There are 5,700 publicly traded companies in the U.S. alone, as well as thousands of mutual funds and ETFs (Exchange Traded Funds).

Add to that stocks that are traded on other countries’ exchanges and you have easily ten thousand choices or more.

How can you decide, within a short time, which stock to buy today?

It’s not a trivial problem. It’s already difficult enough to make a decision between two different stocks. Have a look at the 2 charts below.

 

 

Which one would you consider buying today? Both show an uptrend. Both are from well-known tech companies.

Now try to decide between thousands of stocks… every time you plan to buy. It’s impossible for the personal investor to go through this amount of data, let alone to make a decision.

So how to be efficient when choosing stocks?

I will give you a hint. It’s all about filtering and creating your own, personal list of favorite companies.

We will get to that. But first: Let’s look at the market to see what’s out there to choose from in the first place.

 

Which market are we talking about?

The market I know best is the US market: stocks that are traded on American stock exchanges, like the New York stock exchange (NYSE).

That does not mean it’s the best market or the only choice. You can choose any market in any country that you feel comfortable with.

So how did I end up with knowing the US market best?

At the time when I started trading, the most advanced and affordable online brokers were the ones covering this market. Today there are many more online brokers available than when I started – so that’s not a good reason anymore. It’s up to you to decide which market you like to trade.

Assuming that the stock market is well developed in the country of your choice, you can apply this lesson without any problems to your market.

 

What’s are market indexes?

An index is used as a measure of something.

You might have heard of famous market indexes already – the Dow Jones, S&P-500, or the NASDAQ Composite.

These are “imaginary portfolios” that are used to get a big picture of the current and past market climate. An index cannot be bought – it’s just a mathematical construct.

Most countries have their own representative index, for example:

• USA: Dow Jones, S&P-500, NASDAQ Composite
• UK: FTSE-100
• China: SSE Composite
• France: CAC-40
• Germany: DAX
• India: Sensex
• Japan: Nikkei 225
• Etc.

The S&P-500 index is a mix of 500 companies that represent approximately 75% of the US market value.

If you hear someone saying, “the market is going up”, this usually means that the S&P-500 is in an uptrend. If someone is talking about “market performance”, they often refer to the performance of this index.

There are many indexes that cover a variety of companies based on different criteria. Don’t bother knowing them all – unless you have a fetish for going through little details and lots of time at your hands.

Why bother about indexes in the first place? You cannot even buy them like a stock, so what’s the use?

Here are some good reasons to know about an index:

Understand current market climate

What the current market is doing will affect your trading strategy.

If the market is in a downturn and your strategy is to buy only stocks that are trending up, then you will buy less and keep your cash ready for the market uptrend that will follow the downtrend.

Compare Performance

It’s good to know how you are doing.

Is your trading performance good for the current market climate? I said before that it is nearly impossible to consistently outperform “the market” – means, the S&P-500 index. And that’s OK – there is no need to outperform.

I am conservative when investing; I do not like large dips in my portfolio.

So, what do I do? I use risk mitigation measures. But, like the fire insurance of your home, these come at a cost.

There was a year where the S&P-500 was strongly in the minus, while my portfolio was still growing. Not by much, only single digits, but hey! Better than losing money.

On the other hand, once the market recovered, the S&P-500 grew in the double digits, but my portfolio grew much slower. It’s a tradeoff that I accept because it fits my personality and trading style.

So, comparing portfolio performance to market performance means, comparing it with the performance of an index.

Remember to compare sufficiently long periods – like yearly performance.

Comparing daily performance makes no sense – it’s mainly showing noise instead of genuine performance.

Pre-Selection Filter

But here comes the main reason why knowing about indexes is cool. You can use them as a first filter for your list of personal favorite stocks.

Think about it.

There are 5,700 stocks to choose from. The S&P-500 includes 500 stocks, or less than 10% of the available stocks on the exchange. And yet… it represents 75% of the entire market!

By focusing on these 500 companies, you capture most the market, including all the “biggies”. Tech companies and large, well-known corporations are all part of this index.

Does it mean that the other 5,200 companies do worse? No, not necessarily. But they have less market capitalization and they are traded less often.

By filtering out companies with lower capitalization and lower liquidity you can reduce risks – but, like with any filtering, some underdog company that suddenly outperforms its competitors will initially fall through the cracks (that is, your filter).

If you prefer to trade mainly smaller companies, you can instead use a small-cap index. Just do some research on which companies are within what index and you are good to go.

Who decides which companies should be part of an index? It depends on the index. It could be a committee of experts or a rule based algorithm or a mix of both.

We will come back to filtering later in this lesson. For now, just keep in mind that indexes can be used as a powerful first filter to help you reduce the number of choices in the market.

 

Market Sectors

Another way of dividing the market is by looking at the type of business each company is in.

These are called market or industry sectors. Each company is assigned to a specific sector, which can also be divided further into subsectors.

Commonly the market is split into 10 key sectors, as per the table below.

 

 

Market sectors allow you to filter out companies that are in an industry that you do not want to invest in, for whatever reason.

It also helps to diversify your portfolio; it might be wise to have at least a few companies of each sector on your short list, in case opportunities arise that a sector benefits from.

Sectors have different characteristics because of the different business models.

For example, utility companies are (with exceptions) not the most innovative companies. They sell water and electricity and their customers pay for it. It’s a proven way of doing business and surprises are unlikely. There is limited growth in developed countries, but the income is relatively secure, leading to high dividends.

If you like technology stocks but you also like to diversify a bit into more established and stable companies, here is an idea for creating your shortlist that includes using market sectors:

1. Get the list for all 500 companies represented in the S&P-500 index

2. Split them into their respective market sectors

3. Randomly select:

a) 40 Technology stocks

b) 10 Healthcare stocks

c) 10 Consumer Discretionary stocks

d) 40 randomly from everything else

4. Now you have 100 stocks with focus on high-tech and a selection from other, more conservative sectors.

We will talk more about selection from a list later and in the worksheet.

Let’s move on to another topic: Efficiency!

 

How to become an efficient investor

Doing something in an efficient way simply means that time is the priority.

It does not mean to wing it, or delivering bad quality. But it does mean that you have a limited time to get things done – and often you need to accept tradeoffs between quality and time (and if you sell something, then also price).

It is tempting to be a perfectionist. Tinkering until it works perfectly, doing research and reading books or articles until you figured things out completely. If you have the passion for something, that’s what you do. But it’s not efficient at all.

Why is that? And what’s the issue?

It’s because of diminishing returns.

Imagine you want to become very good in something that needs a lot of work – like playing the piano. At the beginning, you don’t have any idea what to do, and your performance will be terrible.

But very quickly, with every hour of practice, you will improve. In fact, you will improve your skills linearly. 2 hours of practice doubles your new skills compared to only 1 hour of practice.

But this does not continue forever.

You will reach the point of diminishing returns. Suddenly, 2 hours of work does not improve your skills as much as before. And that trend will worsen over time.

 

True experts work many years, often decades to reach their level of expertise – what I call the “Perfectionist Level”.

We need such experts, more than ever. And thankfully for us, we have experts in nearly every field of specialization you can imagine.

But nobody can be an expert in everything.

Chances are that you are already an expert in your own field. And if you are reading this, then I assume you want to learn about trading and investing – but you do not plan to scrap your existing expertise and replace it with “expert investor and trader”.

And… you don’t have to for being a profitable trader!

Instead, I will teach you how to be an efficient trader. Getting the best results possible with the limited time that you have at your disposal is the goal – and that will put you way ahead of most people who do not have any education in finance.

Trust me, that’s a good thing! Sadly, most people have no idea about finances – despite earning good money from their own expertise.

Becoming efficient in trading happens in 3 steps:

1. Find out what takes most time
2. Understand what is most important
3. Automate tasks that take lots of time

What takes the most time when trading?

Beginner traders often believe that as long as they pick the right stocks they will do well in trading.

As a result, they spend most of their time sieving through hundreds of stocks, hoping to find the one that will make them rich.

And while their assumption that stock picking is the most important thing is wrong, it is true that stock picking takes time. Have a look at how I am spending my time when using my own trading system.

There are ways to spend less time on stock picking – some of them I will discuss in the next lesson.

With my trading system (and hence, my personality) it turns out that looking into stock charts, selecting a few candidates and finally making the decision (or not) to buy takes around 2/3 of my time.

And that is today!

In the beginning, I not only spent more than 95% of my time with stock picking, I also spent hours per session on it.

Today, with my system in place, I am spending only 10-15 minutes every 2-3 days; and my trading performance is much better than before!

 

What is most important?

I already mentioned that beginner traders tend to think that stock picking is the most important task when trading (while it’s not).

But I did not say yet what is, hands down, the most important one to be a profitable trader. Check it out below.

 

In a nutshell, keeping your risks in check will make or break your success as a trader.

For that reason, Lesson 6 will be entirely about risk reduction – so I will not cover it here.

Question: why do I still spend a relatively big chunk of my time with stock picking? According to the picture above, I should probably spend no more than 2-3 minutes on doing that!

There are several reasons for that:

• Risk management, after the initial setup, can be automated to nearly 100% 🙂
• I am curious and I like to go through various stock charts to discover new things. So, it’s not a necessity but a personal preference to spend more time doing so.

Having said that – it’s more difficult to automate stock picking and I am just not 100% comfortable to let the algorithms decide on everything.

However, algorithms do a lot of the heavy lifting in my stock picking and helped me to reduce the time from hours to minutes. So, automation has its place here, too.

 

How to automate trading tasks

When hearing about automation, many people think about “intelligent algorithms” that run day and night, looking for the next great trade.

And once it has been found, these bots execute the trade by themselves, not just once or a few times, but millions of times per day. And at the end of the day what remains is a pile of money.

These algorithms do exist; they are the foundation of what is commonly known as “High-Frequency Trading”, of HFT for short.

It’s what investment banks do, with an army of artificial intelligence experts and supercomputers that are so fast that the closer they are located to the stock exchange the better.

It’s very cool, but it’s not what the personal trader does ?.

Automation comes at many levels, and you will be surprised how much time you can save with just a few spreadsheets and some simple formulas.

My primary automation tool is Filtering. It works like that:

 

It’s a 2-stage process.

First I filter the entire “pool” by certain criteria; this reduces the number of stocks that I need to review dramatically. The remaining candidates will be reviewed “manually” – means, visual inspection. Based on what I see, I choose.

What kind of criteria can be used to filter? There are plenty, so here a few examples:

• Is the stock in a major index? YES means keep it, NO means discard it
• Is the stock part of the market sector that I am interested in?
• Is its trading volume above my set minimum trades per day level?
• Is its market capitalization above my set minimum level?
• Is the price above or below a certain value?
• Is the stock trending up?

And so on – there are plenty of parameters that can be used to reduce the size of the candidate pool.

Some of the filtering needs to be done only once per year – e.g. whether the stock is part of a stock index. Normally, that does not change dramatically from day to day. Other filters can be applied daily or weekly, for example, a trend filter.

In the worksheet, I will show how to build a filter by using plenty of examples.

 

What are the drawbacks?

Filters are very powerful. They rigorously filter out stocks that are not deemed suitable for trading as per your trading system rules.

But they are also pretty… dumb. They are rigid and they do what you tell them to do – no exceptions.

Let’s say you added a filter that sets an upper limit to the stock’s price-earnings ratio (PER). It’s a great way to get an idea whether a stock is overpriced or not. It’s calculated like this:

PER = Current Share Price / Company’s Yearly Earnings (per share, ESP)

A high PER could indicate that

1. The company’s earnings are low. Usually that’s a bad thing, or
2. The company’s earnings are OK, but the share price is completely over the top!

What are common PER values? 8 is on the low side, 24 is on the high side (that’s just roughly).

A PER of 24 means that a company needs to continue to make the same amount of money over the next 24 years to accumulate the value the stock price currently represents.

Let’s say you set your filter to 30 and you discard all shares that are above that PER value. Good news, Apple stocks are in your selection 🙂

But how about Amazon.com?

 

Amazon stocks performed very well. From April 2014 until April 2017 they tripled in value, from 300 USD to 900 USD. That is a gain of 200%!

Sadly, with the applied PE Ratio filter, this stock would have been off the radar. It’s PE ratio is hideous, at 184. The reason is that Amazon is focusing on growth, not on optimizing earnings. It made the stock price explode, but the PE ratio suffer.

The uptrend was clearly there. The stock is part of the S&P-500 index (since 2005) – but we would have missed that opportunity if we had filtered by PER.

In conclusion: be very careful when filtering. It is a necessary measure to be efficient, but don’t be too rigid in setting filter limits, especially when following “common wisdom”, like the meaning of PE ratios.

 

Filtering over time

I said already that filtering will help to reduce the number of choices, sort out risky candidates and make stock selection manageable.

At some point, however, we do not want to filter anymore – filter boundaries become too rigid and we might miss important opportunities.

Let’s say our favorites list is down to 100 companies. That’s not bad – considering that we started with 5,700 candidates.

But it’s still a lot to review on a regular basis. Imagine you like to look for new opportunities 3 times a week. Even if you only spend 1 minute per stock, that’s still 100 minutes – more than 1.5 hours – to review the entire list.

Who has time for that? Let’s face it: nobody has!

And even if you had that much time – there are other issues. After the first 20 stocks, not only concentration drops rapidly, but it’s so easy to forget what you reviewed just 20 minutes back. How did the first company on the list compare to number 20? Or number 65?

So, what can we do to optimize this?

We will take advantage of an interesting characteristic of the market – convergence. What does it mean?

Convergence means that groups of stocks, and sometimes ALL stocks, show similar behavior.

Remember the stock charts at the beginning of the lesson?

Both AMD and MSFT showed an uptrend. Sure, there were differences, but overall, similar stocks do similar things over time. At some point, they might change this (for example if an earnings report slashes them), but often it holds true.

How does that help?

It means we can split the list review into time slices.

Instead of trying to review all 100 companies at the same time, just review 10 during one session. During the next session, review the next 10. And so on. After 10 sessions, you went through your entire list and you can start from the beginning.

 

Chances are that you will not miss much – and even if you are a bit late with one opportunity, you are still likely to catch it.

If the market changes and moves into a major uptrend, many of the stocks in your list will do the same – and it will be reflected in your smaller time slice list, too.

To make sure that you get a representative sample of your favorites list you might want to randomize your list first – don’t order the list by market sectors or other criteria, as that might bias your time slice.

 

Updating your trading system

Once you decided on how to create your favorites list (your first step to become an efficient trader), it is time to update the rules of your trading system.

Here is what should be covered in this update:

• What is the starting pool of stocks?
• How many stocks do you want to have on your favorites list?
• What is the main filter?
• How often do you apply this filter?
• Depending on how many review sessions you plan for, what would be a good way to time slice your favorites list?

The worksheet will lead you through each of these steps. Below is how I set my own trading system rules as example:

• Starting pool of stocks: all stocks of the S&P-500 index
• Main Filter: Stock price multiplied by trading volume, ranked from high to low. I take the top 100 of that list as my favorites – these have the highest liquidity and market capitalization
• How often do I create my favorites list: once per year
• Time Slices: 10 stocks per session from my randomized favorites list (I review 2-3 times per week, on average, means I cover the list within 3-4 weeks)

Once you have your favorites list set up, you are ready for the next lesson: how to pick stocks from that list, i.e. how to decide when and what to buy.

Make sure you finalized the worksheet of this lesson before continuing.

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