How to Play the Stock Market Now

how to play the stock marketWhen investors don't have a clear plan for how to play the stock market, they set themselves up to underperform - sometimes drastically.

Over the past 20 years, the S&P 500 has averaged a gain of 9.02%. Yet over the same span, individual investors averaged a return of only 2.53% per year.

We know you can do better than the "average" investor. That's why we've compiled a list of the essential do's and don'ts on how to play the stock market and outperform.

How to Play the Stock Market: The Don'ts

How to Play the Stock Market, Don't No. 1: Don't invest with your emotions.

One of the biggest errors investors make is letting their emotions get the best of them. This leads them to focus on short-term market movements and distracts them from long-term wealth-building plans.

Money Morning Chief Investment Strategist Keith Fitz-Gerald has written extensively on the danger of emotional investing. "I chalk it up to the fact that human memories tend to focus on recent events more emotionally than they do longer-term plans that are put together with almost clinical detachment," Fitz-Gerald said. "Simply put, recent knowledge overrides longer-term thinking and memory. And the more extreme the events or the news, the sharper our short-term focus becomes."

When investors frequently take quick actions based on a major news story or event, the effects on their money can be disastrous.

"Think about what happened on 9/11," Fitz-Gerald said. "Most of the world's major markets bottomed within minutes of each other on short-term panic and emotion. Then, when trading resumed days later, they began to climb almost in sync as highly localized events once again faded into the longer-term fabric of our world."

That leads right into the second habit to avoid...

How to Play the Stock Market, Don't No. 2: Don't follow the crowd.

"Humans would rather be wrong in a group than right individually," Fitz-Gerald said. "So the vast majority of investors tend to make decisions, and mistakes, en masse."

Following the crowd is what makes investors sell low and buy high. Rather than analyzing the situation, they find safety in numbers and in following the statistically poor predictions of Wall Street "experts."

"We see this in a phenomenon known as 'chasing returns' or following the hot money," Fitz-Gerald said. "This is why annual performance issues like those published in Forbes, Money Magazine, or Kiplinger's, for example, are so irresistible. And so dangerous."

This occurred in the fall of 2014, during the height of the Ebola crisis. When news broke that Tekmira Pharmaceuticals Corp. (Nasdaq: TKMR) was given clearance by the FDA to test a vaccine in Ebola patients, the stock soared 40% in three days. But since peaking at $29.93 on Oct. 3, it is down 50%. Investors who bought high saw their initial investment cut in half in about two months.

Following the crowd means failing to stick to your own economic interests, which is a dangerous move.

That brings us to the fear factor...

How to Play the Stock Market, Don't No. 3: Don't let fear win.

Many fearful investors park their cash on the sidelines when stock prices go haywire. Or they lack the confidence to pull out of a losing position before the price goes down even more.

The fact is, investors who are afraid of getting hurt by the market hurt both financially and emotionally.

"That's why people are more likely to let a losing position go against them than they are to take profits - because they can't take the 'pain' of being wrong," Fitz-Gerald said. "The fact that they are unprofitable becomes almost irrelevant."

"That's why I do everything I can to enforce the discipline of taking profits and minimizing losses in careful concert with an overall plan."

How to Play the Stock Market Now: The Do's

How to Play the Stock Market, Strategy No. 1: Have a plan - and stick to it.

the 50 40 10 portfolioMore than any other factor, discipline makes all the difference in preserving and growing your capital. Fitz-Gerald's 50-40-10 structure allocation model is a great place to start.

The idea is to place 10% of your capital in "Rocket Riders," or small-cap stocks with huge upside. These picks are either riding a huge trend, preparing for a major IPO, or are prime takeover targets. Next, 40% of your portfolio targets globally recognized brands with strong balance sheets and high cash flow. They also pay high dividend yields. The remaining 50% of your investments should be in foundational plays. These are defensive positions that hold their value in any market conditions.

Sometimes it's tough to stay disciplined, especially when you find an exciting new "Rocket Rider" and you've already got 10% of your capital in more aggressive positions. But that's actually when you need discipline the most.

By concentrating assets and periodically rebalancing between core assets, growth/income, and speculative positions, you are effectively "forcing" yourself to buy low and sell high using proven logic - not emotion. Plus, this keeps performance-robbing fees low, which Wall Street hates but you'll love because it can add a lot to your returns over time.

How to Play the Stock Market, Strategy No. 2: Do your research.

[epom key="ddec3ef33420ef7c9964a4695c349764" redirect="" sourceid="" imported="false"]

As you're considering a particular company's stock, you must formulate what Fitz-Gerald calls your own personal Ultimate Trailing Stops - questions that can guide your decision. Here are some examples:

  • Is the CEO effective and do I like his vision as a leader?
  • Has there been a game-changing development in the industry that obviates the product suite?
  • Are there new competitors changing the game?
  • Is there an opportunity cost to remaining with the company?
  • Is price in line with value?
  • Has something changed for the worse?
  • Is the smart money leaving?

How to Play the Stock Market, Strategy No. 3: Control your risk.

Here are two great ways to minimize risk, one as you're getting into a stock position, the other as you're getting out:

Dollar cost averaging is the strategy of splitting up your intended investment into a fixed dollar amount and investing on a preset schedule, instead of all at once. This way you're actually forcing yourself to overcome the recency bias associated with big down days or bad news that rocks the markets. Dollar-cost averaging works especially well when you are making a large investment because it minimizes your downside risk.

Trailing stops are a "stop-loss" order that's set at a specific price below the market price of the investment you're holding. A trailing stop helps you stay in a stock that's running higher but ensures that you get clear if it drops by a predetermined amount. And it helps limit losses to small, manageable amounts rather than allowing them to become catastrophic portfolio killers. Trailing stops are also typically moved upward in lockstep with an investment making new highs, but are almost never revised downward.

More Money-Making Tips: