By Timothy Lutts, Cabot Chief Investment Strategist and Editor of Cabot Stock of the Month Report
From Cabot Wealth Advisory  3/23/09 Sign up for Cabot Wealth Advisory free e-newsletter

I was talking with a long-time subscriber last week—a professional money manager—when the topic of education came up. He told me, "The thing I've always liked about Cabot is you educate your readers. You don't just tell them what to buy and sell, you explain why."

Today, recognizing the value of that thought, I'm going back to basics, bringing you five rules for successful growth investing, complete with the all-important reasons why.

1. Use market timing to guide your investing. In bull markets, we say, "A rising tide floats all boats." In bear markets, we say, "It's hard to swim against the outgoing tide," ... as so many investors have learned over the past year. So learn to recognize the major trend of the market, and learn to respect the power of that trend. Today the market's big downtrend appears finished, and a new uptrend is trying to establish itself.

2. Do your very best to ignore the economic news. The fact is, the stock market is always looking six to nine months ahead, so today's news means nothing. Sure, it's fun to talk about the ongoing drama at A.I.G. and the U.S. Treasury Department, but it won't help you make money. In fact, if you're always focused on investing according to the hottest news, you'll find you're always one step behind the professionals. You're at a disadvantage. To succeed as an investor, you've got to find an area where you have an advantage, and that's on the road less traveled, namely younger, less well-known companies.

3. Invest in fast-growing companies. Fast growth can overcome a huge number of smaller deficiencies, like inexperienced management, competition, weak patent positions, and more. And fast growth eventually attracts the attention of institutional investors, who are very useful in both providing downside support and in pushing prices higher as they buy their way in. Your best bets are in small companies growing at triple-digit rates—100% or better—through organic growth, not acquisition. One company that fits the bill today is Alexion Pharmaceuticals (ALXN), and another that nearly makes the grade (these are tough times) is Onyx Pharmaceuticals (ONXX). Interestingly, both companies are developing—and selling—drugs to treat cancer, and both, after years of losses, turned profitable in 2008.

4. Average up in your winners. As the song says, "Accentuate the positive." So when you've invested in a small, fast-growing company, and the market gives you a profit, don't take the profit. Wait for a normal pullback, and then buy some more.

5. Cut losses short. As the song says, "Eliminate the negative." If a stock you bought has declined, it has not done what you hired it to do. Thus, you should consider letting it go. Analyze the chart carefully, and tolerate no losses exceeding your own personal pre-set limits. Our absolute maximum loss limit is 20% in bull markets and 15% in bear markets, but we do our best to cut them even shorter. The very worst thing you can do is let a loss get bigger and bigger.

Perhaps the biggest rule of all, which has existed for centuries, is about diversification. "Never put all your eggs in one basket." Of course, everybody knows this, so I don't even include it my five top rules. But sometimes ... people forget.

Editors Note: Success at growth investing takes just as much commitment of time and energy. But you can profit from our efforts--we spend eight hours a day, five days a week studying stocks and the market in the office ... and more at home--by subscribing to one of Cabot's growth newsletters. If you're just starting out, Cabot Market Letter can teach you more about how growth investing really works than you could learn in years on your own. In clear, entertaining prose, Cabot Market Letter will help you build your growth portfolio on a tested and proved system of stock selection, market timing and portfolio construction. Click the link below to get really prepared for the next visit from the bull.

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