You follow the rules for smart stock trading. But are they the right rules?

By Morey Stettner

Apply the wisdom of investment pros to develop your own consistent methodology

Picking stocks is easy. Picking the right stocks is hard.

To simplify the process, disciplined investors often follow rules of thumb, which takes some of the emotion out of buying and selling.

Maybe you've heard of the 15% rule, for example, in which you allocate 15% of your pretax income toward long-term investments. Or the advice to determine your allocation to stocks versus bonds by subtracting your age from 100.

Perhaps the most prominent rule setter is legendary investor Warren Buffett. One of the 96-year-old's most famous and easy-to-follow rules is to plan to hold a stock for the long term: "If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes."

A proponent of long-term investing, Buffett counsels us to exercise patience and stick with carefully chosen stocks over the long haul.

Sensible rules add consistency and soundness to your strategy. You're less apt to make rash decisions if you follow well-established best practices that help you vet potential investments in a time-tested manner.

Still, ever-changing market conditions require constant rethinking of long-held rules. For instance, the old 60/40 asset allocation model (a portfolio consisting of 60% stocks and 40% bonds) no longer applies as much as it once did. That makes the wisest, most tried-and-true rules all the more valuable in these volatile times.

Finding your rules

Among portfolio managers and financial advisers, the rules can vary. Whether they tweak conventional wisdom or devise an entirely new way to pick stocks, the key is adopting a screening method that works - and then sticking with it.

When picking stocks, Tom Winmill looks for five years of increasing free cash flow per share and five years of increasing revenue per share. (Novice investors can use AI tools to filter those stocks that fit the rule, or talk to their financial adviser.)

"These rules have kept me out of trouble," said Winmill, the longtime portfolio manager at Midas Special Opportunities Fund MISEX.

He will immediately sell a stock if the company reports a quarterly operating loss. That applies to "any type of stock, no matter how much I love it," said Winmill, who's based in New Hampshire.

For Winmill, an operating loss is a major red flag. It can signal an accounting, business or management problem at the company that threatens its stock performance.

If he owns the stock of a company that announces an acquisition, he instantly sells it if the size of the target exceeds 25% of the market cap of the company acquiring it.

"That 25% is kind of random," he acknowledged. "But I've found acquirers often overpay. And it means the acquirer's business isn't very good, because they have to acquire somebody else's business and somebody else's management. Acquiring another business is an admission that your business isn't good."

If acquiring companies tend to overpay, you may want to keep this rule in mind when assessing such stocks. When talk of an acquisition swirls around a company, proceed with caution and examine the rationale for the deal from all sides, rather than trading on frothy rumors.

Other rules apply to metrics that are more concrete and straightforward. Take dividends.

Some stock pickers set rules tied to dividends. They may follow the lead of exchange-traded funds such as Vanguard Dividend Appreciation VIG, which aims to track the performance of the S&P U.S. Dividend Growers Index.

James Harlow, director of research at Novare Capital Management in Charlotte, N.C., only buys stocks in companies that have raised their dividends for 10 years in a row.

"That's a signal of quality," he said. "It screens out speculative names and whittles down the list to companies with long track records of profitability, sound management teams and strong fundamentals."

Conversely, he instantly sells if one of those companies decides not to raise its dividend - or cuts it.

"That can mean something's gone wrong and your investment thesis can be under strain," he said.

Ebb and flow of strategies

As they gain experience, some investors abandon rules that they once followed.

"I used to use stop-loss in my trading," said Eric Berlin, an adviser in Bend, Ore. "But after two or three years doing that, I found that it arbitrarily forces you to sell out of a position" after a short-term adverse market event. (In a stop-loss order, you specify in advance the price at which you want to sell. The trade automatically takes place if the stock falls to the price you set.)

The stock might soon recover, but Berlin no longer owned it. So instead, he has learned to focus on the size of a stock position. What percentage of your entire portfolio does it represent? Does its size reflect the amount of risk you're willing to take with that stock?

"You should be managing the downside risk based on the size of that position," he said.

Another rule he's jettisoned is to sell any stock that hits your price target within a set time frame, especially after a huge run-up. "When a stock makes a big move up 10% or 20% in a day, someone who's caught up in changes in valuation might sell," Berlin said. "But that's often a sign you should be buying more of that stock, that it's just the beginning" of a surge even higher.

"Rather than sell, you should re-evaluate the whole situation, dig down deep and see if it's an indication that your thesis for buying the stock is playing out," he said. "It's counterintuitive. But if your stock goes up 20% in a day, something big is changing, and you want to understand that."

Following these rules will not make you an instantly brilliant investor. Rather, they serve as guideposts to influence how you analyze trades and make decisions. Apply the wisdom of investment pros to develop your own consistent methodology. It's better to have a sound, systemic approach to investing than to follow emotion, impulse and whim.

-Morey Stettner

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11-07-26 1100ET