Can You Diversity Your Investments too Much?
It is a good idea to diversify your portfolio of investments. Doing so reduces the risk of loss by spreading out your investments over several vehicles and several sectors of the stock market. But, can you diversify too much? The answer is, yes. There comes a point where adding more stocks, for example, does not improve your risk profile but makes it harder to keep track of your individual investments. And it takes you away from investments that you understand. If you are a dedicated long term investor, you will routinely review your portfolio and assess intrinsic stock value. While doing this for four or five stocks is reasonable, carrying out this sort of fundamental analysis for more than twenty-five stocks is not. How do you approach this issue? What are the best places to invest your money in order to get a good return and minimize risk? Should you learn how to invest in Mutual Funds or how to invest in index funds and simply let someone else diversify for you?
Diversify Your Investments and Sleep Better
How Can You Diversify Your Investments?
There are some basics to sound investing that set the stage for diversification. After paying off credit card debts and putting enough money in a bank account to cover expenses for three months, it is time to consider investments. For the vast majority of people, owning their own home is the best investment of their whole life. It is cheaper over the long run to pay off a mortgage than to pay rent and for many people, their largest asset becomes the home they live in. So the first investment is in your home.
Investing and having your taxes deferred until retirement is a huge benefit that you can get from a 401 (K) at work or from an IRA. You may be able to invest these by yourself or may need to pick one of several options offered by work with the 401 (K). Whichever is offered, you should take advantage of the tax-deferred aspect of these opportunities and they should be your second routine investment.
A common and time-tested approach to investing is to treat part of your investments very conservatively so that you do not lose money. Last year we wrote about how to invest without losing any money and focused on bank CDs, US Treasuries, and AAA corporate bonds. As you invest over the years, part of your investment portfolio should go into such safe investments.
The U.S. stock market is generally considered to be the best way to make money over the long term for the vast majority of people. The S&P 500 has appreciated by 10% on the average since its beginning in the 1920s and that includes making up for the 1929 Stock Market Crash and Great Depression. U.S. stocks should be part of your investment diversification routine. And, those stocks should be diversified as well.
Diversifying a Stock Portfolio
Some people simply bypass this issue by investing funds with Fidelity or Vanguard in one of their mutual funds or in an ETF. The difference between an ETF and a mutual fund is that the ETF passively tracks a stock sector or even the entire S&P 500 while a mutual fund is managed and charges you for that service. Investing in stocks this way is easy, passive, and takes very little of your time. But, as we mention in our article about picking the best stocks to invest in, smart investors only invest in companies when they know what the company does to make money and how that business plan will continue to work for the long term future. This approach requires that you limit the number of stocks that you hold to those that you understand and have time to follow. But, even if you have all of the time in the world, can you diversify your investments too much? Yes, you can and here are a couple of opinions on the subject.
How Many Stocks in a Portfolio Are Too Many?
In the book, A Random Walk Down Wall Street, the author makes the point that with an efficient stock market, an investor could randomly purchase enough stocks (ten large-cap stocks or 40 small-cap stocks) to reduce risk and outperform many active investors.
By “diversifying in this way, the investor lets the market take over and generate profits. But, there is a point of diminishing portfolio risk reduction compared to market risk.
Risk versus Benefit of Diversification
If one simply picks large-cap stocks and small-cap stocks at random, one’s portfolio risk is the same as market risk by 25 stocks. Holding more stocks does not provide more diversification benefit but it does increase the work needed to manage the portfolio.
A Market Watch article writes about the exact number of stocks one should own. The point they make is that in order to “beat the market” you need to be invested in stocks that you understand and have time to follow and that does not work very well when you have too many stocks to keep track of.
Is there such a thing as too much diversification? Yes, in fact, there absolutely is, according to Phil Fisher, an influential stock picker whom Warren Buffett BRK.A, -0.54% credits as a major source of inspiration.
“Investors have been so oversold on diversification,” Fisher said many decades ago, “that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others which they know nothing about.”
Sean Stannard-Stockton, president and chief investment officer of Ensemble Capital, agrees, saying that while diversification is critical in mitigating risk, active market participants should be mindful of just how much diversity is ideal.
“Too much of anything can be bad for you and diversification can be taken too far,” he wrote in a post on the Intrinsic Investing blog. “But the level at which ‘too far’ kicks in is surprising to most people.”
In the article, they show the graph from The Random Walk Down Wall Street. Their advice for active investors is to stick with stocks that they know and not “randomly” add new investments in the name of diversification.
Investopedia also warns about the dangers of over-diversifying your portfolio. They start by noting why it is that an investor should diversify.
Most investment professionals agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt toward your long-range financial objectives. There are many studies demonstrating why diversification works – to put it simply by spreading your investments across various sectors or industries with low correlation to each other, you reduce price volatility.
This is because different industries and sectors don’t move up and down at the same time or at the same rate. If you mix things up in your portfolio, you’re less likely to experience major drops, because as some sectors encounter tough times, others may be thriving. This provides for a more consistent overall portfolio performance.
But, they make the point that just buying twenty stocks is not true diversification unless the stocks are chosen to be in different sectors. And, they emphasize that you can diversify your investments too much and crowd out your most promising stocks. They end by quoting Warren Buffett. “Wide diversification is only required when investors do not understand what they are doing.”
How to Buy Stock Directly
Long term investing works out well when you choose secure investments whose value appreciates over time. Investments like dividend stocks are a good choice because the dividends can be reinvested during the early years and taken as income during retirement. Many dividend stock investors take advantage of dividend reinvestment plans but these plans are also how to buy stock directly without ever going through a broker.
How to Buy Stock Directly with Dividend Reinvestment Plans
If you already own stock in a company that has a dividend reinvestment plan, all you need to do is sign up and the company will reinvest your dividends for you in fractional shares without any fees or commissions. Such plans commonly let you send them a check to buy more shares as well, free of fees and commission. Some now even allow you to use a credit card or bank debit card to make commission-free stock purchases. What has happened in the last decade or two is that 1) many more companies have dividend reinvestment plans and 2) many of these allow you to make all of your purchases of the company’s stock directly through the plan.
Finding Stocks That Allow You to Buy and Reinvest Directly
An excellent source of information for those who want to know how to buy stock directly and which companies offer this opportunity is DRIP Investor.
In 1992, there were less than 10 companies that permitted investors to buy their first share and every share of stock directly.
Today, the number of companies permitting initial purchases has grown to over 400 firms. There are a similar number of foreign stocks whose shares trade on U.S. exchanges that also allow U.S. investors to buy shares directly, the first share and every share.
Today’s DRIP plans certainly are quite robust from a service level. There are:
- IRA options
- Discounts
- Borrowing features
- Automatic investment programs via electronic debit of a bank account
- Market orders
- Online buys and sells
The DRIP Investor site makes the case for using this method to buy stock directly and continually reinvest dividends.
The combination of long-term (one might even call it the much-maligned “buy-and-hold”) investing, dividend reinvestment, dollar-cost averaging, and no-cost/low-cost investing is a powerful strategy for wealth creation. It worked for me, and it has worked for many of the investors who started with our Charter issue 26 years ago and are still with us today!
But, if you are reading this, you do not need a pep talk about how to buy stock directly but rather the tools find the best stocks to invest in which also have this feature.
You will need to subscribe (for free for 30 days) see if their advice on how to buy stock directly might work for you. The most important aspects will be their list of no-load stocks, the DRIP starter guide, and their “DRIP ratings.”
Best Direct Stock Purchase Companies
And, you do not need to use a service to find out how to buy stock directly. For example, you can buy stocks directly from Apple and there is a Coca Cola direct stock purchase plan. The Johnson & Johnson DRIP is another option. The point is that while there are many companies that offer direct stock purchase and dividend investment plans, the key to success in investing in stocks in this category is to choose the stocks first and then see if they let you buy shares directly or allow reinvestment of stock dividends.
Coca Cola
When to Be Careful about Buying Stock Directly
As a cautionary example, we recently posed the question, when is a high dividend yield dangerous? How to invest in stocks is not simply to jump on an investment that is currently offering a high dividend but rather to choose an investment based on strong intrinsic stock value which will translate into long term safety, value, and profits. If you find an exceptional stock with the promise of great appreciation over the years, it may be wise to invest in that stock even if it does not offer dividends, dividend reinvestment, or direct purchase of shares. The fact of the matter is that young, startup companies commonly do not offer such services until they have grown and matured. How to buy stock directly from such companies may be simply to proceed in a normal investment manner until they offer DRIP and direct investment plans.
Who Should Buy Stock Directly and Who Should Not?
Should your first stock purchases be with companies that let you buy shares directly and reinvest dividends directly? In fact, should all of your investments follow this plan? Over the years we have written about how to start investing in the stock market and noted that the first thing to do is to get your financial house in order by paying off credit card debt, putting some money in the bank, in buying your own home. Then, at least part of any investment portfolio should be very conservative, in regard to which we wrote about how to invest without losing any money.
When you invest in stocks, you should choose companies whose businesses you understand due to your own unique insights or because you have studied the company. Successful long term investors typically limit their investments to companies where they, the investor, have a clear idea of what the company does to make money and how their business plan will continue to succeed into the future. And, investors need to keep track of how their companies are doing. Sears used to be the greatest retailer in the world and now is bankrupt. Kodak was the king of camera film, processing, and prints and lost out to digital cameras. The first choice is to pick a stock you understand and that will appreciate, hopefully pay dividends, and not provide any downside surprises. Then, learning how to buy stock directly from that company is a really good idea.
The Long Term Value of Buying Stock Directly
When you intend to invest for the long term, buying stocks directly reduces the cost of every purchase. This means that you will not be paying a 2.5% commission to a broker or $4.75 to an online broker for purchasing stocks.
The S&P 500 has provided an average of 10% appreciation over the years. Over a forty year span, $1 invested turns into $45.26. This is the value of exponential growth. But, what if you are not investing $1 but rather $0.975? Then the end result is $36.23!
The “extra” 2.5% that a person can invest each month compounds over the years and can make a difference of about 20% in how much of the money invested in your 20s will be worth in your 60s. In other words, there is a great value in learning how to buy stock directly and avoid fees and commissions.
Investments That Let You Sleep at Night
Would “Medicare for All” Kill Your Health Care Investments?
The next U.S. presidential election is 19 months away and politicking is already in full swing. An issue that was raised by candidate and Senator Bernie Sanders in the 2016 presidential campaign has come back with a bang. It is “Medicare for all.” Sanders, and now several others, are proposing that all Americans be covered by a health care program run by the U.S. government instead of private insurance under the current Affordable Care Act (aka Obamacare). While this may or may not be a good idea for taking care of sick people, investors need to wonder, would “Medicare for all” kill your health care investments? Just having the issue mentioned in the early days of the 2020 campaigns has driven down health care stocks. Here are the news and some thoughts about the healthcare system, Medicare for all, and how Medicare for all would kill your health care investments, or not.
Comparison of Health Care Costs by Country
Image: Sanigest International
Health Care Stocks and the Possibility of Medicare for All
Bloomberg writes about how health stocks crumble on the possibility of a “Medicare for All” solution to America’s health care issues.
“Presidential primary politics,” said Evercore ISI analyst Michael Newshel, are “more in focus than fundamentals.”
The slide began in earnest on Tuesday when UnitedHealth Group Inc., [which is] treated by investors as a bellwether for the insurance sector, waded into the debate over “Medicare for All,” which would expand government-administered coverage to most of the population and rewrite the businesses of U.S. health insurers, hospitals and doctors.
While it’s a longshot to become law despite the backing of some contenders for the Democratic presidential nomination, the proposal has the power to upend company stock prices. Together, the shares of hospitals and insurers lost $28 billion in market value on Tuesday, according to data compiled by Bloomberg. The Tuesday losses capped the worst five-day stretch since 2011 for health insurers, despite UnitedHealth reporting earnings that beat analysts’ estimates and raising its 2019 forecast.
How Health Care Companies Are Affected by the Threat of “Medicare for All”
Companies like UnitedHealth Group Inc. have invested heavily in systems to manage the costs of health care and, in fact, how health care is delivered. This money has been spent and complex systems are in place to evaluate doctors, hospitals, medicines, and treatment plans for effectiveness and efficiency. In other words, these folks have spent decades now looking critically at how health care is delivered and forcing changes by altering payment based on treatment results and costs. In fact, UnitedHealth has such a treasure trove of information that they sell their expertise to other health insurers and managed care companies to help those folks provide better care while reducing costs. And, the end result for UnitedHealth Group has been higher profits and a share price that went up ten-fold in the last decade (before the recent “Medicare for All” scare).
Why Does Sanders Want Medicare for All?
Although roughly half of the 40 million uninsured, non-elderly, American get health insurance under the Affordable Care Act, there are still around 25 million uninsured younger Americans and the numbers went up last year. Sanders wants the USA to use a system like Canada, England, Germany and other developed nations have. Each of these countries has a universal health care system. Senator Sanders chooses to call his approach “Medicare for All” instead of a universal health care system, but they are one and the same. In these systems, well-to-do individuals can have private insurance and go to private doctors and private hospitals but the vast majority of their citizens receive the majority of their care under the government system.
Countries in Green Have Universal Health Care
Would “Medicare for All” Kill Your Health Care Investments or Not?
The concern is this. If such a plan were to come into being in the USA, the health care insurers and managed care companies like UnitedHealth Group would lose business, but how much? In the USA two-thirds of “insured” people have private health insurance. Because 8% of Americans are still uninsured, it means that about 60% of Americans have private health insurance. In Canada that number is about 27% for folks with comprehensive coverage but 70% of Canadians have some degree of supplemental coverage as the Canadian system covers about 70% of health care costs.
Thus American health companies would lose more than half of their clients that have complete coverage but could pick up clients for “supplemental” policies if a transition to a “Medicare for All” system in the USA followed the Canadian model.
(HealthAffairs.org and Health Care in Canada: Wikipedia)
As a quick glance at the figures for private health insurance in Canada versus private health insurance in the USA demonstrate, there would still be a place for private insurance, and that niche would probably grow and become more profitable due to the nature of universal health care systems.
Universal Health Care Cost to Taxpayers will Protect Your Healthcare Investments
We recently wrote that the Trump tax cut was a bust for investment and hiring but nevertheless will have substantially increased the national debt to $22 Trillion. The interest on an ever-increasing national debt is currently at $479 Billion a year. Servicing all forms of U.S. debt takes 10% of the yearly budget.
(Interest on the National Debt: The Balance)
Bloomberg quotes a study saying that “Medicare for All” would cost $32.4 Trillion over ten years.
The latest plan from the Vermont independent would deliver significant savings on administration and drug costs, but increased demand for care would drive up spending, according to the analysis by the Mercatus Center at George Mason University in Virginia. Doubling federal individual and corporate income tax receipts would not cover the full cost, the study said.
Sanders’ plan builds on Medicare, the popular insurance program for seniors. All U.S. residents would be covered with no copays and deductibles for medical services. The insurance industry would be relegated to a minor role.
Your Investment in Health Care Will Be Protected by the Definition of “Non-essential”
The problem with universal health care systems is that they need to be managed in such a way as to deliver “essential” medical services to everyone at an affordable cost to the government. The problems in such systems come from what ends up be defined as “essential.” In the Canadian system, drugs and psychological/psychiatric care are not covered! “Essential” is too often defined by the economic needs of the system and the willingness of taxpayers to pay for the health care of others.
Another issue is that “non-essential” health care services tend to be used to a greater degree when one does not need to pay any money to receive that service. The Canadian system uses “co-payments” to discourage excessive use of non-essential services. This would not be a feature of the Sanders proposal as it currently stands.
The bottom line is that a universal health care system is expensive to operate and such systems tend to require citizens to pay larger and larger shares of the cost out of their own pockets or pay for private insurance to cover against excessive risk.
So, would “Medicare for all” kill your health care investments? We don’t think so.
Choosing Undervalued Investments
Choosing undervalued investments that the market has ignored or misunderstood can be very profitable. But, the key to this manner of investing in stocks is to find investments with hidden value and not just use a stock screener to find cheap investments. There are always reasons why the market prices a given stock as it does. Investments that are really undervalued are being ignored by the market because they are small stocks, stocks that no analysts are following, or stocks that the market in general does not understand and therefore gives them a too-low stock valuation.
Because the stock is being ignored, the company could be making significant changes that will result in long term profits and no one would know. The key to choosing undervalued investment is to recognize and exploit such situations. And, the funny thing is, many such investment opportunities are hiding in plain sight and not just in small cap or mid cap stocks. Choosing undervalued investments in large cap stocks is possible as well. In those cases the issue is one of the market not understanding a stock’s long term growth potential.
Choosing Undervalued Investments
Image: US News and World Report
How to Go about Choosing Undervalued Investments
When looking for undervalued investments do not assume that you need to look for penny stocks under $1 or stocks that nobody has ever heard of. Although screening for cheap stocks is not a good way for choosing undervalued investments, there are sources of information you can tap. You can subscribe to an investment advisory service such as Morningstar Stock Investor, Kiplinger’s, or simply read the Motley Fool’s advice. The point is that you can get good ideas from these folks without a lot of effort. But, then you need to do your own homework.
Situations That Result in Undervalued Investment Opportunities
The Motley Fool has some good advice about finding an undervalued stock. The first step is to understand just why the stock is undervalued, as opposed to correctly valued and cheap.
One of the central ideas of value investing is that the market misprices stocks from time to time. There are many potential reasons why a stock can become undervalued, but these are a few of the more common ones:
- Missed expectations: If a stock reports quarterly results that fall short of expectations, shares can drop more than the situation calls for.
- Market crashes and corrections: If the entire market drops, it’s a great time to look for undervalued stocks.
- Bad news: Just like when a stock misses analysts’ expectations, a bad news item can cause a knee-jerk reaction, sending shares plunging more than they should.
- Cyclical fluctuations: Certain sectors tend to perform better at different stages of the economic cycle. Sectors that are out of favor are good places to look for bargains.
In each of these cases, the market drives a stock price down below what it is worth over the long term. This can be simply a panic response to a falling market or in can be an over-leveraged investment group that is forced to sell at a discount in order to cover margin calls on options trades that went badly. In either case, these are classic situations in which choosing undervalued investments can work out well.
Stock Market Crash
Image: Market Watch
Choosing Undervalued Investments in Your Areas of Expertise
The most important part of making money by choosing undervalued investments is to always work within your area of expertise. This can be you profession. A computer scientists will have more insight in this area than someone else. Or a medical doctor ought to have more insight into the pharmaceutical industry or medical products companies. But, your area of expertise can be one in which you have studied the investment opportunities, have invested for years, and in which you have experience with rising and falling markets. The point is that when you are investing on your “home turf” you will have a much better sense of when an investment is undervalued.
Specific Guidelines for Choosing Undervalued Investments
There are a whole set of “metrics” that you can apply to come one investment to another or than investment to its market sector as a whole. Using these is not the whole story but a good place to start.
P/E Ratio
This is the share price of the stock divided by annual earnings (price to earnings ratio). A really high P/E ratio usually indicates and overpriced stock and a really low P/E ratio typically goes with an undervalued investment.
P/B Ratio
The price to book ratio is the share price divided by the company’s equity per share. This metric has to do with the margin of safety of a stock. Companies with lots of cash on hand and very low debt have low P/B ratios can be good undervalued investments to consider.
PEG Ratio
Price to earnings growth is based on its P/E ratio which you can calculate and its earnings growth projection is an estimate which you need to work out or trust someone else to provide for you. The argument for using this indicator is that there are stocks that are growing rapidly and therefore attracting lots of investors at higher share prices. The argument is that you are paying a lot for this stock today but its growth will still make you rich. Choosing undervalued investments using this metric takes a lot of faith and, some would say, gullibility.
ROE
Return on equity is the company’s net income for the year presented as a percentage of total shareholder equity. This is a useful metric as it gives you an idea of how well the company generates revenue in light of the total money invested in its stock by investors. This metric can be used to compare companies within a sector, but beware of using it across the board because different kinds of businesses typically have different returns on equity.
Debt to Equity Ratio
This is another margin of safety metric. It is the total company debt divided by total shareholder equity.
Current ratio
This one has to do with short term cash flow and the ability of a company to pay its immediate debts. It is current company assets divided by current liabilities. When choosing investments that are undervalued and otherwise seem like good prospects, beware of this one because it could predict that the company will run out of money and credit before accomplishing the changes needed to grow profitably.
(The Motley Fool)
Non-metric Indicators and Predictors of Stock Value
Established companies may or may not have an advantage over upstarts in an industry. But, many areas of high tech are “high cost of entry” businesses. When a company has money in the bank, low debt, a strong brand name, and the ability to reduce prices to freeze out competition, they have a huge margin of safety. Over the long term this argument can apply to a variety of businesses but is one of the reasons why successful long term investors step in and buy more shares of companies like Microsoft or Walmart when their prices go down.
Another indicator to follow is when company executives buy or sell stock in the company. It is reassuring to see the folks in charge buying more stock during a market downturn instead of selling out and heading for the door. Keep track of this when choosing undervalued investments.
The Virtue of Patience in Choosing Undervalued Investments
We often mention Warren Buffett in our articles. He is one of the richest people in the world and unlike the others in the top echelon like Bill Gates, the Walton family, and Jeff Bezos, Buffett’s wealth does not come from a single company in a single market niche. His wealth comes from investing and his holding company, Berkshire Hathaway. Buffett has become incredibly rich over the years by successfully choosing undervalued investments which he commonly goes on to hold forever.
The point of mentioning Buffett has to do with the general approach to choosing undervalued stocks. Buffett only invests in a company when he has a clear idea of what they do, now they make money, and how they will continue to do for a long, long time. When he and his staff look for new investment opportunities, they look for intrinsic stock value which is determining a stock value based on the assessment of forward looking earnings and then comparing that value to the current stock price.
He has been quoted as saying that he throws out 95% of all investment prospects as “too difficult to call.” This is a good example for the normal investor to follow. Be patient and find stocks with good intrinsic value that have been beaten up or forgotten by the market. Luckily for investors who are mere mortals and not Warren Buffett, we only need to find a handful of stocks to invest in and not a hundred in order to reinvest billions in profits every month!
Best Way to Find Good Stocks
The stock market has been going up for a decade ever since the depths of the Financial Crisis. During that time S&P 500 has more than tripled in value. Many investors who were hurt badly by the stock market crash of 2008 to 2009 have hesitated to reenter the market. And, many who might have invested in stocks are unsure of how to find good stocks and how to avoid losing everything should the market correct or crash again. A valid concern for investors today is not buying overpriced stocks in an aging bull market. Likewise, investors want to find stocks that still have growth and earnings potential that will last over the years. What is the best way to find good stocks with these priorities in mind? And, are there sources of stock investing advice that you should routinely ignore?
Best Way to Find Good Stocks
Finding good stocks to invest in can be broken down into three steps. What information sources do you use? What criteria do you look for? And, how do you verify what are the best stocks to buy right now and for the long term?
Useful Information when Searching for Good Stocks to Buy
There are lots and lots of business and stock investing-related websites. They provide lots and lots of information. But, they also have the tendency to promote individual stocks, investment management companies, and their own unique points of view.
Information about the Economy, Markets, and Stocks
A good place to start if you are looking for unbiased information about stocks, the markets, the economy, trade, and more is Bloomberg News. The best way to find good stocks is not to immediately start looking for hot stock tips but rather to educate yourself about the things that drive stock profits and stock prices. The business section of The New York Times is a good source of unbiased information as is The Wall Street Journal. To the extent that these sources of information try to sell anything, other than online subscriptions, is when they tend toward one side or the other of the political spectrum. But, each of them is an excellent base from which to start. Our first choice is Bloomberg.
Specific Stock Investing Information
If you have a stock in mind and want to know its price history, dividend, and a thumbnail sketch of the business, both Google Finance and Yahoo Finance are good sources of information. These are good news sources but not as in-depth as the Times, Journal, or Bloomberg. But you can look up information about specific stocks such as this graph of the Apple stock price going back to 1981.
Google Finance Apple Stock Price: All
The information that you find on a chart on Yahoo Finance or Google Finance is not colored by the opinions of someone who is pitching that stock. Rather it is basic and useful which is the best way to find good stocks.
Sources of Stock Tips
If you have followed our advice so far you have educated yourself about the economy, the markets, foreign trade, and other factors that drive profits and stock prices. And you know where to go (Yahoo Finance and Google Finance) to check out stock price history, P/E ratio, and dividends. But, where do you find information about good stocks for dividends, cheap stocks on the rise, or simply the best stocks to buy today. Here is where the stock commentators are useful. These folks follow the markets and have lots of useful information along with their own strong opinions. CNBC has good investing information as do Market Watch, Barron’s, Investor’s Business Daily, and The Motley Fool. Jim Cramer’s “Mad Money” is full of useful tips and entertaining as well.
For those who are not interested in doing a lot of research on their own, following these sources for stock investing tips can be profitable. They commonly write about good stocks for cheap, good stocks for day trading, and what they consider to be the best stocks to buy today. However, we strongly suggest that you use their tips as a starting point and not an endpoint in picking profitable stocks for the long term.
Criteria for Choosing Stocks
The basic things to consider before choosing stocks are these. What are your investing goals, horizon, and risk tolerance? And, what do you know personally that will give you solid insight into specific sectors of the stock market? In one of our core articles about investing in stocks, we note that time spent considering how long you will be investing before you need money for retirement, college for the kids, or money to start your own business will affect your choices. And, when your work, your hobbies, or your life experience give you an advantage over other investors in any given market sector, grab that advantage with both hands and hold on!
Risk versus Reward in Stock Selection
When investing, there should always be a balance between risk and reward. Part of your money should be in investments that are as secure as you can find. We dealt briefly with this in our article about how to invest without losing any money. Then, you will want to look at any prospective investment and consider how the company makes its money and how it can be expected to keep doing that over the long term. This is where having your own insights into a specific line of business are useful and those insights should always be used.
Specific Stock Selection Criteria
Some investors prefer to look for good stocks for cheap. But, these may or may not be the best stocks to invest in today. The best dividend-paying stocks should be part of your investment portfolio. But, when is a high dividend yield dangerous? Read the article for insight into how failing stocks sometimes sport high dividends before they fade away. As we noted, you should always look for stocks in sectors where your knowledge and experience give you an advantage. This is because you will have better insight into how a company makes a profit and if they are likely to continue to do so over time. And, this leads us to our last part of the best way to find good stocks.
How to Verify Good Stocks to Buy
So, now you have a few stock prospects that you picked up from following Bloomberg and The New York Times, listening to Jim Cramer’s Mad Money, and even a stock tip or two from family and friends. How do you verify that any or all of these are good stock picks for your time frame, risk tolerance, and area of expertise?
The Fundamental Value of a Stock Investment
When you buy a stock you are looking for it to reward you in two ways. You want its stock price to appreciate over time and you would be pleased with dividends that you can reinvest during your working years and collect during retirement. For these things to work out you need a stock that makes money over the years, increases its profits as it goes, and has a substantial margin of safety in terms of low debt, money in the bank, a famous and strong reputation and brand, and has a business model that you clearly understand.
Intrinsic stock value is what you are looking for. This is a calculation based on your assessment of forward-looking earnings. This approach evolved in the years after the 1929 stock market crash and in the years of the Great Depression. For those who paid attention, it replaced the idea that one would simply “play the market” in hopes of making a profit. Investors who follow this approach use fundamental analysis to determine if a company will continue to sell its products and services at a profit over the years, add more products and services, and manage the business wisely in order to most efficiently use those profits to reward shareholders.
Our best way to find good stocks may sound time-consuming but, if you are into investing for the long haul, what is your hurry? Experts like the famous investor Warren Buffett have said that they commonly throw out 19 out of 20 stocks that they consider in an intrinsic value calculation as “too difficult to call.” Here is where your own expertise comes into the picture. You are not trying to find investments for a multi-billion dollar portfolio. You are looking for three or four stocks whose businesses you understand, which have good track records, and are likely to keep making money for their shareholders for at least as long as you choose to stay invested.
Investments That Let You Sleep at Night
When Is a High Dividend Yield Dangerous?
Dividend stocks are generally good investments. When a company is well-run and routinely making money, it can afford to reward its shareholders with quarterly dividend payments. Companies that have been paying and routinely increasing their dividends for decades or even more than a century are cornerstones of a strong investment portfolio. When looking for dividend stocks, investors often screen for the highest yields. But, when is a high dividend yield dangerous? In this article, we are going to look briefly at dividend stock investing and dividend reinvesting. Then, we will look at when to avoid a too-high dividend when choosing stocks.
Dividend Stocks
A common misconception is that stocks are either ones that appreciate in value or ones that pay a dividend. This is true but only to a degree. For example, as Microsoft grew from a little startup to the tech giant that it is, its stock price skyrocketed and it did not pay a dividend. When it reached the plateau common for successful companies, its stock price slowed its climb and the company started paying dividends (2003). Interestingly, Microsoft stock today sells for four times the price today that it sold for when dividends started. This is a better appreciation than the S&P 500 over the same time span! So, investing in dividend stocks is a good idea. And, higher dividends are better than low dividends but when is a high dividend yield dangerous? It has to do with long term investment and dividend reinvestment plans.
Reinvesting Dividends
Dividend stocks are not investments where you try to time the market and make a quick profit. They are long term investments (5 to 10 years at least). Although a quarterly dividend check is a nice thing to receive during your retirement, most long term investors reinvest their dividends in company-sponsored dividend reinvestment plans. Because these plans reinvest every cent of your dividend with fractional shares, your investment grows exponentially, fueled by stock price appreciation as well as reinvested dividends. The key issue here is that you expect to hold onto this investment for decades. So, it has to be a safe investment! Thus, you do not want to be tempted by a high dividend yield in a failing stock!
Dividend Stock Screening
The Yahoo Stock Screener is a readily available tool for finding stocks with healthy dividend yields. (And, there are many more.) When using such a tool an investor can screen for various criteria such as market cap, dividend percent yield, stock price, market sector, and more.
To create three examples, we screened for U.S. stocks, large-cap, share price greater than $25, and dividends greater than 2%, 5%, and 10%.
In the 2% category, the screener returned 492 stocks. In the 5% category, it returned 57 stocks. In the 10% category, it returned 6 stocks.
Large Cap, U.S. Stock, Dividend Greater Than 10%
Four out of six of these are Annaly Capital Management which is a real estate reinvestment trust. They borrow short term repurchase agreements and reinvest the proceeds in securities that are asset-backed. They have been in business for 22 years. Selling at just over $10 a share their share price is virtually unchanged from when they started but the stock did trade as high as $20 before the financial crisis and in the $17 range until 2013 when it returned to its $10 range.
Energy Transfer Operating LP stores and transports natural gas. They have been in operation since 1995 but became publicly traded only in 2006. Google Finance only shows stock prices since 2018 and it has traded in the $21 to $25 range.
Icahn Enterprises L.P. went public in 1998 at $10 a share and today trades at $73, having been as high as $117 in recent years. The controlling shareholder is the company’s founder, Carl Icahn, the famous takeover artist. The company is a conglomerate of metals, energy, casinos, food packaging, auto parts, real estate, rail cars, and home fashion products.
In the case of this stock screen, Annaly is not a growth company in that it trades for the same price today as when it went public. In fact, since it traded for $19 a share with the same dividend, you might think of it as a 5% dividend stock fallen on hard times.
Energy Transfer works in a somewhat protected niche in the oil and gas sector by getting paid for storing and transporting natural gas. However, these folks are commonly at swords points with the environmentalists in regard to their natural gas pipelines. The long term fate of this company is tied to the energy industry nevertheless.
Icahn Enterprises is tied to the smarts and success of Carl Icahn which brings up the question of how well the company will do when he is no longer part of the business.
We did not “fudge” these numbers to come up with examples but simply ran a screen like you would. Now, we will look at stocks that might really be dangerous investments.
When Is a High Dividend Yield Dangerous?
A recent article by The Motley Fool looks at three “dangerous high-yield dividend stocks.” They start by making the same point we did, that dividend stocks are a good part of a strong portfolio and that the ability to pay dividends year after year correlates with long term business success. And, then they note that a too-high dividend should be a warning sign.
Dividend stocks also have a bit of a dark side. Namely, yield and risk tend to be correlated to some extent. This is to say that high-yield (4%-plus) and ultra-high-yield (10%-plus) dividend stocks may lag in the return department when stacked up next to companies paying out say 2% a year. Remember, since yield is simply a function of share price, a flailing business model with a declining share price can lure in unwitting investors with a high yield.
These are the three dangerous dividend stocks they mention and a brief summary in each case of why you should avoid them.
First Dangerous High Dividend Stock: Gamestop
The point that The Fool makes is that Gamestop is tied to brick and mortar retail stores that sell games and accessories.
GameStop’s business model has been completely upended by the emergence of digital downloads from the cloud. In other words, the need to go to a gaming store for new games or accessories is dwindling fast.
Like a lot of companies tied to brick and mortar locations, these folks have tried, without a lot of success, to sell more online.
The company’s stock has sold in the high 50s both in 2007 and 2013 but right now is back where it started in 2002 in the $10 a share range. Their 15.1% dividend is a result of the stock dwindling from $56 a share in 2013 to $11 a share today.
Gamestop Stock Price
So, if you screen for high dividends and find Gamestop, remember that this stock is in trouble and is not a long term buy and hold prospect.
Second Dangerous High Dividend Stock: BP Prudhoe Bay Royalty Trust
This stock sports an 18.4% dividend yield. It traded for $126 a share as recently as 2012 and today sells for $27 a share. This is another case of a stock that has gone down (80%) in share price without changing its dividend so the company looks great when viewed through the dividend lens. But, it has issues that should concern long term investors.
The problem with this investment is that the money comes from Prudhoe Bay oil production which is soon to run out. The company’s own 2017 annual report suggests that dividends will cease this while the 2018 annual report pushes the cessation of dividends back to 2022. Either way, this is not a great long term investment and anyone who invests at current prices stands a good chance of losing a substantial portion of their investment.
BP Prudhoe Bay Royalty Trust Stock Price
Third Dangerous High Dividend Stock: Barnes & Noble
The nation’s largest bookstore chain has taken repeated hits from the likes of Amazon.com and other online booksellers. Despite repeated downsizing, attempts to operate online, and a healthy 11% dividend as of today, Barnes & Noble is losing the battle and is not a great long term investment of the kind usually associated with dividend stocks.
Barnes & Noble Stock Price
So, how dangerous are these high dividend stocks? What happens when a company begins to lose business is that as their profits fall the company cuts jobs, cuts stores, and eventually cuts dividends. What happens in many cases is that management does not want to scare shareholders is dumping the stock and sending the share price downward. So, they preserve the dividend and come up with a story about how they are going to fix things.
In the cases of Gamestop and Barnes & Noble, the handwriting is on the wall no matter what management says. The companies will not fold and go away but they will dwindle with lagging stock prices and dividends readjusted to meet reality.
In the case of the Prudhoe Bay Trust, the situation is imminent because the company itself is predicting that the oil is running out and that in a very short time the 18% dividend will go to zero!
The High Stock Dividend and High Investing Risk Take-Home Lesson
The bottom line to this discussion is that investors need to beware of extremely high dividends. High dividends commonly come associated with a stock price that has fallen or with a business model where there is not much expected growth but a good current cash return. Utilities commonly fall into this category as does the capital management company we picked up in our own screen.
Whether or not you choose to invest in any of these stocks with so-so prospects but a high dividend yield will depend on your own view of the fundamentals of the company. To the extent that you have unique expertise and can see a genuine “light at the end of the tunnel” in the form of a high takeover bid or a true recovery of the business, these can be spectacular investments. Otherwise, take care.
Which of Your Safe Investments Will Amazon.com Kill Next?
We invest to make more money, do the things in life that we want, and have enough for a comfortable retirement. It has always been good advice to balance your investment portfolio with a combination of the very safe and the somewhat risky investments with growth potential. We often mention our article about how to invest without losing any money. Although the main focus is on cash in the bank, treasuries, and corporate bonds we also give a nod to value investments which are “safe stocks.” Unfortunately, many investments previously thought to be safe have been destroyed in the era of online sales. Our question right now is which of your safe investments will Amazon.com kill next?
What Are You Paying for a Safe Investment and Is It Really Safe?
This is a valid question in our extended bull market. Investors are paying a premium for companies with strong balance sheets and a long history of success. But, is the price you are paying going to protect you? Forbes writes that in many cases safe stocks are no longer safe.
You probably know that fast-growing stocks in exciting industries may be pricey. But boring, slow-growing stocks are often expensive, too, if they’re perceived as safe.And while you might not realize it, there’s a good chance you’re paying through the nose to keep your money safe.
Their first point is that investors pay a price for perceived investment safety. Then the problem is whether or not the price you pay is really buying safety as they look at P&G versus Amazon.com.
They make the point that the average P/E ratio in the S&P 500 is 21 while the P/E ratio for P&G is 25. A main selling point for these folks is that when the stock market crashed a decade ago P&G fell by a percent or so. The risk Forbes sees is that Amazon.com is moving into P&G’s product line by delivering dish soap, diapers, and batteries to people’s door every day. If you wonder which of your investments will Amazon.com kill next, wonder if Procter & Gamble is on the list.
A List Investments at Risk of Being Killed off by Amazon.com
Kiplinger goes beyond Forbes by looking at dozens of companies whose very existence is threatened by Amazon.com and online sales in their article, 49 Companies Amazon Could Destroy.
Amazon is willing to try its hand at almost any sort of business, does well at the bulk of them – and threatens to destroy dozens of other companies with its success.
From groceries to online pharmacy sales with a foray into video game development as well, Amazon.com tries its hand at anything and usually succeeds. If you have several safe investments in your portfolio and Amazon.com decides to move into that niche, how safe are you. Here is the beginning of the list that Kiplinger put together.
O’Reilly Automotive (ORLY), AutoZone (AZO) and Advance Auto Parts (AAP)
As delivery networks get better and inventory management technology improves, these previously safe businesses are now worried.
Kroger (KR), privately owned Albertsons and the grocery arm of Walmart (WMT)
People are getting more and more comfortable with ordering all sorts of food items and even snacks to be delivered to their home, especially with Amazon Prime and no charge for delivery.
Audiobooks.com and Playster
These folks are directly threatened by Amazon.com and their own company, Audible.
Barnes & Noble (BKS) and Joseph-Beth Booksellers
These folks are still hanging on despite worse sales figures every year. It is only a matter of time.
Beam, Dailymotion, Hitbox, Mixer, YouTube Gaming and More
This niche is about people paying to watch other people play video games. And Amazon.com has the most popular platform, Twitch. This is one more niche that they intend to own.
Best Buy
Despite an impressive turnaround, Kiplinger thinks that these folks will be driven down by Amazon.com in the end as people will opt for lower prices and home delivery.
Duracell, Energizer Holdings
This last one gets us back to the safe stock niche. These are leaders in the market and Duracell is one of Berkshire Hathaway’s holdings. Although Amazon.com does not have a well-recognized battery brand behind them, they do have pricing, delivery, and customers who are simply used to buying from Amazon.com.
Which of your safe investments will Amazon.com kill next? Take a look at the Kiplinger article for the complete list.
What Are Safe Investments in a Competitive World?
Any student of investing knows how Sears went from being the retail giant of the world to an afterthought. Likewise, we all know how digital photography virtually removed Kodak’s reason to exist. But, we have always believed that a product that people will always consume with a strong brand name will last forever. Procter & Gamble is a well-run company that fields a lot of brands and essentially wrote the book on business management. Coca Cola is known and consumed everywhere on the planet. But, in both cases, management needs to keep up with the times, effectively manage product lines and listen to what consumers are saying. A sad of example of an old company not doing that is the Kraft Heinz fiasco.
Sears Was the Best and Then It Was an Afterthought
We always suggest that investors use the principle of intrinsic stock value to guide their investing. We also mention in that article that the trick to making the concept work is to learn how to anticipate future earnings. When experts like Warren Buffett throw out 95% of their evaluations as too difficult to pick, what is the average investor to do?
Kraft Heinz Did Not Listen to Its Consumers
First of all, the average investor does not need hundreds of stocks but rather just a handful. Understanding how the company makes its money and how it will withstand threats, like Amazon.com, are basic to good analysis. And, the other rule is to pay attention as you go. With stocks like Procter & Gamble you can sleep at night but should spend a little time each year thinking about whether to add more to that stock or buy something else.
Best Stocks to Invest In
For generations, the U.S. stock market has been the best and most reliable money-making machine on the planet. But, how to get started investing and take advantage of the stock market’s power is always the issue. The average return on the basket of stocks in the S&P 500 has been 10% per year per year ever since the index began as the Composite Index of 90 stocks back in 1926. Today the S&P 500 is a group of 500 stocks that accurately mirror the U.S. stock market as well as the U.S. economy. Are the best stocks to invest in the individual stocks in this index? In this article, we would like to offer some investment tips for beginners and even look at some of the best long term stocks to buy right now. But, our best advice is really not about exactly which stocks to buy today but rather how to go about the process of investing so that you can always understand which are the best stocks to invest in today and tomorrow and for years to come.
(Investopedia: S&P Annual Return)
Knowing Which Are the Best Stocks to Invest In
Our opinion at Profitable Investing Tips is that there are always best stocks to invest in. However, these stocks change as time goes by. Knowing what makes the current favorites the best stocks to invest in is how to succeed always in the business of investing. In this regard, there is an old saying in regard to how to help someone in need.
Give a man a fish, and you feed him for a day. Teach a man to fish, and you feed him for a lifetime.
Although the idea is old, the current quote may only be about 50 years old.
(Quote Investigator: Give a Man a Fish)
We at Profitable Investing Tips would like to follow this example and rather than routinely give you short-lived stock tips, we prefer to give you, our readers, the tools to know how to invest in stocks both now and for years to come.
Someone’s List of Best Stocks to Invest In
Investing Goals, Timelines, and Risk
As we note in our companion article, investing in stocks, we invest to make money, attain specific goals, and be financially secure. It sounds simple but most truths are. The U.S. Securities and Exchange Commission advises beginning investors to define your goals as a first step to investing in stocks.
A good idea when investing is to be very careful with a portion of your money so that a bad investing decision, a market crash, and recession, or some other unforeseen problem does not totally wipe you out. In this regard, we wrote about how to invest without losing any money. Read this article for some useful thoughts about how to treat the most conservative part of your investment portfolio.
Some of the most successful investors are also some of the richest people in the world. Warren Buffett, the so-called Oracle of Omaha, comes to mind. People who invest over the very long term benefit from that 10% per year per year market appreciation that the stock market offers. They make a lot of money in a bull market and may lose some in a bear market, but over the years their investments continue to appreciate. And, because they do not attempt to time the market, they are not caught with short term losses on investments that they first made. Although there is the promise of great profits when you pick just the right stock at just the right time, jumping in and out of investments carries its own risk and a greater investing overhead in terms of fees, commissions, and taxes.
The best stocks to invest in over the years are from companies that make money year in and year out and who business plans are likely to continue to work for decades to come.
How to Get Started Investing
When we think about how to start investing at 18, just out of school, what comes to mind are penny stocks simply because they are cheap. But, the best stocks to invest in for beginners are not necessarily the cheapest stocks. And, you do not necessarily need to wait until you have saved up to buy even a single share to get started investing.
Fractional Share Investing
With fractional share investing, beginning investors can invest in the stocks of their choice. The Balance lists seven excellent choices for fractional share investing.
If you want to invest in the stock market, you might be scared off by the perception that you need thousands of dollars right from the start. But that isn’t true – in fact, you can get involved without even buying a whole share of stock at once. With fractional share investing, you can buy as little as $5 or $10 of a stock in a single trade.
Rather believing that you will never be able to buy stocks that sell for more than $1,000 a share like Amazon.com or Alphabet (or Berkshire Hathaway at more than $300,000 a share) beginning investors can go to a brokerage that buys these stocks and then resells fractions of shares. Here is their suggested list of brokerages.
- Stockpile
- Motif
- M1 Finance
- Folio Investing
- Betterment
- Stash
- Computershare
Additionally, when you have purchased stock from a company like 3M (about $210 a share) you can sign up for their dividend reinvestment plan. This allows you to buy fractional shares with your quarterly dividends, without paying fees or commissions. This is another good way to purchase good companies without paying a lot.
Investing Using Dollar Cost Averaging
When a beginning investor purchases inexpensive stocks, or preferably fractional shares of excellent stocks, the best approach is to simply pick an amount that you can afford to invest and put that into stocks every payday, every month, or every quarter. U.S. News wrote about dollar cost averaging.
DOLLAR-COST AVERAGING is a disciplined way for investors to build wealth in their portfolio over time while helping them avoid emotional-driven decisions.
Many people mistakenly believe that they need thousands of dollars to start investing for their retirement, causing them to be risk-averse in opening a traditional investment retirement account or Roth IRA. But nearly anyone can get started with the strategy. For instance, this style of investing can help novice investors who have recently opened a retirement portfolio, and don’t have a large sum of money for an initial investment.
Always buying the same dollar amount of stocks works because by purchasing more stocks when prices are low you will get good deals and by purchasing fewer stocks when prices are high you will not overspend in an overpriced market.
Best Stocks to Invest in Now
You can take stock tips from your barber or a taxi driver. You can take stock tips from any of the numerous pundits on the various investing publications. But, you need to do a bit of homework to verify that the suggested stock tip is really a good idea. There are two ways to approach this decision. First, is this a stock that has, in your mind, a temporary low price? If so, you are in the business of marketing timing. You buy the stock, wait for the price to go up and then you sell it before a volatile market takes the price down again. This is short term investing and to do it successfully you are more interested in how the market views this stock than in its long term value. As noted in our article about proven stock market strategies, this is simply a matter of buying low and selling high.
But, what if you want the best stocks to invest to buy right now but hold onto forever? The first part is the same. You are looking for stocks that are cheap and likely to go up in price. The second part is that you are not looking for a stock that will have a higher price in a month or two but a stock that will keep appreciating value for ten, twenty, thirty years, or more!
The Real Value of a Stock Investment
Back in the “Roaring Twenties” it was common to “play the stock market.” Stocks were going up and almost no matter which one you bought it was more valuable the next year or even the next month. Then the 1929 stock market crash ushered in the Great Depression and not many folks wanted to “play the stock market” any more. Nevertheless, the market recovered and money investing before the 1929 crash is what is used in the estimate that the market returns 10% per year per year on the average!
It was the in years after that the 1929 crash that a new view of investing appeared. It was an approach that did not dwell first of all on the price of the stock but on the ability of the company to make money and the likelihood that the company would continue to do so for the indefinite future. Intrinsic stock value is based on anticipated earnings. In order to determine if a stock is a good investment today and for years to come an investor needs to understand what the company does to make money and how that business plan will continue to work for years to come. Then the investor determines what that ability to generate income will do to the stock price over years and he or she compares that projected stock price to the current market price.
Best Stocks to Invest In Based on Intrinsic Value
Kiplinger wrote about what they consider to be the 10 best value stocks to buy now. Here is their list.
- Berkshire Hathaway
- Loews (NYC holding company, $2.1 billion stock portfolio plus insurance companies, hotels, a packaging business, and oil businesses)
- Viacom
- J.M. Smucker
- CVS Health
- Macy’s
- Best Buy
- Southwest Airlines
- Dollar Tree
- Lennar
If you are interested in any of these stocks, start by reading the Kiplinger’s article and then do your homework. The point of using intrinsic stock value is a guide is that it helps you determine if a stock is a good long term bet instead of something to buy, hold for a few months and then sell. But, even though a stock with strong intrinsic value is always a good bet long term, these stocks are better when you pick them up at bargain prices. Such was the case when Berkshire Hathaway bought lots of Coca Cola stock at depressed prices in the late 1980s. Today the dividend paid on these shares of stock is close to half the original share price!
Intrinsic Stock Value versus Market Price
Why Is the Stock Price Depressed?
As we noted before, there is a temptation to buy penny stocks because they are affordable. But, why is the stock cheap? Is the price depressed because the company has long term unfixable problems? Are its competitors taking away all of its business? Are its debts so overwhelming that recovery is merely a fantasy? When this is the case, the stock is cheap but not cheap enough! On the other hand, there are stocks that have fallen off the Wall Street “radar.” They have made changes and will soon be reporting fantastic earnings. Once the earnings are reported the stock price will skyrocket. These are absolutely the best stocks to invest in when you find them. But, be careful. Some such stocks are “story” stocks and the story may never materialize. These stocks are being hyped. When the stock price goes up the folks hyping the stock will sell, leaving your investment to plummet. This is called a “pump and dump. Investopedia offers advice about how to avoid getting pulled into a pump and dump scheme.
Investors should be wary about notices that a stock is about to take off – especially when they are unsolicited – no matter how tempting it may be. Consider the source and check for red flags. Many notices come from paid promotors or insiders, who should not be trusted. If an email or newsletter only talks about the hype and doesn’t mention any of the risk, it’s probably a scam. Always do your own research in a stock before making an investment.
This advice takes us back to the beginning. The best stocks to invest in are those that have money-making potential in excess of what the market as a whole currently appreciates. When someone is talking up a storm about a stock, check it out. But, remember something that the famous investor Warren Buffet said. It was that when he and his team look at stocks and their intrinsic stock value, they throw out 95% of the stocks they look at as being “too difficult to call.” And, if you don’t know and cannot be sure, do not buy the stock. There is absolutely nothing wrong with leaving your money in your bank account until you make a decision that you can live with!
Investing in Blue Chip Tech Stocks
The stock market was driven to higher and higher values since the financial crisis largely due to earnings of a handful of tech stocks, Alphabet (Google), Microsoft, Apple, Amazon.com, Facebook, and Netflix. Are stocks from large companies like these the best stocks to invest in? Facebook is having issues of its own and may be left out of this discussion. But, many smart investors do not worry about finding a “needle in the haystack” stock that is underpriced and due to skyrocket. Rather, they are perfectly happy with a stock that pays a nice dividend (which they reinvest) and appreciates nicely in stock price year after year. For this approach to work, you still need to understand how the company makes its money and how they will continue to do so into the indefinite future. But, many believe that the best stocks to invest in are not only ones that provide a nice return on your capital but also allow you to sleep soundly at night.
Investments That Let You Sleep at Night
Proven Stock Market Strategies
There is always someone giving investment “advice” as they promote one stock or another. But, what proven stock market strategies can you follow profitably over time? In this article, we look at a general approach to reliably profitable investing and then at specifics. For most investors, the best approaches are the simple ones. These are folks who have money they want to put away for retirement, a rainy day, putting the kids through college, or starting their own business. These folks have neither the time nor the inclination to get overly involved in the details of stock market investing but they do have money that they need to invest. And, then there are those who wish to become truly active investors in hopes of gaining a better return by picking and choosing individual stocks, timing the market, and engaging in shorter term investing and trading.
Proven Stock Market Strategies for the Passive Investor
You have a good job, a successful business, or perhaps you came into a large inheritance. Thus you have money to invest. You have heard that over the years the U.S. stock market has been the best place to put money for the long term. But you do not believe that you can learn enough to “beat the market.” So, you would rather take a safer approach. For most investors the most effective and proven stock market strategies are to put their money into highly diversified index funds such as those that track the S&P 500, use dollar cost averaging, and when owning dividend stocks, always reinvest dividends.
Passive Stock Market Strategy with Index Funds
The use of index funds for passive investing has become more and more common in recent years to the point when nearly half of the money invested in the U.S. stock market is in funds that track the S&P 500, its subsets, or other stock indexes. At some level, passive investment can be risky but not so much as trying to pick individual stocks when you do not have the skills or time to devote to the task.
Dollar Cost Averaging
This is a strategy for when you invest and how much you invest but not a strategy for what investments to buy. However, dollar cost averaging is most effectively applied to conservative long term investment portfolios of value investments. As we note in our article about how to invest in stocks, an investor sets aside a certain amount of money to invest with each paycheck or every month. They start this approach early in their investing career and continue for years and years. Because they invest a set amount of money they buy fewer shares of stock when prices are high and more shares of stock when prices are low. This approach is useful for two reasons. First of all, an investor does not pay too much in a bull market but takes advantage of low prices in bear markets. And, they invest all of the time so that their money is always working for them over the years.
Benefits of Dollar Cost Averaging
Dividend Reinvestment is a Proven Stock Market Strategy
When a company grows to a certain point its rapid growth phase is over. It makes lots of money and needs to find a way to reward its investors and keep its stock price up. One way is to pay dividends. As a stock appreciates in value over the years and decades its dividend at a set percent of its stock price appreciates as well. The dividends paid today by Coca Cola, Microsoft, and others are multiples of their share prices back around 1990. And, when an investor uses dividend reinvestment plans with these companies the dividends are not paid out but are reinvested even in fractional shares and without any fees or commissions.
Coca Cola
Proven Stock Market Strategies for Active Investors
And, then there are individuals who like active stock investing, have areas of expertise which give them advantages in picking investments, and are willing to devote the time and energy required to do the job right. There are really just two basic approaches for these folks. One is to attempt to time the market in order to catch a stock just before it rises or falls in value. Then the investor buys or shorts the stock, waits until its market value changes, and then cashes out with a profit. The other approach follows the time-honored approach of Benjamin Graham, the father of “value investing.” In this case, the investor looks for strong intrinsic stock value in a stock that the market is ignoring and underpricing. He or she purchases this stock and then moves it to the “passive” corner of the portfolio where it simply appreciates and creates riches over the years.
Five Proven Stock Market Strategies
Each of these five approaches to active investing and trading can be very profitable when executed properly. However, they require time, expertise, energy, and an appetite for risk. These approaches include the following:
- General trading based on anticipating the ups and downs of the market
- Selective trading of individual stocks over a few months to a year
- Buying low and selling high
- Finding and buying strong growth stocks
- Scouting out stocks at bargain prices
Although the time frames for these proven stock market strategies are different, they all work on the same basic principle. The investor evaluates stocks based on how the market is likely to treat them and on the fundamentals that eventually set the stock price. Investors hope to make money when they find a stock that the market has valued incorrectly either in the short term or in regard to its long term value.
The “tools” that investors use may vary but all are versions of fundamental analysis. This kind of approach goes back to Benjamin Graham who was an investor during the heyday of the 1920s stock market and for decades thereafter. His intrinsic value approach is based on projected future earnings. Other methods include comparing P/E ratio (price to earnings ratio) of a stock to other similar investment opportunities, following a “moving average” of the stock price, as looking at “margin of safety “ issues such as depressed stock prices of companies with huge cash reserves, not debt, and lots of property. The “game” is always to look for market inefficiency and buy or sell the stock before the market adjusts. Very short term traders use technical analysis tools to predict short term market and stock trends and trade accordingly.
Consistency Is Essential for All Successful Stock Market Strategies
As we said, any and all of the approaches we mentioned can be very successful. But the success depends upon sticking with the approach, adjusting tactics as necessary, and not jumping around to different approaches every time the market fluctuates. For beginning investors, a good “exercise” is to go to Investing.com and look at the last 50 years or so of the S&P 500 index.
In February of 1970 the index was 89.50 and today it is 2861! However, over the years there have been significant peaks and valleys in the S&P 500 as recessions took hold and market crashes and corrections occurred. Despite the ups and downs of the market, long term investors have seen their stock investments appreciate on the average 10% a year. Investors and traders who were able to correctly “time” the market or individual stocks can do even better if they are willing to do the work, take the time, and accept the risk.
S&P 500 All Through January 2019
Can Passive Investment Be Risky?
Over just the last few years the proportion of the US stock market that is invested passively has moved up to 45%. Investors are attracted to ETFs (exchange traded funds) because of their low overhead. And, many have outperformed actively traded vehicles like mutual funds and other actively managed investment vehicles. But, can passive investment be risky?
Passive Investment Is on the Rise in the US Stock Market
CNBC reported that passive investing automatically tracking indexes has risen to nearly half of the US stock market.
Passive investing, made up of funds tracking market barometers, has now taken over nearly half the stock market as more investors shun stock-pickers and flock to index funds.
Market share for passively managed funds has risen to 45 percent, up a full point from June 2018, according to data this week from Bank of America Merrill Lynch. That continues a trend over the past decade in which investors have moved to indexing, particularly through exchange-traded funds.
Despite the risks that some see in this approach, investors are pleased with the results and are even applying it to buying bonds! But, can passive investment be risky? It turns out that there are valid concerns. But, first, just what investment vehicles are we talking about?
Active versus Passive Investment Management
Passive Investment Funds versus Active Investment
Investopedia discusses active versus passive investing.
Active investing, as its name implies, takes a hands-on approach and requires that someone act in the role of portfolio manager. The goal of active money management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations. It involves a much deeper analysis and the expertise to know when to pivot into or out of a particular stock, bond or any asset.
This investment approach obviously applies to when you choose stocks yourself using an approach like intrinsic stock value. It also applies to when an investment professional oversees a fund that invests in millions or billions of dollars in stock investments.
If you’re a passive investor, you invest for the long haul. Passive investors limit the amount of buying and selling within their portfolios, making this a very cost-effective way to invest. The strategy requires a buy-and-hold mentality. That means resisting the temptation to react or anticipate the stock market’s every next move.
The prime example of a passive approach is to buy an index fund that follows one of the major indices like the S&P 500 or Dow Jones.
Such investments have become popular for three main reasons. Their fees are very low because no one is getting paid to research stocks to buy and sell, an investor always knows exactly what investments are in the fund, and because there is not a lot of buying and selling, investors are not paying a lot of taxes on capital gains every year!
The Value of the Passive Investment Approach
As noted, funds that track the S&P 500 and other indexes are cheap to run and this fact shows up in a lower “investing overhead” for the passive investor. In the last few years as the bull market has exploded in the aftermath of the Great Recession the passive approach has made excellent money and often out-performed many active investors.
Here are three very large funds that qualify as passive investment vehicles.
SPDR S&P 500 ETF (SPY)
This vehicle is a unit investment trust that manages about $280 Billion in assets. It is up six times its initial value per share in 1993. Because of its huge size this fund is very liquid for those who choose to buy and sell. And, it has performed very well for passive buy and hold investors.
SPDR S&P 500 ETF (SPY)
iShares Core S&P 500 ETF (IVV)
iShares is an ETF that manages about $165 Billion by tracking the S&P 500. It can be traded like a single stock for those who wish to buy and sell and has been good to buy and hold passive investors. IShares is trading at three times its single share value at the depths of the stock market crash but is less than double what it started at in 2000.
iShares Core S&P 500 ETF (IVV)
Vanguard S&P 500 ETF (VOO)
This fund is a true ETF that manages about $106 Billion. Is the newest of the three having begun in 2010 although Vanguard has been around for a long, long time. The shares are up to 250% of their original value.
Vanguard S&P 500 ETF (VOO)
As can be seen, these three funds are managing half a trillion dollars in stocks. The total S&KP 500 market cap is about $22 Trillion and the total US stock market cap is around $30 trillion. But, remember that there are a lot more such vehicles as of today they manage nearly half of all US stock market equity.
Now, what is the down side of this approach?
Can Passive Investments Be Risky?
Critics of the current infatuation with passive investing say that the great bull market since the Great Recession has strongly influenced our view of these investments.
Passive Investments Can Be Inflexible
First of all, these vehicles track the market and are up because the market is up. When the market falls, so will they! Warren Buffet pulled a lot of investments out of the market and held a large amount of cash just before the dot com crash. He said the market did not make any sense. He did not lose when the market crashed and was ready with lots of cash to buy bargains as the market recovered. ETFs and other passive investment vehicles will not and cannot do this as they are forced to buy and sell to maintain a mix of stocks that reflects the index that they track!
Passive Investment Vehicles May Need to Sell into a Falling Market
When the next crash comes, and it will, a well-structured ETF that tracks the S&P 500 could weather the storm and recover. But, what if its investors panic? On a normal day these funds buy and sell to adjust their mix of stocks. If just one in ten of their investors want to cash out, the selling will drive the share price lower and lower. And, as the market in general goes down, the mix of shares making up any given index may shift dramatically. This sets up a scenario where the fund needs to buy and sell in large volumes and not as efficiently as they would normally. And, as the value of the fund’s shares fall there is likely to be panic among novice investors who have never seen a real crash. The end result could be a race to the bottom in share prices of the ETFs and the market!
Active Investors “Police the Market” While Passive Investors Are Along for the Ride
The eventual price of any stock is determined by its intrinsic value. It is the pool of active investors and especially the investing professionals who use fundamental analysis to determine how much a stock is worth and will be worth going forward. When more and more investors follow the passive route, the determination of intrinsic stock value is being done by an increasingly small portion of the market. This sets the market up for the herd effect which is all too often seen in offshore investing but increasingly affects US markets.
Is Passive Investing Worth the Risk or Not?
The responsibility of the average investor is not to his or her fund, pension plan, or other vehicle with lots of passive investors depending on his or her decisions. The responsibility of the average investor is to his own best interests. For the time being, passive investment vehicles are still doing well and, unless you have some great ideas about what else to invest in, leaving things as they are is an option.
If you worry that the market may correct more strongly or crash, it might be a good idea to diversify a little. Some time back, we wrote about how to invest without losing any money. With this approach an investor will take of portion of his stocks or ETF shares and sell. Then he or she will buy CDs at the bank, US Treasuries, AAA corporate bonds, or a handful of stocks carefully chosen to successfully ride out a market downturn.
If you are a passive investor, it is not your responsibility to worry about how passive investing affects the market as a whole. But, you need to be aware that a passive investment can be risky and take some sensible precautions.