LEVEL: INTERMEDIATE
Having a written trading plan is one of the most important elements of becoming a successful investor. You should complete a trading plan before trading on Zolio or, for that matter, before investing at all. Designing your plan is a disciplined process that needs to be written down and not just “thought about”; it will become your beacon at future decision junctures when you will need to make the difficult call to either steady or change course.
Just as there is no “one right way” to trade there is no one right way to develop a trading plan. Your trading plan is as individual as you are. This introductory article on developing a trading plan focuses on the critical questions you need to answer as an investor. Over time with investing experience you will refine the answers to these questions and update your trading plan.
What is a Trading Plan?
A trading plan has two distinct components; firstly you need to define your overall market strategy, trading approach ad risk/return targets. Secondly you will determine an approach to each individual trade. This introduction focuses on the first of these two aspects of a trading plan.
Market Strategy and Approach
Defining a market strategy focuses on some of the most important questions when it comes to investing. These questions help you define, and later refine, your core competencies as an investor. This is also the part of the plan where you have to articulate as much about yourself as you can. Knowing yourself, your strengths and weaknesses, what you enjoy and what you dislike are as important in investing as they are in making any important professional decision. It is essential to spend time thinking through the answers to the following questions. It is worth noting that these questions are interrelated, and by definition, your thought process will need to be iterative across all the questions.
In what markets do you want to invest?
This is an obvious question and for your Zolio experience the answer has been determined for you i.e. equities and ETFs listed on NYSE and NASDAQ. However, in broader terms you might be someone who is so interested in broad macro/global themes that you see investing in government debt and currencies as the right market for you. Or you may be fascinated by the intricacies and opportunity of companies in distress and want to focus on being a distressed debt investor. We hope that whatever your long term interests are your learning experiences on the Zolio platform will be valuable.
What type of investor are you?
There are unlimited numbers of ways to answer this question and no two investors would give exactly the same answer. There are some commonly used investing strategy definitions that help you develop your own individual answer. For example, are you a value investor or a growth investor? Are you more comfortable holding on to stocks while they rise in value or do you see more opportunity in declining stocks and/or distressed assets? What time frame for trading is most comfortable for you? For example it is difficult to be a value investor if you prefer to get out and in of trades very quickly; it usually takes some time for the market to recognize your perceived value in a currently undervalued stock.
What is your “edge”?
Inherent in answering this question is your sense of where you have a unique perspective that you can use to create value. For example do you have strong views on broad investment, economic, financial and economic themes that will impact movements in the markets? If so you will want to employ a more “top down” investing strategy driven by these high level themes. Or, are you someone with deep expertise in an industry or sector which you believe gives you an advantage in understanding the earnings and growth trajectory of certain types of companies? If this is the case then you may be more of a “bottom-up” fundamental investor. Again there are as many ways to define these unique sources of investing advantage as there are investors, it is important only that you can articulate what is your unique source of advantage.
What process will you use to extract positive returns from the market?
Once you know your investment style, then you need to define the process you will employ to create value as an investor. If determining what type of investor you are is like setting your business strategy then this step is equivalent to developing your business plan. A critical question here is the role of fundamental research versus technical analysis in your investing decision process. At extremes you have investors such as the legendary Warren Buffet who are deep fundamental investors who buy huge stakes in a few companies based on his, and his team’s, intensely detailed analysis of an individual company. At the other end of the spectrum you have “black box” traders who write complex trading algorithms and use computers to execute thousands, sometimes millions, of trades a day. Those of you on the Zolio platform will be somewhere in between.
Again the key here is to understand both your core skills and what you really enjoy doing. To be a successful fundamental investor you will need to be good at understanding company financials, building earnings models or some other way of predicting the future growth and earnings of individual securities. Using technical analysis requires comfort with computer model and charting techniques as well as a willingness to understand the history of market and security behavior. Again, if you are new investor and using the Zolio platform as a learning experience there is no need to focus on the intricacies of these approaches, rather it is important to articulate your high level sense of how you will chose which securities to invest in. There will be plenty of time and Zolio materials to help you think through these aspects in more detail as you learn by doing on the Zolio platform.
What are your initial investing views?
Having thought through your investing market, strategy and process you can now bring in your initial investing views. You need to have some investing views to determine how you will begin putting a portfolio of investment together. Here you will answer questions such as; where do you perceive value in the markets or opportunities to invest? For example, are you long the dollar or short the dollar? Do you believe in global economic expansion or contraction? Where do you see the price of commodities and energy? Are you sure social networking companies will thrive or have they reached their peak and will decline in value? How will the outcome of the 2012 presidential election affect the markets? It can be overwhelming to think about all of these questions. So once again refer back to who you are as an investor and how you believe you will add value. Let that drive your investing choices and use a detailed risk management plan to help you manage the impact of all the questions you don’t have a strong view about. So now the next key part of the plan is to articulate your personal risk/return profile, and then for your portfolio at large, the ways in which you will manage risk, set an acceptable volatility range, return targets and drawdown limits.
What is your return target and your tolerance for volatility?
These two questions are directly related, and you can’t answer one without answering the other. On the Zolio platform we will give you a fictitious $1 million to invest. What you need to do now is determine what you hope to earn on that $1million. Again there are many ways to think about investing targets; most importantly are they absolute (e.g. I want to make 10% regardless of the market) or they related to the market (e.g. I want to outperform the market by 5%). As Zolio is a learning platform you may be less concerned about the numbers either way but it is important to have some idea of a target so you can decide how to approach trading.
Of course you can’t answer this question without a clear sense of how you want to manage volatility. Any good investor will tell you investing is all about the risk-return trade-off; to put it in simplistic terms you can’t generate more return without taking more risk. Of course every investor has his/her own sense of what that trade-off is and has more or less confidence in his or her ability to manage the down side in any portfolio and in any individual trade. There are many rules of thumb in the investing market; one common one is 3:1 i.e. any individual trade should have a 3 to 1 return to risk trade off (e.g. I can make $15 dollars on the trade and only expect to lose $5 in the worst case scenario). Rules of thumb though are exactly that and cannot be used in all circumstances. You need to define your risk return target for your portfolio and also for each individual trade.
Setting the right return and volatility has a great deal to do with why you are investing. Are you investing your own money to save up for a deposit on a house? In that case it is likely more important that you don’t lose money than it is that you achieve a very high return target. On the other hand if you view yourself as the manager of a long term concentrated investment fund that has very high return targets you have to be willing to live with big draw downs.
Again, Zolio is a learning platform and we expect you to make mistakes; so set your return target based on what you think will help you learn the most given your already defined market, strategy and investing process. It is much more important that you can articulate a target and how each trade helps you meets that target rather than the absolute target itself.
It is worth reiterating that an honest self-assessment is critical here; don’t set a very high return target with the inherent volatility implications if you will get stressed and anxious about the interim drawdowns. On the other hand if you get bored easily and want to be an active and aggressive investor make sure your risk return targets allow you to do that. Think about how you’ve reacted to disappointment and/or stress in the past and bring that knowledge of yourself to your investing on Zolio.