One of the most important decisions in starting an investment journey is choosing an investment strategy. The ultimate goal of course is to make money, but how? What do you choose to buy, when do you buy it and when do you sell it? This is where The IBD Methodology will help.
The IBD Methodology Origins
Decades ago, William O'Neil, the founder of Investor's Business Daily, tried to give people a framework. He published his 1988 bestseller "How To Make Money In Stocks." In this book, he shared decades of research on the best-performing stocks of each market cycle.
The book, and its newer editions, provided a structure for investment decisions. There are four main pillars supporting this structure: Fundamental analysis, technical analysis, general market analysis and risk management together build a strong foundation for investment success. Bill O'Neil used these pillars for decades. When IBD launched in 1984, they became the cornerstones of what is now known as The IBD Methodology.
Pillar 1: Fundamental Analysis And Stellar Companies
The combination of fundamental and technical analysis might not seem revolutionary now. But when O'Neil started as a stock broker in the late 1950s, the two camps didn't mix. Studying the best market performers over multiple market cycles convinced him that both are important.
Fundamental analysis focuses on the financial aspects of the company, the things you typically find in an earnings report or balance sheet. Earnings, sales, cash flow and other metrics make up this type of analysis. Its importance to The IBD Methodology is highlighted by the IBD EPS Rating. That compares a company's earnings profile on a relative basis to all other companies in the IBD database.
Another related fundamental rating is the IBD SMR Rating. This looks at the sales, profit margins and return on equity of a company. These three critical components feed into the earnings.
Pillar 2: Timing Buys And Sells With Technical Analysis
By contrast, technical analysis focuses on aspects of the stock chart. Think price and volume.
As O'Neil studied the best-performing stocks of each market cycle, he recognized the importance of studying charts. He noticed that many of the best-performing stocks had the combination of strong fundamentals but also offered repeated base patterns in the stock's price and volume. Identifying these base patterns determined the proper entry for the stocks.
O'Neil also found that strength begets strength. Many times the stocks that already had a history of outperformance continued to outperform. The Relative Strength Rating helps identify the strongest stocks and assigns them a percentile based on their performance vs. all other stocks in the IBD database.
Finally, being able to decipher stock charts gives an investor insight into the movement of institutional investors, mass psychology and the interplay of supply and demand. A picture can indeed be worth a thousand words.
While fundamental analysis got him looking at the strongest companies, the chart patterns helped with the timing. Both these factors were usually in place before winning stocks made their big price moves.
Pillar 3: Get Favorable Conditions With General Market
O'Neil had a solid list of rules for choosing stocks with the biggest potential. But his work wasn't done.
In 1961, he made some solid choices in stocks but didn't recognize when the market turned against him that summer. Because he believed in analyzing his trades from start to finish, O'Neil discovered he needed to expand his rules. Specifically, he needed to know when the market was in your favor or going against you.
His in-depth study of market bottoms and tops led him to develop the follow-through day concept for recognizing market bottoms and distribution days for recognizing market tops. These concepts are evaluated daily with market analysis in The Big Picture column including a progressive exposure model that helps manage risk.
Pillar 4: Stay In The Game With Risk Management
Speaking of risk management, the summer of 1961 uncovered another weakness in O'Neil's system as it stood: His sell rules needed work. Risk management is an important part of The IBD Methodology. Protecting capital is the golden rule of The IBD Methodology.
A common factor among the most successful investors is that they stayed in the game over time by not taking big losses. Specifically, cutting losses at 7% -8% from his purchase price helps purge small mistakes early before they become big mistakes. O'Neil also recognized the need for locking in profits when he had them.
But it's not just about the stock trades themselves. Another component is how each position fits into your portfolio as a whole. Position size, levels of concentration and even the volatility of your stocks are important considerations to make sure you don't take on more risk than you should.
These foundational concepts put William O'Neil on the map as a legendary investor. IBD's creation was partially to share these rules with a larger audience. The IBD Methodology remains a tried and true investing system. It's already helped thousands of investors achieve their own financial success. Our hope is that many more success stories follow.
