Faced with market turmoil, many investors panicked and blindly sold stocks, dumping good companies that could soon rebound. Others have sought to profit from the downturn by buying shaky junk bonds. While those risky investments may appear cheap, they could sink the next time the market drops.
To avoid losses, move cautiously. Buy solid companies that can grow over the long term. Be prepared to hold these steady performers for years — and don’t abandon good businesses at the first sign of a minor problem. As I discovered during a long career on Wall Street, the best stocks can provide healthy returns for investors with patience. Even people in their 60s and 70s may have long-term investment horizons. Rules that I follow…
Don’t buy or sell in reaction to stories in the media. At a time when so many news articles are frightening, investors may panic and sell — but this can result in irrational choices.
Example: After General Electric cut its dividend, newspapers were full of negative articles about the company’s problems. Investors raced to sell. The stock dropped from a high above 12 in February to a low of less than seven in March. Soon investors realized that the company was still profitable, and the stock began rebounding, rising above 12 in April. Investors who sold based on the headlines suffered sizable losses.
Better: After you see some bad news, wait a few days. Calmly consider the information and make a dispassionate decision based on the fundamental performance of the company and the long-term outlook for earnings.
Likewise, don’t be easily swayed by good news. Chances are that whatever story you’ve heard actually made its way around Wall Street for weeks before the news articles appeared. If that happened, the pros have already pushed up the share prices before retail investors learned of the positive developments. If you do see a report of a positive earnings surprise or record earnings, calmly evaluate the news. Watch patiently for days or weeks to decide whether the good news is an isolated incident or the beginning of a long trend.
Limit your losses. When a stock proves disappointing, be prepared to recognize that you made a mistake. If the stock drops 15% to 20%, have the discipline to reassess your position, determine if the business outlook is intact and decide whether you made an error and should cut your losses. By accepting relatively small losses, you can avoid disastrous declines.
Don’t try to “catch a falling knife.” After a stock has fallen by half or more, it may seem like a bargain. But all too often, the shares keep dropping. When Internet stocks collapsed in 2000, some shares dropped from more than $100 to less than $10. Although Wall Street analysts recommended the shares at the low levels, many of those stocks lost all their value.
Emphasize dividend-paying stocks. When stock prices soared in the late 1990s, many investors considered dividend-paying stocks to be stodgy. But dividend stocks have proven to outperform the market averages over long periods. During the 80 years ending in 2006, US stocks returned about 11% annually on average. More than 40% of that result came from dividends. In the next several years, markets will struggle to recover from the financial crisis, and stock investors will likely achieve only modest single-digit total returns. Dividends will account for a big percentage of returns.
In today’s rocky markets, dividends serve as important indicators. Most companies that pay consistent dividends have plenty of cash and are financially sound. And because they reward shareholders with steady cash payments, dividend stocks are often quite resilient during market downturns.
Seek revenue growth. Look for companies that have been increasing revenues steadily. Such businesses are likely to have a competitive edge — and are likely to continue to grow.
Exception: Beware of companies that are reporting rapid annual growth of more than 25%. Such high rates are unsustainable. When the inevitable slowdowns occur, share prices could collapse. Sub-par revenue expansion during a severe economic contraction is reasonable as long as the pace is relatively healthy compared with the competition.
Pursue expanding profit margins. The best companies report stable or increasing profit margins. These are displayed in annual reports and on stock-related Internet sites, such as Yahoo! Finance (http://finance.yahoo.com). If a company has been increasing revenues and profit margins for the past five or 10 years, it likely has a unique product or strong management. At the same time, beware of companies with profit margins that are far superior to those of their industry competitors. It may be hard to maintain such high levels.
Avoid turnarounds. Be wary of companies with weak profit margins and declining earnings. While some value investors favor such troubled businesses, these turnaround candidates rarely succeed. Once a company begins spiraling down, it may appoint new management or engage in big cost-cutting programs. Such moves can give the stock a short-term boost. But most often bad news is followed by more problems.
Shop for bargains. Even if a stock’s revenues and earnings are growing rapidly, it may not be worth buying if the price is too high. Expensive stocks can drop sharply at the least bit of negative news. To avoid overpaying, focus on stocks with price-to-earnings ratios (P/Es) that are below the current average for their industries. Over long periods, stocks bought cheaply tend to outdo expensive ones. For a rough gauge of the average P/E of an industry, go to the “Industry Center” at Yahoo! Finance, http://biz.yahoo.com/ic, and select an industry from the list.
Avoid short-term trading. Once you buy a stock, aim to hold it for at least one year. If the stock continues performing steadily — and does not drop by more than 15% to 20% — stick with it for years. Short-term trading rarely produces good results because share prices can bounce around unpredictably. If you crave excitement, set aside 5% of your assets for short-term trades — and be prepared to lose all this money.
Set realistic goals. During the 1990s’ bull market, stock investors routinely enjoyed double-digit annual returns. But in today’s difficult economy, profit margins are under great pressure, and stocks are likely to deliver only modest results. If you record 5% to 10% annual returns, be satisfied with your strategy. Don’t take on more risk in hopes of obtaining results that may be difficult to achieve.
Stay diversified. Hold a mix of stocks and bonds. Most investors should follow the example of T. Rowe Price Capital Appreciation (PRWCX), a mutual fund that keeps about 60% of assets in high-quality stocks and most of the rest of the portfolio in cash and investment-grade bonds. Since the fund started in 1986, it has averaged a 10.7% return annually, achieving modest returns nearly every year. That consistent showing has enabled the fund to outperform most of its competitors and avoid the worst losses during the recent market downturns.
