3 Basic Rules for Growth Investing

By Paul Goodwin, Chief Analyst, Cabot China & Emerging Markets Report
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I have a friend who's an avid tennis player, the kind of guy who routinely finishes high in his club championships and sometimes wins. But he has always believed that with just a little advice from a top tennis coach he could be a truly great player. 

He got what he wanted (in a way) when he attended the 2004 U.S. Open Tennis Tournament in New York and got a great seat at one of the quarterfinal matches, in the second row behind the end line. He realized that he was sitting two seats away from Andy Roddick's coach (and brother), John Roddick. This, he hoped, might be his chance to overhear what a top coach had to say to a top player.

And he did.

After Roddick lost the first two sets, his brother screamed at him during the changeover, "Keep your eye on the ball!" Roddick eventually lost the match (to Joachim Johansson), but not before coming back to even the match at two sets apiece.

The lesson? Even at the highest levels of any enterprise, the most basic things are still the most important. If you're looking for some inside trick that great growth stock investors use to make more money than the rest of us, you're probably wasting your time. There is no Holy Grail, no Philosopher's Stone.

But if you asked my opinion on the most important basic rule, the one that's the equivalent of "keep your eye on the ball," I couldn't pick one ... but I could pick three. And here they are.

1. Follow the market's trend. If you buy growth stocks when the market is going up, you put the odds on your side, because a bull market changes the odds. It's always easier to swim with the tide or run with the wind at your back. Stock markets are no different. And when markets are going down, you should work extra hard to weed out your losers and move toward cash for the same reason.

2. Cut your losses short. When a stock starts falling, you have no idea how far it might go. The only theoretical limit is zero. And the longer you stick with it, the less capital you have to put to work.  No matter how much it hurts—and it does hurt, I know from personal experience—you have to admit that you made a mistake and sell the stock when it reaches your sell point. Cabot's growth stock investing rules advise selling when you have a loss of 20% in bull markets and 15% in bear markets. But these are the absolute limits; we often sell at a 5% or 10% loss if the market has turned sour or a stock has been hit by bad news.  Calculate the sell point when you buy the stock, write it down and stick to it. The number of times you get shaken out of a stock that then starts rising again will be more than made up for by the number of times you save your money to fight another day.

3. Let your winners run. Some investors set buy points as well as sell points. When a growth stock is showing a 20% profit, or 25%, or whatever, they will sell the stock and book the profit. While booking a few smaller profits is fine, doing it across the board makes it impossible to enjoy the wealth-building benefit of a stock that doubles and then doubles again, which is how really enormous gains are made. The profit from these big gainers, which reward you with compound growth, is what makes aggressive growth investing a winning proposition. It takes just one of them to compensate you for a bunch of stocks that fall short.

There's a reason that the same old rules are still the rules. Keep it simple. Keep your eye on the ball. And you'll come up a winner.

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