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“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.” -Benjamin Graham

  • Rules-based decision-making can prevent poor emotionally-driven investment decisions.
  • A ranking system can help keep you determine when to buy or sell stocks.
  • Action Alerts PLUS' stock ranking rules could boost portfolio returns.

Investors often focus too much on performance relative to benchmarks. It’s easy to understand why. Humans are addicted to comparisons. We want better jobs, homes, and cars than our neighbors. We also want better returns. Our bragging rights depend on benchmarking our performance.

However, that’s pretty short-sighted. The flipside of benchmarking is it can lead to all sorts of reactionary decisions. For example, underperformance in a bear market may prompt decisions contrary to your long-term plan, such as selling your stocks in hopes of buying back later – something that’s easier said than done.

Instead, investors should focus on developing investment rules to govern decision-making and mindset, so they can stick to their plan when the market gets tough.

For instance, creating a ranking system that includes rules for buying and selling stocks in your portfolio can help you make better decisions that, in the long run, allow you to reach your financial goals. That’s far more important than knowing if you outperform your neighbor on any day, month, or year.

A simple stock ranking system

Action Alerts PLUS Co-Portfolio Managers Bob Lang and Chris Versace recently explained how they revamped the AAPs rating system to make better decisions. Categorizing AAP's portfolio into four distinct categories has made it easier for members to know when to buy, increase, decrease, or outright sell positions.

The framework they’ve created isn’t only applicable to AAP’s holdings. It can be adapted to fit just about any investor's portfolio or watch list. So, here’s their four-category stock ranking system, followed by my comments where appropriate.

Lang and Versace write about one-rated stocks:

1 - Buy Now (BN): Stocks that look compelling to buy right now.

We have high conviction in these shares. The reward-to-risk tradeoff in the stock is very attractive, and there is meaningful upside potential to our price target. We are in the early to mid stages of building out the portfolio's position in the name, and the technical setup is bullish.”

If your research led to your buying a new position, it would likely deserve this rating. Similarly, if you’re ranking stocks on your watch list, you may determine that the next stock you seek to buy for your portfolio deserves this rating. Stocks with one rating may not remain there long, though. Consider it your ‘starting” point for ranking your highest-conviction stocks to buy.

Back to Lang and Versace:

2 - Stockpile (SP): Positions we would add to on pullbacks or a successful test of technical support levels.

The risk-to-reward tradeoff, potential upside to our price target, or near-term uncertainty in the shares warrants a more cautious approach. We would be buyers of the shares on a pullback and would like to see a successful test or retest technical support before committing more capital to the position. Like consumers stocking up on products when they are on sale or deeply discounted, we would look to make a similar move in a Stockpile-rated position.”

This rating could be a natural progression for a one-rated stock. Once you’ve bought your initial position, your research may lead you to decide that the stock or market behavior dictates a more prudent approach to accumulating a full position. For instance, a high-conviction yet underweighted stock could deserve a two rating. Alternatively, a stock on your watch list that’s arguably overpriced short-term might deserve this rating. Similarly, you might give this rating to a stock you want to own if it drops after a short-term catalyst, such as an earnings report, passes.

Three and four-rated stocks are fairly self-explanatory. They write:

3 - Holding Pattern (HP): Stocks we are holding as we wait for a fresh catalyst to make our next move.

The portfolio has built out a full position in the stock, and there is ample upside potential to our price target to warrant owning the shares. However, we are waiting for a fresh catalyst to emerge to determine our next step. The technical picture is neutral, and the risk reward is also neutral. We would revisit a position's Hold rating should a new catalyst - either fundamental or technical - come into play or the shares pull back to levels offering a better risk-to-reward tradeoff. This rating is like a holding pattern one sees when traveling by air with the aircraft circling until it is given the all-clear to land or told to move to another airport.”

4 - Sell (S): Positions we intend to exit.

Either the fundamental picture is eroding, or the technical outlook suggests material downside is ahead. We are looking to exit the shares and either raise cash or use some of the proceeds to fund other positions."

The Smart Play

Planning trades and trading plans is a proactive investment strategy that reduces the likelihood of reactionary, emotion-driven decisions. The best way to implement this strategy is to develop rules for how you’ll behave if certain conditions exist. The more specific the rule, the less likely you’ll decide to overrule it or ignore it.

A simple four-stage ranking system is a great starting point. First, regularly ranking your holdings forces you to consider the fundamental and technical backdrop for every stock you own. It allows you to stress-test your thesis for owning and reevaluate your conviction where necessary. Second, a system like this allows you to attach specific rules to each rating, such as buying two-rated stocks or selling four-rated stocks at specific prices. These rules make it easy to invest in a disciplined rather than seat-of-pants manner.

A word of caution, though. Make sure you match your time horizon to the rules associated with your rating. If you’re a long-term buy-and-hold investor, don’t rate a stock a four simply because you don’t like something in the short-term that’s unlikely to persist long term. Many investors adjust their time horizons during periods of uncertainty because of the stress associated with performance comparisons. That can be a costly mistake.

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