For many investors — probably most, in fact — there is definitely a logical disconnect between the fundamental goal of investing and the approach of choice.
The goal of investing is about as simple as it gets: come out with more money than you had going in.
To achieve that simple goal, we’re taught to take an equally simple approach: buy low, sell high.
And yet, despite these super-basic, two-plus-two-equals-four kind of relationships, so many end up confused, lost, and often poorer than they were when they started.
Human psychology surely plays a role in this, as no other force in the universe would compel an otherwise logical being to have internal dialogs like this one:
“Damn, Tesla (NASDAQ: TSLA) is up 15% over the last two weeks… I better get in before I miss the boat!”
Or: “Holy profit margins, batman! Apple (NASDAQ: AAPL) just hit an all-time high. I need to double down on my position!”
Looking at this with cold, hard reasoning, it seems like either scenario, if followed through to its logical conclusion, would, at best, lead to a less-than-optimal realized profit, or, at worst, a loss.
And yet too many people think this way.
So when it comes to picking my next stock, the first and most important step to take is NOT to take any emotional steps.
Accept the fact that a sudden spike in prices does indeed mean that you’ve probably missed the boat already, and that you’re statistically far more likely to lose in the long run than catch a second wind of liquidity.
And then accept the fact that you’ll miss the vast majority of boats, and you will already have removed a decent chunk of unnecessary risk.
In the game of finding the next boat while it’s still in port, this is just the start.
Here is my approach to removing the most amount of risk while retaining the highest degree of profit potential.
Expanding the whole “buy low, sell high” premise to a more global level, the idea of buying already giant companies with world-famous brands and world-beating product lines is not the right approach if your goal is to make money.
Yes, it can be a viable method for preserving wealth against the forces of inflation, but the simple fact is, if you’re already at the top of your industry, you are probably not going to be seeing a doubling or tripling in sales in the near future — or possible ever.
Your goal should always be to own that big company, but only if you bought it before it blows up into a global brand.
It’s a tall order, as only the rare few ever reach that status, but successes on a smaller scale are possible, and they become more probable when you target smaller companies for the buy-in.
It can be intimidating to put your real, hard-earned dollars into the trust of a company that you’ve never heard of before, but this is exactly the point where risk level is raised in order to raise upside potential.
You have to be smart, measured, and cool-headed every step of the way, but if you want to ever see those short- or mid-term three-figure paydays, there is no way around it.
I generally keep my searches isolated to companies under $100 million market capitalization — a threshold that qualifies them as micro market capitalization, or “microcap.”
It may seem absurdly hypothetical to even make this comparison, but if you’d managed to buy Apple stock when it was at this level, today you’d have about $5,000 for every $1 invested.
Perhaps an extreme example, but this is the goal I’m shooting for in every investment.
Even if your risk lands you a gain that is 1/100 this size, you’ve still multiplied your capital by a factor of 50.
Focus on the Overlooked
Being ahead of the curve means being ahead of the pack, and there is a very easy way to tell if you’re on the right track.
Check the recent trading volume and see if you can spot any patterns or aberrations.
If the stock trades fairly lightly (less than 100,000 shares per day), then you know it’s not something the average investor knows about.
If the average trading volume has seen some odd spikes (volume 5 to 10 times normal or more) in the last three months or so, then you know there have been bursts of buying.
If you can match up these bursts of buying with similarly timed press releases, you can safely assume two things: it’s on the radar for some niche and inside investors, and if and when the share price rises, many of those investors will be selling.
That doesn’t mean you’ve missed the boat necessarily, but it does mean the boat is getting crowded, and upside potential will suffer as a result, at least in the short term.
Ideally, I want to see steady but modest volume with minimal volume spikes going back six months or so.
Do that, and you know that you’ve zeroed in on a company that’s got a decent, loyal following, but hasn’t sparked the interest of the larger investment community just yet.
Remember, it’s not all numbers at this point. You should be looking at news as well.
Any press releases that indicate the closing of major deals or the rollout of new products mean the best time to buy may already be over.
Press releases discussing impending deals or rollouts are what you want to be seeing.
Look to the Future, Not the Present
You’re not going to be investing in companies trying to perfect things like record players, piston-powered biplanes, or VCRs, right?
That’s a no-brainer, but it should also be obvious not to invest in companies producing established products and services to compete with major suppliers.
Are you really going to make money owning a tiny company that’s making the next iPhone rival? Unless this rival comes with an industry-changing improvement, or costs so little that it can be effectively marketed to the world’s poorest, the answer should be no.
What you should be looking for are companies developing disruptive products or seeking to disrupt the markets themselves by achieving never-before-seen price points.
Don’t invest in a rival for the iPhone. Invest in its replacement — something that will do to the iPhone what the iPhone did to every flip phone that came before it.
Or invest in an iPhone rival that can be produced and sold for $30 and still make the company money.
Disruptive products and disruptive markets are called that because they shake up, undermine, and redefine the status quo.
If you’re not doing that, all you are investing in is the status quo — another move that will guarantee you a ticket on a boat that’s already left port.
Your emotions will tell you it’s safe, but being safe in this dynamic is the same as being dead.
To see if you’ve isolated a company that fits this bill, you’ll need to research it thoroughly. Identify and quantify the novelty in its products or its marketing approach, and make sure this novelty is something that will tend to create panic in the boardrooms of the major brands, and you’ll know you’ve found a winner.
Thankfully, these days, all of this research can be done without getting out of bed. You have the Internet to thank for that — which, by the way, is the all-time best example of a disruptive industry.
You’re Almost There
Make these three steps part of your routine, and in the long run, you will come across winners that make Tesla’s last price spike look like a hiccup.
Just bear in mind that this is just the start.
Once you’ve cut your list down using the first three steps, you still need to go in and cut it down further to ensure that the company is set up in a way that tends to realize this theoretical potential.
You can have all the good intentions in the world and still drop the ball for purely technical reasons…
As you may have suspected, however, there is a way to avoid those pitfalls as well.
I will get to those in the weeks to come.
If you can’t wait, however, click here to see how the full approach to derisking your speculative investments can work for you.