Ask 100 individual investors what they think is the number-one secret to making money in the market, and the answer you're likely to hear most often is: "Choosing the right stocks." But that would be wrong. Because the number one secret to making money on Wall Street is:
Never suffer a big loss. In other words, control risk by never losing a lot of money.
Why? Let's say you have $10,000 to invest, and you hear about a $20 stock that's a sure thing to generate a 50% return in one year. However, after one month, the stock loses $1, so you're down 5%. No big deal, you say, stock prices fluctuate and this one's going to be a winner, so you hold. And after two months, the price is $17.50 and you hold; and after three months it's $15, and after six months it's down to $10.
Now, you're sitting on a 50% loss instead of a 50% gain. Worse, now you need a 100% return in six months just to break even, and a 200% gain to make your goal. However unlikely it may have been for the stock to hit $30 when you bought it, it's even more unlikely you'll break even now. Instead, if you'd bailed out when you'd only lost, say 10%, you'd only need an 11% return to break even.
The science of modern portfolio management calls for eliminating most of the structural risk of a big loss by spreading your stock holdings out over 10 to 20 different issues. And since it doesn't do much to spread the risk if you put your money into 10 to 20 different banks or software companies, here are the four key diversification criteria that can help maximize your stock returns while minimizing your risk of a big loss:
- Invest in five or more sectors. Depending on the source of your information, the U.S. economy consists of between 10 and 12 sectors - industry groups that tend to perform in distinctly different ways at different times in the business cycle. This Standard & Poor's list gives you an idea of what a sector is and the types of industries they include.
- Consumer Discretionary -- General and specialty retailers, broadcasting, auto manufacturers, homebuilders, clothing, restaurants, hotels.
- Consumer Staples -- Food, beverages, tobacco, personal care products, drug retailers.
- Energy -- Coal, oil and gas drilling, exploration, field services, refining, and marketing.
- Financials -- Asset managers, banks, REITS, insurance, investment banking, and brokerage.
- Health Care -- Biotechnology, health care equipment, facilities, services and supplies, HMOs, pharmaceuticals.
- Industrials -- Aerospace and defense, airlines, construction and engineering, industrial machinery, railroads, trucking.
- Information Technology -- Computer hardware and software, data processing and outsourcing services, Internet software and services, semi-conductors.
- Materials -- Metals, chemicals, forest products, containers and packaging, fertilizers.
- Telecommunications -- Integrated and wireless telecommunication services.
- Utilities -- Electric, gas, water.
- Invest in different company sizes/capitalizations. Stocks are divided into three general classifications by size: large, mid-sized, and small. A firm's size is determined by multiplying the number of shares that a company has in the hands of investors by the share price. The result is called "capitalization," and you'll often hear the size of a company referred to as its "market capitalization" or "market cap" for short.
Different stock research companies have different definitions of what constitutes a large-, mid-, or small-cap stock. Standard & Poor's currently defines them in this way:
- Large-Cap -- More than $3 billion
- Mid-Cap -- $750 million to $3 billion
- Small-Cap -- Less than $750 million
- Invest in different styles. There are two basic investment styles: growth and value. To enjoy the greatest risk-reducing benefits, invest according to both styles, as one tends to perform well while the other less well (and vice versa), often over periods lasting several years.
- Growth stocks exhibit high rates of annual revenue growth and high valuation figures, the chief being their price/earnings (P/E) ratio. To be considered a growth stock, the underlying company typically shows revenue growth of at least 20% a year and has a P/E ratio of at least 20; ordinarily, true growth stocks show higher figures in both areas. Growth investors buy these kinds of stocks, because booming business growth often leads to rapidly rising stock prices.
- Value stocks are stocks of companies with relatively low rates of revenue growth - anywhere from 5% to 15% a year - and relatively low P/E ratios, normally below 15. If you think of growth stocks as the hares of the market, value stocks are the tortoises - they are the slow but steady performers that never go up very far very fast, but are less likely to go down as far or as fast as growth stocks do in bad markets.
- Invest in different geographies. The final dimension involves where the companies whose stocks you buy are based: the United States, in a highly developed foreign country, or in less-developed countries, collectively called the "emerging markets."
The key here is that these three different geographic classifications take turns being the top performer. From the end of World War II until recently, as a group, the stocks of companies based in Western Europe, Japan, Canada, and Australia, had higher long-term rates of return than stocks based in the United States. Lately, their performance has been close to the U.S. long-term average, but they still are on a somewhat different time cycle than U.S. stocks.
As a group, since the 1970s, stocks of companies in the emerging markets - Eastern Europe, China, India, Israel, Southeast Asia, Africa, and Latin America - have had higher rates of return than either U.S. or the developed foreign markets. A downside is that these stock markets show much higher volatility than those in the other regions of the world.
To recap: diversity in your stock portfolio is an important way to reduce risk. Introduce some diversity by investing different sectors, different size companies, both growth and value stocks, and different geographies. For help determining the best way to diversify your portfolio for your unique needs, please call.