As you begin investing, you need to learn to ignore the static and stick to your game plan.
But over the years, many old chestnuts have fallen, half-rotten, to the ground — even Warren Buffett’s exuberant 1990s dictum that “our favorite holding period is forever.” Tell that to anybody who bought Cisco (CSCO) at $146 in March 2000. Even some very good businesses can get so overpriced that hanging on for a lifetime won’t bail you out.
So how do you come up with a solid plan? Well, certain commonsense investment principles have proven their worth time and time again.
Value, Always Key
The first, and most important, rule that has worked for centuries (and still works today) is “Buy cheap, sell dear.” It’s almost laughably easy to grasp, yet difficult for most investors to act on. Overpriced assets tell an enticing story. Growth, new technologies, “inevitable” trends, charismatic business chiefs — all can keep us from asking the bedrock question, “How much is it really worth?” Ponder this issue carefully before you lay a nickel on Tesla (TSLA) or the next Facebook-like (FB) IPO!
You’ll catapult your odds of investment success if you buy things that are objectively cheap, not just depressed in price. When picking stocks, for example, look for proof of intrinsic value, such as a generous dividend yield, a large amount of free cash flow relative to the share price, or a well-established pattern of stock buybacks that significantly shrink the number of shares outstanding.
“Selling dear” calls for objective standards, too. You should carry around in your head a price at which you would consider each of your investments fully valued (and thus ripe for sale). That price will adjust, up or down, as the fundamentals supporting the investment change.
Say, for instance, a company slashes its dividend. In that case, the stock might be richly valued, even at a lower price than you paid. Watch for a temporary bounce as your chance to exit the position.
Diversification for Safety
The second truth that has stood the test of time is diversification. A couple of years ago, the financial news media were lionizing money managers who ignored this principle. By concentrating your portfolio on a few “great ideas,” you could strike a bonanza while the rest of us suckers were just plodding along.
Hedge-fund star John Paulson was the poster boy for putting all your eggs in one basket. In 2008, when he was a relatively small operator and largely unknown, Paulson reaped billions from placing a go-for-broke wager on the housing collapse. Over the next two years, as word of his success got around, investors banged down the doors to gain entrance into his highly concentrated funds. By the start of 2011, he had $38 billion under management.
Uh-oh. During the first half of 2013, his highly touted PFR Gold Fund cratered 65%, according to Bloomberg.
Live by the sword, die by the sword!
For the great majority of investors, it’s wiser to spread your risks around. Within the stock segment of your portfolio, never allow any single company to hog more than 5%. Gold, collectibles and other “alternative” assets should normally make up 10% or less of your total — probably much less under today’s circumstances.
My third enduring principle is that of low turnover and low cost. The two are actually intertwined, because you tend to lower your costs (commissions, taxes, wrong timing decisions) if you trade less frequently.
Observe: I’m not arguing that you should “hold forever” and never swap horses. Buffett himself committed a major blunder in 1998 when he failed to sell even a modest sliver of his Coca-Cola stake after the shares rocketed to a mind-blowing 54 times trailing earnings.
Instead, I advise you to trade methodically and deliberately. A couple of times a year, after market prices have risen substantially, you should review your holdings and pare investments that have reached the highest level you can justify for them, looking forward a year or more.
It doesn’t matter whether the candidate for elimination has performed well or poorly. If it has reached what you believe to be a plateau for at least the coming year, get rid of it. There will be plenty of frisky ponies to take the old nag’s slot.
How will you know you’re doing the right amount of trading? In my studies of the great value-oriented money managers (not the 10-minute wonders of the hedge-fund world), I notice a pattern. The masters generally turn over 15% to 30% of their portfolios in a normal year.
In a long sideways market (such as we’ve had with the U.S. stock indices since 2000), a somewhat higher turnover rate might make sense. Even now, though, you probably shouldn’t move more than 50% of your portfolio around within the space of a year unless you think a massive market dislocation on the scale of 2008 or 2002 is in the cards. Frankly, I don’t expect any such event in the near future.
To keep your costs down, I recommend doing most of your investment business through discount brokers — TD Ameritrade (AMTD) is my all-around favorite — and no-load mutual funds.
Natural Leverage From Savings
There’s a fourth tactic that works as well today as it did when I began investing almost four decades ago. Add regularly to your portfolio through systematic savings. Whether you’re age 21 or 91, your goal should always be to keep your living expenses comfortably below your income, so that you’ve got a constant flow of fresh cash to invest.
Many investors try to compensate for a lack of personal savings by plowing their money into high-risk speculations (in hopes of parlaying a small stake into a fortune). Junior mining shares, technology startups and obscure Chinese companies all appeal to the gambler’s instinct, as do IPOs and options buying.
Unfortunately, these artificial forms of leverage often backfire, with painful losses. You’ll come out far better if you invest in conservative situations and harness what I call the “natural” leverage of your own savings.
Take the case of two investors, Sam and Sue. Both start with $10,000 and earn an 8% annual return on their money. The only difference is that Sam never adds to his portfolio, but Sue adds $2,000 at the end of each year.
After 10 years, Sam’s account is worth $21,589. Not bad. However, Sue’s account has zoomed to $50,562.
She has earned $20,562 on top of her invested principal, while Sam has earned only $11,589 on his. The rates of return are the same, but what really counts is that Sue now has much more cash to play with (because she put more in).
Natural leverage from savings is the main secret of my own financial success. I recommend it to you, along with the other three techniques I shared with you earlier, because they still work — beautifully — and probably will for the rest of your lifetime and mine.
Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk value approach has won nine Best Financial Advisory awards from the Newsletter and Electronic Publishers Foundation.