Create a stock investing strategy in 3 steps

The investment strategy aims to guide confident and effective trading decisions. Without a strategy, investors are likely to over-trade, let emotions take over, or unintentionally change their risk profiles. Any of these outcomes could limit long-term growth potential.

Whether your goal is gains or income, a specific approach provides the best chance of success in the stock market. Fortunately, you don’t have to be an investing expert to create a strategy that works for you.

You can develop a strong, personal investing framework in three steps.

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Risk tolerance describes the amount of volatility you will accept within your investment portfolio. Your appetite or aversion to risk should influence every aspect of your investment strategy.

Also note that risk and reward work together in investing. Higher risk assets have greater growth potential, while lower risk assets have lower growth potential. The relative risks and rewards of investing in stocks versus cash illustrate this.

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Since risk tolerance is a key component of your strategy, it is wise to define it in writing. With this documentation, it will be easier to review and validate your approach periodically. If your risk appetite has not changed, your strategy is likely still in place. Or, if your specific risk tolerance no longer suits you, it’s probably time for a strategy overhaul.

The simplest way to illustrate your risk tolerance is to consider portfolio downside scenarios. Can you handle a 10% drop in your investment account? What about 50%?

Your maximum capacity for unrealized losses can indicate where you are within your risk tolerance range. You incur an unrealized loss when the value of the stock you own declines. Losses only occur when you sell a stock at a lower price than you paid for it.

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

• If the maximum is 10%, you are risk averse.

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

• If you can accept declines of 30% or more, you are able to take risks.

With a higher risk tolerance, you can comfortably own stocks that have greater growth potential — stocks like Nvidia, for example. Ayako Yoshioka, director of portfolio advisory at independent asset manager Wealth Enhancement Group, notes that Nvidia shares (NVDA) went through multiple periods when it declined by more than 50%. Thus, the stock provides a useful thought experience for investors. If the stock you own lost half its value, would you panic and sell it or would you be willing to wait for the recovery?

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

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

A portfolio with a higher percentage of stocks can deliver greater gains but with more risk. That’s why aggressive investors who can handle risk prefer exposure to larger stocks of up to 90%.

You can also divide your target stock exposure into smaller categories, such as growth stocks, value stocks, small-cap stocks, mid-cap stocks, large-cap stocks, and international stocks.

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

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

1. As the stock price rises, the value of holding that position becomes a larger percentage of your portfolio. The position could eventually exceed the maximum exposure to the individual stock. This will be a signal to sell some of your shares to reduce your exposure and take profits.

2. A decline in price may leave you room to increase your position. If you still think the stock has an uptrend when that happens, it may be time to buy.

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

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

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

Note that many investors set their desired purchase price below their value estimate. This provides a margin of safety from further declines in stock prices.

Setting target selling prices can be more straightforward. You can base these ratios on unrealized profit ratios or any price that might cause the stock to exceed your allocation goals. For example, you may want to take profits when the stock price rises 20% above the purchase price.

Other data points that can inform your triggers include:

1. Relative Strength Index (RSI). The Relative Strength Index (RSI) is a momentum indicator that measures the speed and magnitude of recent changes in stock prices. An RSI of 70 or above indicates that the stock may be overbought and ready for a price correction. An RSI of 30 or below indicates that the stock is oversold, which may create a bargain price point.

2. Evaluation ratios. Price-to-sales and price-to-earnings ratios quantify how expensive a stock is compared to its revenues and earnings, respectively. These ratios are most important 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’re not infallible, but analysts can quickly recognize how recent developments impact a stock’s outlook. If you’re questioning a stock’s forecast, try checking what analysts are saying as a starting point.

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