Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

Part I. The Essentials of Stock Investing

Chapter 3. Defining Common Approaches to Stock Investing

IN THIS CHAPTER

Pairing stock strategies with investing goals

Deciding what time frame fits your investment strategy

Looking at your purpose for investing: Growth versus income

Determining your investing style: Conservative versus aggressive

“I nvesting for the long term” isn’t just some perfunctory investment slogan. It’s a culmination of proven stock market experience that goes back many decades. Unfortunately, investor buying and selling habits have deteriorated in recent years due to impatience. Today’s investors think that short term is measured in days, intermediate term is measured in weeks, and long term is measured in months. Yeesh! No wonder so many folks are complaining about lousy investment returns. Investors have lost the profitable art of patience!

What should you do? Become an investor with a time horizon greater than one year (the emphasis is on “greater”). Give your investments time to grow. Everybody dreams about emulating the success of someone like Warren Buffett, but few emulate his patience (a huge part of his investment success).

Stocks are tools you can use to build your wealth. When used wisely, for the right purpose and in the right environment, they do a great job. But when improperly applied, they can lead to disaster. In this chapter, I show you how to choose the right types of investments based on your short-term, intermediate-term, and long-term financial goals. I also show you how to decide on your purpose for investing (growth or income investing) and your style of investing (conservative or aggressive).

Matching Stocks and Strategies with Your Goals

Various stocks are out there, as well as various investment approaches. The key to success in the stock market is matching the right kind of stock with the right kind of investment situation. You have to choose the stock and the approach that match your goals. (Check out Chapter 2 for more on defining your financial goals.)

Before investing in a stock, ask yourself, “When do I want to reach my financial goal?” Stocks are a means to an end. Your job is to figure out what that end is — or, more important, when it is. Do you want to retire in 10 years or next year? Must you pay for your kid’s college education next year or 18 years from now? The length of time you have before you need the money you hope to earn from stock investing determines what stocks you should buy. Table 3-1 gives you some guidelines for choosing the kind of stock best suited for the type of investor you are and the goals you have.

Table 3-1 Investor Types, Financial Goals, and Stock Types

Type of Investor

Time Frame for Financial Goals

Type of Stock Most Suitable

Conservative (worries about risk)

Long term (more than 5 years)

Large cap stocks and mid cap stocks

Aggressive (high tolerance to risk)

Long term (more than 5 years)

Small cap stocks and mid cap stocks

Conservative (worries about risk)

Intermediate term (2 to 5 years)

Large cap stocks, preferably with dividends

Aggressive (high tolerance to risk)

Intermediate term (2 to 5 years)

Small cap stocks and mid cap stocks

Short term

1 to 2 years

Stocks are not suitable for the short term. Instead, look at vehicles such as savings accounts and money market funds.

Very short term

Less than 1 year

Stocks? Don’t even think about it! Well … you can invest in stocks for less than a year, but seriously, you’re not really investing — you’re either trading or short-term speculating. Instead, use savings accounts and money market funds.

tip Dividends are payments made to a stock owner (unlike interest, which is payment to a creditor). Dividends are a great form of income, and companies that issue dividends tend to have more stable stock prices as well. For more information on dividend-paying stocks, see the section “Steadily making money: Income investing,” later in this chapter, as well as Chapter 9.

remember Table 3-1 gives you general guidelines, but not everyone fits into a particular profile. Every investor has a unique situation, set of goals, and level of risk tolerance. The terms large cap, mid cap, and small cap refer to the size (or market capitalization, also known as market cap) of the company. All factors being equal, large companies are safer (less risky) than small companies. For more on market caps, see the section “Investing for Your Personal Style,” later in this chapter, as well as Chapter 1.

Investing for the Future

Are your goals long-term or short-term? Answering this question is important because individual stocks can be either great or horrible choices, depending on the time period you want to focus on. Generally, the length of time you plan to invest in stocks can be short-term, intermediate-term, or long-term. The following sections outline what kinds of stocks are most appropriate for each term length.

remember Investing in quality stocks becomes less risky as the time frame lengthens. Stock prices tend to fluctuate daily, but they have a tendency to trend up or down over an extended period of time. Even if you invest in a stock that goes down in the short term, you’re likely to see it rise and possibly exceed your investment if you have the patience to wait it out and let the stock price appreciate.

Focusing on the short term

Short term generally means one year or less, although some people extend the period to two years or less. Short-term investing isn’t about making a quick buck on your stock choices — it refers to when you may need the money.

Every person has short-term goals. Some are modest, such as setting aside money for a vacation next month or paying for medical bills. Other short-term goals are more ambitious, such as accruing funds for a down payment to purchase a new home within six months. Whatever the expense or purchase, you need a predictable accumulation of cash soon. If this sounds like your situation, stay away from the stock market!

warning Because stocks can be so unpredictable in the short term, they’re a bad choice for short-term considerations. I get a kick out of market analysts on TV saying things such as, “At $25 a share, XYZ is a solid investment, and we feel that its stock should hit our target price of $40 within six to nine months.” You know that an eager investor hears that and says, “Gee, why bother with 1 percent at the bank when this stock will rise by more than 50 percent? I better call my broker.” It may hit that target amount (or surpass it), or it may not. Most of the time, the stock doesn’t reach the target price, and the investor is disappointed. The stock can even go down!

The reason that target prices are frequently missed is that it’s difficult to figure out what millions of investors will do in the short term. The short term can be irrational because so many investors have so many reasons for buying and selling that it can be difficult to analyze. If you invest for an important short-term need, you can lose very important cash quicker than you think.

technicalstuff During the raging bull market of 2002–2007, investors watched as some high-profile stocks went up 20 to 50 percent in a matter of months. Hey, who needs a savings account earning a measly interest rate when stocks grow like that! Of course, when the 2008–2009 bear market hit and those same stocks fell 50 to 85 percent, a savings account earning a measly interest rate suddenly didn’t seem so bad.

remember Short-term stock investing is very unpredictable. Stocks — even the best ones — fluctuate in the short term. In a negative environment, they can be very volatile. No one can accurately predict the price movement (unless he has some inside information), so stocks are definitely inappropriate for any financial goal you need to reach within one year. You can better serve your short-term goals with stable, interest-bearing investments like certificates of deposit at your local bank. Refer to Table 3-1 for suggestions about your short-term strategies.

SHORT-TERM INVESTING = SPECULATING

My case files are littered with examples of long-term stock investors who morphed into short-term speculators. I know of one fellow who had $80,000 and was set to get married within 12 months and then put a down payment on a new home for him and his bride. He wanted to surprise her by growing his nest egg quickly so they could have a glitzier wedding and a larger down payment. What happened? The money instead shrank to $11,000 as his stock choices pulled back sharply. Ouch! How does that go again? For better or for worse … uh … for richer or for poorer? I’m sure they had to adjust their plans accordingly. I recall some of the stocks he chose, and now, years later, those stocks have recovered and gone on to new highs.

The bottom line is that investing in stocks for the short term is nothing more than speculating. Your only possible strategy is luck.

Considering intermediate-term goals

Intermediate term refers to the financial goals you plan to reach in two to five years. For example, if you want to accumulate funds to put money down for investment in real estate four years from now, some growth-oriented investments may be suitable. (I discuss growth investing in more detail later in this chapter.)

Although some stocks may be appropriate for a two- or three-year period, not all stocks are good intermediate-term investments. Some stocks are fairly stable and hold their value well, such as the stock of large or established dividend-paying companies. Other stocks have prices that jump all over the place, such as those of untested companies that haven’t been in existence long enough to develop a consistent track record.

tip If you plan to invest in the stock market to meet intermediate-term goals, consider large, established companies or dividend-paying companies in industries that provide the necessities of life (like the food and beverage industry or electric utilities). In today’s economic environment, I strongly believe that stocks attached to companies that serve basic human needs should have a major presence in most stock portfolios. They’re especially well-suited for intermediate investment goals.

remember Just because a particular stock is labeled as being appropriate for the intermediate term doesn’t mean you should get rid of it by the stroke of midnight five years from now. After all, if the company is doing well and going strong, you can continue holding the stock indefinitely. The more time you give a well-positioned, profitable company’s stock to grow, the better you’ll do.

Preparing for the long term

Stock investing is best suited for making money over a long period of time. Usually, when you measure stocks against other investments in terms of five to (preferably) ten or more years, they excel. Even investors who bought stocks during the depths of the Great Depression saw profitable growth in their stock portfolios over a ten-year period. In fact, if you examine any ten-year period over the past 50 years, you see that stocks beat out other financial investments (such as bonds or bank investments) in almost every period when measured by total return (taking into account reinvesting and compounding of capital gains and dividends)!

Of course, your work doesn’t stop at deciding on a long-term investment. You still have to do your homework and choose stocks wisely, because even in good times, you can lose money if you invest in companies that go out of business. Part 3 of this book shows you how to evaluate specific companies and industries and alerts you to factors in the general economy that can affect stock behavior. Appendix A provides plenty of resources you can turn to.

remember Because so many different types and categories of stocks are available, virtually any investor with a long-term perspective should add stocks to his investment portfolio. Whether you want to save for a young child’s college fund or for future retirement goals, carefully selected stocks have proven to be a superior long-term investment.

Investing for a Purpose

When someone asked the lady why she bungee jumped off the bridge that spanned a massive ravine, she answered, “Because it’s fun!” When someone asked the fellow why he dove into a pool chock-full of alligators and snakes, he responded, “Because someone pushed me.” You shouldn’t invest in stocks unless you have a purpose that you understand, like investing for growth or income. Keep in mind that stocks are just a means to an end — figure out your desired end and then match the means. The following sections can help.

tip Even if an advisor pushes you to invest, be sure that advisor gives you an explanation of how each stock choice fits your purpose. I know of a very nice, elderly lady who had a portfolio brimming with aggressive-growth stocks because she had an overbearing broker. Her purpose should’ve been conservative, and she should’ve chosen investments that would preserve her wealth rather than grow it. Obviously, the broker’s agenda got in the way. (To find out more about dealing with brokers, go to Chapter 7.)

Making loads of money quickly: Growth investing

When investors want their money to grow (versus just trying to preserve it), they look for investments that appreciate in value. Appreciate is just another way of saying grow. If you bought a stock for $8 per share and now its value is $30 per share, your investment has grown by $22 per share — that’s appreciation. I know I would appreciate it.

Appreciation (also known as capital gain) is probably the number-one reason people invest in stocks. Few investments have the potential to grow your wealth as conveniently as stocks. If you want the stock market to make you loads of money (and you can assume some risk), head to Chapter 8, which takes an in-depth look at investing for growth.

warning Stocks are a great way to grow your wealth, but they’re not the only way. Many investors seek alternative ways to make money, but many of these alternative ways are more aggressive than stocks and carry significantly more risk. You may have heard about people who made quick fortunes in areas such as commodities (like wheat, pork bellies, or precious metals), options, and other more-sophisticated investment vehicles. Keep in mind that you should limit these riskier investments to only a small portion of your portfolio, such as 5 or 10 percent of your investable funds. Experienced investors, however, can go higher.

Steadily making money: Income investing

Not all investors want to take on the risk that comes with making a killing. (Hey … no guts, no glory!) Some people just want to invest in the stock market as a means of providing a steady income. They don’t need stock values to go through the ceiling. Instead, they need stocks that perform well consistently.

If your purpose for investing in stocks is to create income, you need to choose stocks that pay dividends. Dividends are typically paid quarterly to stockholders on record as of specific dates. How do you know if the dividend you’re being paid is higher (or lower) than other vehicles (such as bonds)? The following sections help you figure it out.

Distinguishing between dividends and interest

Don’t confuse dividends with interest. Most people are familiar with interest because that’s how you grow your money over the years in the bank. The important difference is that interest is paid to creditors, and dividends are paid to owners (meaning shareholders — and if you own stock, you’re a shareholder because shares of stock represent ownership in a publicly traded company).

remember When you buy stock, you buy a piece of that company. When you put money in a bank (or when you buy bonds), you basically loan your money. You become a creditor, and the bank or bond issuer is the debtor; as such, it must eventually pay your money back to you with interest.

Recognizing the importance of an income stock’s yield

When you invest for income, you have to consider your investment’s yield and compare it with the alternatives. The yield is an investment’s payout expressed as a percentage of the investment amount. Looking at the yield is a way to compare the income you expect to receive from one investment with the expected income from others. Table 3-2 shows some comparative yields.

Table 3-2 Comparing the Yields of Various Investments

Investment

Type

Amount

Pay Type

Payout

Yield

Smith Co.

Stock

$50/share

Dividend

$2.50

5.0%

Jones Co.

Stock

$100/share

Dividend

$4.00

4.0%

Acme Bank

Bank CD

$500

Interest

$5.00

1.0%

Acme Bank

Bank CD

$2,500

Interest

$31.25

1.25%

Acme Bank

Bank CD

$5,000

Interest

$75.00

1.50%

Brown Co.

Bond

$5,000

Interest

$300.00

6.0%

remember To calculate yield, use the following formula:

yield = payout divided by investment amount

For the sake of simplicity, the following exercise is based on an annual percentage yield basis (compounding would increase the yield).

Jones Co. and Smith Co. are typical dividend-paying stocks. Looking at Table 3-2 and presuming that both companies are similar in most respects except for their differing dividends, how can you tell whether the $50 stock with a $2.50 annual dividend is better (or worse) than the $100 stock with a $4.00 dividend? The yield tells you.

Even though Jones Co. pays a higher dividend ($4.00), Smith Co. has a higher yield (5 percent). Therefore, if you have to choose between those two stocks as an income investor, you should choose Smith Co. Of course, if you truly want to maximize your income and don’t really need your investment to appreciate a lot, you should probably choose Brown Co.’s bond because it offers a yield of 6 percent.

remember Dividend-paying stocks do have the ability to increase in value. They may not have the same growth potential as growth stocks, but at the very least, they have a greater potential for capital gain than CDs or bonds. I cover dividend-paying stocks (good for investing for income) in Chapter 9.

Investing for Your Personal Style

Your investing style isn’t a blue-jeans-versus-three-piece-suit debate. It refers to your approach to stock investing. Do you want to be conservative or aggressive? Would you rather be the tortoise or the hare? Your investment personality greatly depends on your purpose and the term over which you’re planning to invest (see the previous two sections). The following sections outline the two most general investment styles.

Conservative investing

Conservative investing means that you put your money in something proven, tried, and true. You invest your money in safe and secure places, such as banks and government-backed securities. But how does that apply to stocks? (Table 3-1 gives you suggestions.)

If you’re a conservative stock investor, you want to place your money in companies that exhibit some of the following qualities:

·        Proven performance: You want companies that have shown increasing sales and earnings year after year. You don’t demand anything spectacular — just a strong and steady performance.

·        Large market size: You want to invest in large cap companies (short for large capitalization). In other words, they should have a market value exceeding $5–$25 billion. Conservative investors surmise that bigger is safer.

·        Proven market leadership: Look for companies that are leaders in their industries.

·        Perceived staying power: You want companies with the financial clout and market position to weather uncertain market and economic conditions. What happens in the economy or who gets elected shouldn’t matter.

remember As a conservative investor, you don’t mind if the companies’ share prices jump (who would?), but you’re more concerned with steady growth over the long term.

Aggressive investing

Aggressive investors can plan long term or look over only the intermediate term, but in any case, they want stocks that resemble jack rabbits — those that show the potential to break out of the pack.

If you’re an aggressive stock investor, you want to invest your money in companies that exhibit some of the following qualities:

·        Great potential: Choose companies that have superior goods, services, ideas, or ways of doing business compared to the competition.

·        Capital gains possibility: Don’t even consider dividends. If anything, you dislike dividends. You feel that the money dispensed in dividend form is better reinvested in the company. This, in turn, can spur greater growth.

·        Innovation: Find companies that have innovative technologies, ideas, or methods that make them stand apart from other companies.

remember Aggressive investors usually seek out small capitalization stocks, known as small caps, because they can have plenty of potential for growth. Take the tree example, for instance: A giant redwood may be strong, but it may not grow much more, whereas a brand-new sapling has plenty of growth to look forward to. Why invest in big, stodgy companies when you can invest in smaller enterprises that may become the leaders of tomorrow? Aggressive investors have no problem buying stock in obscure businesses because they hope that such companies will become another Apple or McDonald’s. Find out more about growth investing in Chapter 8, and check out small cap stocks in Chapter 14.