for gold, and bad for bonds. .
Interest rate are another critical thing to look at. That's why we need to have a close eye on Federal reserve and their plan for interest rate. Equities do extremely well in low interest rate environment like we are having now. When interest rate starts to rise, they tend to fall.
Credit cycle is important as well. When credit is easily available, then equity market does well.

(b) Fundamental analysis: SVPG
Fundamental analysis of company includes companies Strength (S), Value (V), Profitability (P), and Growth (G)
Strength assess ability of the company to stay solvent or liquid. Common ways to analyze are by Current ratio, Quick ratio, and Debt/Equity ratio. Valuation assess current value of company whether it is cheap or expense. Commonly assessed by P/E, Forward P/E, PEG, Price/Sales etc. Profitability assess ability to remain profitable. Commonly assessed by ROE, and ROI. Growth prospectus evaluation will let you know how much company has growth prospects for future. This needs to be researched, and there are various websites like yahoo finance which gives you future revenue and earnings estimates.

(c) Technical analysis: BLM
Technical analysis will include Behavior (B) , Location (L) and Momentum (M)
Behavior: How is market behaving is it up trending, down trending, or going sideways or is it in consolidation. Four common behaviors include: Uptrend, Downtrend, Sideways, and Consolidation
Location: Where is market located right now? Is it located in area of support, resistance, supply, demand? Is it located above or below 200 period moving average?
This will help you make decisions whether it is right time to buy or not
Other very common technical analysis are Relative Strength Index, Stochastics, MACD etc.
Support, Resistance, Supply, Demand zones. These are places where buying and selling gives you high probability of success.
Momentum: Momentum is rate of change of price. How quickly is price moving up or down. If momentum is strong to the down side, then it is better not to buy until momentum starts to slow down.

Thank you

MacroPD
Pradeep Dahal