The risks of Wall Street are numerous even in good times, and in a sideways or bear market there are even more pitfalls to avoid. Juggling the charts, the economic data and the earnings of your stocks can be a daunting task, and it’s hard to stay ahead of the game.
But whether times are good or bad, there are a few distinct classes of investments that almost always are trouble for your portfolio.
These stocks might not be obvious trouble spots because they can come in pretty packages or even be disguised as “low-risk” trades. But they can siphon cash out of your retirement fund just as fast — even if there’s not a big headline or macroeconomic event behind the damage.
I like to call these investments “pickpocket investments,” because oftentimes you don’t know you’ve been had until you go for your wallet … then realize it’s too late.
To help reduce your risk and protect your holdings, here’s a detailed description of five types of investments I think could cause serious damage to investors who aren’t on their guard: dividend cutters, low-volume stocks, Dumpster dives, high-frequency trading targets and fashionable investments.
Let’s take a look at each group.
#1: Dividend Cutters (and Misers)
Everyone is hungry for yield these days in the form of dividends, and with good reason. The market is volatile and 10-year Treasury bonds yield a painfully low 1.6%.
But when those dividends aren’t as big as you expect, it can really hurt your holdings.
The dividend cutter many investors remember most is General Electric (NYSE:GE). The industrial conglomerate slashed its payday from 31 cents a quarter to 10 cents a quarter in 2009 — a 68% slash in dividends that has not been replaced. InvestorPlace author Jim Woods recently compiled a more recent list of 17 dividend disappointments of 2012, including KB Home (NYSE:KBH) and Noble Energy (NYSE:NE).
Other dividend cutters who aren’t as well publicized are companies where volatile payments are common and thus not as noteworthy. These often are players in the mREIT space like Annaly Capital (NYSE:NLY), which has seen its payout slump 75 cents quarterly in 2009 to 55 cents now, or shipping stocks like Frontline (NYSE:FRO), which paid a peak dividend of $3 in 2008 and just 2 cents last September before killing payments altogether.
How do you protect your income? For starters, make sure you examine the distribution history of a stock carefully before even investing. And once you’re in, pay attention to cash flows and earnings history to prevent having your pocket picked by these dividend cutters. I recommend a simple calculation involving the dividend payout ratio. In short, if a company starts to pay out significantly more in dividends than it does in earnings per share, warning bells should go off. After all, how can stock afford a $2.50 annual dividend per share when its earnings are only $1.50? The math just doesn’t work — and a cut could be looming.
As for dividend misers, the earnings history and dividend payout ratio are equally important. If a company is throwing off profits significantly higher than their dividend, you have to wonder what they are doing with that cash if they’re not paying you. A small-cap growth stock has a good excuse for paying only 10% of its earnings back to shareholders via dividends — or even not having a dividend at all — if management is investing in growth. But a large-cap stock that’s hoarding cash — I’m looking at you, Google (NASDAQ:GOOG) — for no reason isn’t giving you the value you deserve.
#2: Low-Volume Stocks
Penny stocks and microcaps (the stocks most commonly characterized by low volume) can be rewarding if you buy them at the right time and make big profits. But they also can bankrupt you with their volatility.
The nature of these small stocks means a little buying pressure goes a long way, and simply placing a buy or sell order can cause these companies to soar or crash. That means they can move big on news — or move big on no news at all. That makes them prime targets for pump-and-dump artists trying to drive up the price through unscrupulous tactics.
I have written extensively on inherent problems to penny stocks and microcaps that trade over-the-counter and on the pink sheets (see this post about microcap risks, this post about low volume and this post about penny stock scammers).
I highly recommend never buying a stock with a volume of less than 100,000 shares daily or a market cap of under $500 million. There are exceptions, of course, but this is a good rule of thumb to avoid this ugly part of town and steer clear of pickpockets.
If you must trade low-volume stocks, always use a limit order to protect your entry price and sell price. And if you are buying a significant amount, consider distributing your transaction over a few days or weeks instead of moving the market with one big order.
#3: Dumpster Dives
I wrote at length about this kind of pickpocket investment in my recent article “Buy Quality on Pullbacks, Not Stocks in Their Death Throes.” The idea is simple: There’s a big difference between a good stock that has had a bad run and an ugly stock that you’re hoping will just get less worse.
In a bear market or a sideways market, it’s tempting to talk yourself into why a downtrodden name is a good bargain based on a rock-bottom P/E ratio or a strong history of outperformance in the past. But never fool yourself into thinking that a stock that has gone down dramatically can’t go even lower.
Consider Research In Motion (NASDAQ:RIMM). Shares peaked at $150 in 2008. They finished 2011 at around $15. Still, many investors were convinced that the BlackBerry maker wasn’t dead. It still had a footprint in enterprise with many business connections even if consumers preferred Apple (NASDAQ:AAPL) and its iPhones. It had well over a billion in cash to make some moves and operating cash flow of nearly $3 billion.
Well, pity on you if you thought it was oversold. RIMM lowered estimates and delayed its BlackBerry 10 launch, causing the stock price to be cut in half again to under $8 and proving Research In Motion can indeed go even lower.
The moral of the story is that if sentiment is ugly and secular trends clearly are against a stock, don’t fool yourself into thinking that the market has somehow miscalculated the value of an investment. You’re better off buying a stock you believe in on a pullback.
Or, to turn a phrase, shop the sale rack at Neiman Marcus instead of Dumpster-diving.
#4: High-Frequency Trading Targets
Unlike low-volume penny stocks that can be juiced by unscrupulous traders, equally troublesome are mega-volume companies that are the playground of Wall Street computers.
For those unfamiliar with the practice of “high-frequency trading,” it involves stocks that trade almost instantaneously when a sophisticated algorithm is identified by supercomputers. Some HFT positions are held for only a matter of seconds, and often there’s no net investment at the end of a given trading day. A report by the Tabb Group estimates that as many as 98% of orders placed by these computers are canceled before they become trades.
Worst of all, many think it was high-frequency trading algorithms that resulted in the May 2010 “Flash Crash” that caused a nearly 1,000 plunge in the Dow for a brief period.
HFT is legal, though an article earlier this year in The Wall Street Journal says the Securities & Exchange Commission is looking to take on the practice. Until more regulations are in place, however, you need to understand the risks to your portfolio to prevent getting your pocket picked.
For starters, be aware that HFT tactics work best on low-priced stocks with high volume. That would be companies like Bank of America (NYSE:BAC), which some estimate makes up 5% to 10% of total U.S. stock market volume while the computers run wild with shares. Headlines and financial reform will play into how BAC performs, to be sure. But you can bet the HFT algorithms will have their say — even on a day with no news.
Secondly, be aware of the risks of placing stop-losses in HFT targets. Volatility can be par for the course despite the big size of these picks, and you easily could be stopped out of a position one day and see it bounce back the next.
#5: Fashionable Investments With False Pretenses
This category of investment can sometimes be of the criminal variety, but oftentimes can hide behind the idea of free speech in their “commentary” as they try to pump up a battered stock or push down a company unfairly for personal gain.
And don’t be fooled by the idea of personal gain as share appreciation. Sometimes, all these people are after are your clicks on their website or your subscription to their “elite” newsletters.
These Wall Street pickpockets prey on investors in the following ways:
- Offering opinion as fact: Fluffy marketing about your product is par for the course for any company. Most folks know to take any company press release with a grain of salt. But in the financial media and blogosphere, sometimes it’s hard to know what the source is. Phrases like “best-selling” or “industry leading” must be attributed to hard data (and time frames) to be meaningful.
- Masquerading as the “smart money”: There are some great minds in financial media. There are also some hucksters. Finding someone you can trust is not easy, but even when you believe you have found a real ally in the stock market, you always should be careful of folks looking to protect their own positions or to get ahead by making hyped-up claims. I’m talking about you, Brian White, looking to make a name for yourself with headline-grabbing price targets for Apple (NASDAQ:AAPL).
- Hiding their true track record: There are certain benchmarks for greatness in all industries. A perfect game in bowling is almost expected of the great players, but a perfect game in baseball is a holy and rare event. In the stock market, perfection isn’t even close to attainable. So beware of the misinformers who are afraid to offer up track records with blemishes. The bottom line is that no stock goes up every day, and no stock picker is right every time. Particularly egregious are those hucksters who use “back-tested data” for their track records. Under that model, since I own Apple (bought at $550 this spring) I could say I have “backtested” returns of 16,500% through 1980 when Apple went public. I wasn’t even in kindergarten then … but hey, it looks good on a marketing message.
So how do you protect yourself from these kinds of pickpocket schemes? Simple: Demand consensus, and read voraciously. Never accept anything at face value and never rely on a single source no matter how trustworthy.
This includes me, for the record. If I can’t stand up to scrutiny don’t follow my advice, and please harass me at email@example.com to make fun of my errors. I don’t pretend to be perfect, and I welcome the two-way communication.
Jeff Reeves is the editor of InvestorPlace.com, and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, Jeff Reeves owned a position in Apple.