We've all learned to play newgames during the course ofour lives. Sometimes the rulesare complex, and they're explained to usbefore we even begin to attempt playingthe game. Other times we're told therules are easy to understand, and we canpick things up as we go along.
The stock market, on the other hand,is not a game, and the penalties for notknowing fundamental rules of investingcan be a lot worse than landing onBoardwalk or Park Place when a hotel ispresent. But there are solid stock investingstrategies that, if learned before youdecide to play, can make the differencebetween a fruitful experience and afinancially painful roll of the dice.
Every fruitful endeavor starts with aplan, and one of the keys to successfulstock investment planning is to knowyourself. Matthew Bernstein, CFP®, of M.Bernstein & Associates, suggests that thefirst thing an investor should look at istheir time horizon. In other words, howlong are you planning to invest beforeyou need to call on those funds?
1. Set Time Horizons
Understanding your time horizonsets you up for how you are goingto allocate your investments,"Bernstein explains. "That will also helpyou determine how much risk you'reable to take on. But first, you need toknow how much time you have."
A physician might have a goal ofpurchasing a home within the comingyear, regardless of what the market isgoing to do. That person's money,Bernstein says, does not belong in thestock market because it's impossible topredict market performance duringthat year. Given that short time horizon,the individual could lose most ofthe funds they had been planning touse as a down payment.
Jordan Kimmel, president and portfoliomanager at the Magnet InvestingGroup and author of (Next Decade Inc; 2000;$24.95), echoes Bernstein's thoughts.He points out, "The most importantthing people can do is make certainthey have a game plan before theyinvest. Because once you invest, youremotions start to take over."
An individual might have multipletime horizons. "The same individualwho has a retirement time horizonmight also have a college-fundingtime horizon," Bernstein says. "Andthose are 2 different pools of money."
What Bernstein advocates, is thecreation of an investment policy statement.This type of document definesan investor's time horizon, risk tolerance,investing parameters, and methodof maneuvering investments overvarious market cycles. It remains a constantguide for investment decisions.
"It helps to have a written documentto refer to," Bernstein explains."When things get crazy, this documentwill keep you out of extreme situations.It's fine to take a percentageof your money, say 10%, set it aside,and play in the market. But a properlycrafted investment policy statementgoverns the serious money. That's abuilding block for successful portfoliosand money management."
2 Understand Your Risk-Tolerance Gauge
Webster's Unabridged Dictionarydefines risk as "exposure to thechance of injury or loss; a hazard ordangerous chance." Of course, whatone individual may perceive as a"dangerous chance," another mayview as simply a carefully calculatedgamble. As Matt Patsky, CFA, portfoliomanager at Winslow ManagementCo, explains, risk tolerance is a verypersonal thing.
"There are lots of individuals whodo not tolerate risk well," Patsky says."Even a newly minted, 28-year-oldphysician who should be putting almostall of their investments towardaggressive equities, may not have atolerance for handling that type ofrisk." Patsky believes that each investorneeds to assess their own abilityto accept risk. "If an initial $10,000investment that is at $15,000 a yearlater, but then drops to $7000 the followingyear is something you can'ttolerate, by all means treat investinglike a 60-year-old who is retiring in 5years, and stay conservative."
Bernstein believes that an individual'srisk as an investor is always temperedby what is going on aroundthem. "In order to be successful, youhave to separate yourself. That meanshaving the courage to stand up andbuy when others are running for thehills, and to sell when others are buying.And that's the most difficult thingin the world to do." Contrary to hisbeliefs, Bernstein recalls that when themarket peaked in 2000, investorscouldn't buy enough. But when it hitbottom just 2 years later, investorscouldn't sell fast enough. "Investorshave learned a lot about risk over thepast 2 years, but too many people haveshort memories. And if the marketstarts ramping up as it did a few yearsago, too many people will start tossingcaution to the wind."
Gilbert Davis, CPA, PFS, president ofFinancial Advisors, Inc, cautions thatphysicians often expose themselves tothe dual risk that comes from investingtoo heavily in one's own industry.Investing in what you know is a popularstrategy, but too many eggs in 1 basketcould leave you scrambling for cover.
"If the health care sector suffers insome way, physicians could be hurt byinvestment risk as well as professionalrisk," Davis explains. "Not only mightphysicians be hurt by investment losses,but their income might be affectedas well. They're overexposed to 1particular sector of the market. Theway to avoid that potential pitfall isasset diversification."
3. Learn the Art of Diversification
When it comes to successful investingstrategies, the importance ofdiversification and asset allocation cannot be overstated. An investment portfoliothat is properly diversified is like abuilding whose foundation is evenly distributed.Left unbalanced, the building—just like your investmentportfolio—could shift and tumbleduring a storm. Andas physician-investorsought to know, themarket has been apretty stormy environmentto tread throughfor the past 2 years.
Unfortunately, theconcepts of diversificationand asset allocationare often confused. For example,you may own stock in 10 differentcompanies, but if they're all in thetelecommunications industry, that'snot diversification. Similarly, purchasing5 different mutual funds that areall of the same type or style is not assetallocation. What happens is that you'llend up owning the same stocks overdifferent funds.
"One of the biggest impacts on anindividual stock is the sector that thestock or company resides in," Kimmelexplains. "Some studies show that30% of a stock's movement is specificallyrelated to its sector." He explainsthat sometimes the worst companiesin a hot sector will run up, while thebest companies in a sector that is outof favor will decline by a greater percentagethan people realize. "It'simportant to diversify not only amonglarge, small, or mid cap companies, butamong industries or sectors as well."
Case in point:
Patskyrelates that as atrustee of his company's401(k) plan, hewas recently involvedin analyzing the funds'offerings within theplan. The plan is comprisedof 4 differentgrowth funds, all largecap in orientation.What he found wasthat in examining thetop 10 holdings of each fund, 7 were thesame in all 4 funds. That's a recipe fordisaster; there's nothing to provide balanceshould large cap, growth-typefunds go out of favor.
Of course, as Kimmel points out,there are investors who are willing toaccept volatility to be in what they perceiveas the best sectors. "The highest,long-term returns come from securitieswith the greatest volatility," Kimmelexplains. "But most investors will notwant to handle a portfolio of the mostvolatile securities because it's too difficultemotionally. That's why for the beststeady performance, it's essential to beproperly diversified among sectors."
4. Seek Quality with Research and Patience
Regardless of what type ofstock you're consideringpurchasing, make certain it's aquality stock. What is quality?That can be difficult to pinpointbecause, as Bernsteinpoints out, quality is often amoving target.
"People might say theylike IBM as a quality stock,but was it a quality stock when it wentfrom 100 down to 60?" Bernstein asksrhetorically. "Sysco is a well-run company,but is it a quality stock when it goesfrom 100 down to 8? I don't think so."Bernstein says it's important to separatethe company from its stock. You canhave a quality company but a lousystock. "For me, quality means you'rebuying a company that has earningsand cash flow you can forecast, a companythat makes a real product. Ifyou're a value investor, you look to buyunderpriced stocks. If you're a growthinvestor, you look for stocks with forward-looking earnings and productsthat will maintain their market shareover a cycle or 2. And that means thatthe idea of quality may have to rotatefrom time to time."
In , Kimmel detailsthe magnet stock selection process,which he says contains underlyingfundamentals thatare important, whether youare buying small, medium, orlarge cap stocks. That's becausethe top-performingstocks, he says, display somecommon characteristics. Andthe term MAGNET is anacronym that describes thecharacteristics of the companies thatshould attract investors.
• M stands for management andmomentum. A quality company musthave outstanding management. Inaddition, momentum (ie, the relationshipof a stock's share price to the overallmarket) must be improving.
• A is for the acceleration of earnings,revenues, and margins. Kimmelsuggests that a minimum increase of15% in quarterly revenues and earningsas a benchmark.
• G stands for growth rate, whichmust exceed current valuation. Ideally,Kimmel says, when a stock is purchased,the current market valuation of a company,based on its price-to-earnings ratio,should be one half its growth rate.
• N is for new product or new management.Often, a new product willcreate renewed awareness of a company,and new management signals achange in direction, which could alsodraw attention.
• E represents an emerging industryor product. Often, this can signal greatinvestment opportunities.
• T means that timing must beright. In effect, the company is technicallypoised for a large price increase.
The key, Kimmel says, is recognizingthat in today's market there are nosacred cows. That's why careful analysis iscritical in selecting quality investments.
There's no question that the stockmarket today can sorely test aninvestor's patience. Still, it's importantto maintain patience and a long-termfocus rather than jumping in and out ofstrategies, trying for a quick fix. AsDavis points out, it's not coming.
"I've followed the market for a longtime, and I was around for the 1987crash," Davis explains. "Unfortunately,investors in their early or mid-30s havenever seen a bad market, until now.And the market of the 1990s completelyblew their expectations out of proportion.Now investors are expecting torecover everything they lost. I tell themthat it's past history, and their expectationshave to change."
Patsky says it's important to rememberback to your original game planand stick with it. He points to studiesshowing that investors who chase themost recent hot stock of the past 3months often get burned. He likens thetactic to the sports fan who jumps onhis team's bandwagon when they'rehot, then jumps back off when they hita bad streak 2 weeks later.
"You have to watch the entire season,"Patsky says. "Look at 10-, 5-, and 3-year track records. Don't worry so muchabout the most recent 6-month period."
Kimmel cautions againstbecoming overly patient, and comparesmaintaining a portfolio to tending a garden.If you planted 10 seeds one day, youwouldn't come back the next to seewhat's growing because you know that'stoo soon. However, if over time only 7 ofthose 10 seeds grew, you'd rip out thebad seeds and plant something new.
"What happens in the stock market,"Kimmel says, "is investors sit with a lossindefinitely, waiting for the stock to comearound. That's a bad strategy. You have tohave patience in investing, but not allowstagnation to take place in any one ofyour holdings. And that will be true in2003 as well as 2013."