Can A Rules-Based Investing Framework Improve Your Stock Market Results?

The following is a guest post. Jay Delaworth is the founder of Intelligent Trend Follower, where each week you can get actionable investment ideas and free educational content designed to help you apply a rules-based framework to limit risk and reduce stress in the stock market.

When you were a kid, did you follow the rules?

Did you clean your room, wash your hands before dinner, and always play nice with others?

It’s funny, as children, we are constantly told to obey all kinds of rules. Then, as we grow up and acquire our independence, the shackles of rules slowly loosen their grip.

We get more freedom, more leniency and more trust. Suddenly, you realize you’re an adult who can do whatever you want, whenever you want (so long as you don’t break any laws).

But why does this matter?

Well, let me put it this way:

  • Do you ever look at your investment portfolio and wonder why you own some of the stocks in there?
  • Do you ever scratch your head and wonder whether you should buy, sell or hold?
  • Have you ever bought a stock based on a tip or news story, only to end up unsure what to do with it?

The reason I ask is because I believe these common errors can easily be avoided. All it takes are a few simple rules you can use to make better investment decisions. So in this blog post, I want to show you why (and exactly how) you can start using rules to help your investing.

Plus, at the end, you can get a free cheat-sheet with a checklist to help you put these ideas into action if you find them helpful.

And don’t worry, I promise I won’t be too strict or make you wash out your mouth with soap if you cuss at this proposed approach.

But before I show you exactly which rules I use to make consistent investment decisions, let’s first discuss the value of rules in a little more detail.

Three Key Reasons You Can’t Ignore a Rules-Based Approach to Investing:

As an intelligent independent investor, I expect you to be skeptical of anybody proclaiming a better way to get stock market results. So before we dive into the specific rules I use, let me tell you why this approach works.

And by the way, it doesn’t just apply to the stock market. I believe conscious rules-based behaviour is the foundation for good habits in all areas of life.

#1 – Rules-Based Investing is Best Practice:

To those of you in the FI community, this should come as no surprise. In fact, everywhere you look, there are accepted best practices (rules) for achieving financial freedom.

Some examples that come to mind, from savings to investing, include:

  • Pay yourself first: set up automatic payroll deductions to move money into a retirement account before it hits your chequing account.
  • Make a budget to track your expenses and understand where your money is going each month.
  • Index investing: every single index and most ETFs are based on simple and mechanical rules. If you think about it, even the S&P 500 is a basic investing system governed by rules to add and eliminate stocks from the portfolio!

So my point is, you’re probably already using a rules-based approach to money management in some area of your life. And you do it because it’s been proven to work, right?

Now, although these “one-size-fits-all” rules are a great place to start, is it possible you could build your own set of rules that works even better than these off-the-shelf solutions?

Do you think you can you build a set of rules that work better than buying-and-holding an index?

#2 – Rules-Based Investing is Consistent:

When you are considering an investment opportunity, do you diligently hold each potential portfolio holding to the same rigorous selection standard?

Well, if you’re anything like my friends and family, the answer is probably no. And unfortunately, that can be a disaster waiting to happen.

On the other hand, if you have a consistent checklist that every investment idea must pass, then you’re much less likely to put your hard-earned money at risk based on a hot stock tip or exciting investment idea.

Because chances are, Cramer’s latest stock pick won’t pass your tests. This helps you avoid risky investments and makes it much easier to compare your existing investments and potential trade ideas based on a common benchmark. Make sense?

A rules-based formula for managing your money also takes away the guesswork, which itself can make your life less stressful. Again, this isn’t esoteric stuff. It’s just common sense.

Think of the passive index investors who have set asset allocations and then rebalance once or twice a year to get back to their target weights. Maybe you’re even one of them! I love it because it’s a consistent and transparent rules-based approach designed to improve performance.

Can you see how consistency could eliminate guesswork and make your investing a little easier?

Speaking of which, that bring us to the third key reason investing with rules is something I recommend…

#3 Rules-Based Investing Prevents Emotional Decision Making:

Without a shadow of a doubt, this third reason is the most important of all. That’s because I’ve seen hundreds of individual investors destroy their wealth and jeopardize their financial future due to emotional mistakes in the face of a manic Mr. Market.

Whether it’s jumping-in before you think, doubling down on a losing investment or selling your stock in a panic, emotionally-driven actions can be frustrating and downright dangerous when it comes to your bottom line.

Instead, wouldn’t you rather be cool, calm and collected?

Personally, I remember when I was just getting started with the stock market. And to be honest, it took me years to come up with an investing approach that worked and meshed with my personality. So I vividly remember turning ideas over in my head again and again trying not to give into the impulses of fear and greed.

Turns out, it wasn’t until I developed a comprehensive set of guidelines and rules to guide my investing actions that I began to stop worrying and begin seeing consistency in my stock market results.

And while it was tough at first to stick with my investing plan, the more I abided by the rules, the easier it has become.

Based on this experience, I’ve come to believe that following investing rules not only improves performance; but, also builds self-trust and confidence in your own abilities to follow through. This alone is worth the price of admission.

If you still don’t believe me, you might enjoy reading The Checklist Manifesto to further familiarize yourself with this important subject. It’s worth it, too. Because as I mentioned, not only does a rules-based approach perform better, it helps you stop second-guessing and worrying as well.

So let me show you how I apply these concepts to my investment portfolios (and how you can do the same!)

Rules-Based Fundamental Analysis:

Fundamental analysis is a critical tool for any investor who’s considering buying individual stocks. In fact, when I first started my investment career I was all about fundamental analysis. I spent hours each day reading 10Ks, conference call transcripts, and trying to calculate what a company was worth.

The biggest problem I ran into though was that without a rules-based model to follow, I felt like I was always comparing apples to oranges. Companies don’t always have the same business model, accounting standards or competitive advantages. So…

That’s why I decided to create a fundamental checklist to help me find and filter high quality investment ideas. It was a common benchmark I could compare against. Plus, it also helped me avoid getting adversely influenced by a particularly charismatic CEO or led astray by an exciting alleged growth story.

So let me show you how I put this idea into action.

Fundamental rules I use in my own investing:

Now, keep in mind that I’m looking for long-term investing ideas with potential to compound capital year-after-year. If you’ve ever heard of Warren Buffett’s equity bond idea, then that’s the kind of company I’m looking for.

So basically, whenever I’m intrigued by a stock idea that pops up on my Twitter feed or is mentioned by a friend, I go over to Morningstar.com and type in the ticker. Then, I click on the Financials tab, which, for AAPL,  looks like this:

The great thing about Morningstar is that not only is the fundamental data high quality, but you can also get a 10-year view of how the company has performed. This is exactly the kind of data set a rule-based investor can sink their teeth into.

So what rules do I use specifically?

Well, I ask myself the following questions and if the answer is no, then I take a pass.

And in fact, most companies I evaluate don’t pass these rules. But I do my best to stay disciplined and not succumb to the fear of missing out.

Questions for fundamental rules:

  1. Is revenue trending up over the last 10 years?
  2. Are gross margins consistent each year?
  3. Are earnings per share tending up over the last 10 years?
  4. Has book value per share grown consistently over the last 10 years?
  5. Has free cash flow per share grown consistently over the last 10 years?
  6. Does the company pay a dividend and has it been increasing with a steady payout ratio?
  7. Does the company have a debt/equity ratio under 1 and are interest expenses below 10% of operating income?

Now, these are just my personal rules based on my desire to own high quality companies with consistent track records of compounding capital and returning it to shareholders.

On the other hand, if you’re looking for small cap growth stocks or buying industrial companies expecting a cyclical rebound, your rules will probably be different.

That said, whatever your style, I believe this rules-based approach can help you come up with a checklist to sort investments based on whatever criteria you like best.

And by the way, if you want to see more of this kind of analysis in action, I encourage you to check out my Seeking Alpha articles where I regularly demonstrate this approach with real investment ideas.

By now, I hope you’re starting to see how a rules-based approach is of value: It can help you get started on the right foot, and you can augment your existing investment strategy by being a little more methodical and consistent.

But the benefits of a rules-based approach don’t stop at the fundamentals. Quite the opposite, in fact…

Rules-Based Technical Analysis:

Now, I know the online personal finance community is pretty skeptical of technical analysis. And rightfully so!

There’s a ton of hocus-pocus on Twitter, StockTwits and anywhere else you find technically-oriented stock traders congregating. I’m always wary of people who publish annotated stock charts with esoteric indicators and perplexing patterns.

I get it.

But it’s not all bad.

In fact, having a healthy respect for technicals might even help you outperform the market. Academic research shows that professional portfolio managers who include technical analysis tend to outperform. The key is doing it the right way. So what does that look like?

For me, I use some very simple technical analysis to manage risk and rule out stocks that are unlikely to present capital gain opportunities. Let me show you what that looks like:

Technical Rules I Use In My Own Investing:

To be honest, I keep this part of my investing pretty simple. My main goal with technical analysis is to limit risk and increase my chances of capital gains. It doesn’t always work, but on balance these techniques have helped me deploy capital more effectively.

Like with the fundamental rules, I simply have a list of questions I ask and if the answer to any of them is no, then I take a pass.

Questions for technical rules:

  1. Is the stock price above the 20-day moving average?
  2. Is the 20-day moving average above the 50-day moving average and sloping up?
  3. Is the 50-day moving average above the 200 day moving average and sloping up?
  4. Is the stock making a new 50-day high?

The goal of these rules is to find companies that are moving in uptrends. The reason I like uptrending stocks is because you can’t make capital gains on the long side if your stock is going down. Simple, right?

So personally, I don’t think you need to employ exotic oscillators to get your edge. Instead, you can use some basic technical analysis to help you focus on the opportunities that are most likely to be profitable right away.

And to be completely honest, in the past I have incurred sub-optimal returns by trying to buy undervalued stocks too early. I’ve ended up tying up capital, getting frustrated and selling out too early for a loss.

For me personally, I’ve discovered some technical analysis can really help me stay out of my own way. I even wrote a detailed blog post on how you can use FinViz.com to find stock idas that meet your fundamental and technical rules.

Now I know this has been a lot to digest. But I hope you’re beginning to see how a methodical and mechanical rule-based approach to allocating capital can make your investment results more consistent and less-stressful.

So before wrapping this up, I just want to add a few more possible rules you could use to evaluate dividend growth stocks.

Rules-Based Dividend Growth Investing:

By now, your mind is probably already guessing what these dividend growth investing rules will be.

And that’s a good thing!

I hope you’re getting the hang of it. It doesn’t have to be complicated. So here are some potential questions to ask when considering dividend growth stocks.

  1. Does the company have a long (10-year+) history of increasing their dividend?
  2. Has the company ever reduced or cut the dividend?
  3. Is the free-cash-flow-adjusted payout ratio consistently below 70%?
  4. Has management publicly stated they are planning to increase the dividend?

Does that make sense? I hope you’re seeing how this rules-based thinking can improve your market results, or at least make the decision-making process a little  easier for you.

By looking for companies that meet the above criteria, you can eliminate those that may not have great dividend growth potential. Do you see what I mean?

Great. But that’s enough from me. Now, I want to hear from you: are you using any rules in your investing? If so, what are they? If not, do you think this approach could work for you?

By the way, I’ve also created a free PDF cheat sheet you can download as a handy reference. It contains all the rules I mentioned in this blog post so that you can easily reference the meat of this post in your own investing. Click here to get your free cheat sheet now.

 

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