If a stock market investment’s beta is below 1.0, the stock is less volatile than the market. High-beta stocks above 1.0 are generally more volatile than the market. (If a stock has a negative beta, it has an inverse relationship with the market; it tends to fall when the market goes up, and vice versa.)

By following our three-part advice, you naturally diversify into high- and low-beta stock market investments

In a rising market, high-beta stocks tend to jump ahead of the market indexes. However, when the market declines sharply, high-beta stocks can fall more quickly than the market, and be slower to recover. Low-beta stocks may not move up as quickly as the market indexes, but they’re unlikely to fall as far during market declines.

In managing the portfolios of clients of our Successful Investor Wealth Management service, we employ our three-part investment strategy: invest mainly in well-established, dividend-paying companies; spread your stock market investments across the five main economic sectors (Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities); and avoid stocks in the broker/public-relations limelight.

By doing this, we naturally diversify into high- and low-beta stock market investments. That adds the potential for strong gains when the market is rising, but also adds an element of stability that helps protect your portfolio when the market declines.

You could see double- or triple-digit profits, even in a turbulent market. Discover how you can profit regardless of which way the market moves in Pat McKeough's The Successful Investor newsletter.

That’s in contrast to market advisors and portfolio managers who take on a lot of risk by loading up on high-beta stocks. These managers can show bursts of high performance when the market is rising. However, when the market declines sharply, these portfolio managers can lose far more than the market, and be far slower to recover — if they recover at all.

For instance, many portfolio managers who focused on high-beta stocks fell much further than the market in the second half of 2008, when the TSX dropped more than 50%. Our selections, on the other hand, fell a lot less than the overall market, and have rebounded much faster.

Well-established companies are the key to earning consistent returns — with greater safety

It’s hard if not impossible to predict when the market will jump. It’s even harder to predict when a rising market will reverse course and plunge. This simple fact of investment life causes an extraordinary amount of loss and investor bewilderment. That’s because it’s all too easy to give yourself credit for a gain that you owe to buying a high-beta stock when the market is rising, or just before the market takes off.

If you mistakenly give yourself credit for a gain like this, you may then go on to fill your portfolio with more of the same kind of stock. That can keep on paying off for a time. But inevitably the market quits soaring and stumbles. When that happens, the worst stocks to hold are the high-beta variety. When the market is falling, they tend to fall even faster.

If stocks like these make up a big part of your portfolio, even a mild market downturn can leave you with horrendous losses.

Keep beta ratings in perspective

All in all, a stock’s beta rating makes a broad statement about its history of volatility. Unfortunately, it tells you nothing about its inherent safety or future prospects. For that, we look to the nine key factors we analyze in awarding one of our six Successful Investor ratings (Highest Quality, Above Average, Average, Extra Risk, Speculative and Start-up). We’ll examine these ratings more closely in one of our upcoming Wednesday Investor Toolkit updates.

If you’d like me to personally apply my time-tested approach to your investments, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.

1. Focusing on three or fewer of the 5 main economic sectors: Manufacturing and Resources stocks expose you to above-average risk, Utilities and Canadian Finance stocks involve below-average risk, and Consumer stocks fall in the middle. The sectors go in and out of investor favour, depending on economic conditions and investor whim. But in the long run, winners and losers appear in all five.

Spreading your money out across most or all of the five sectors limits the role of luck in your results. Your stock market investments will always have some exposure to the year’s most profitable investment area, and that’s a key factor in successful investing.

2. Overindulging in speculative stock market investments: Even the best speculative companies go through wider price fluctuations and expose you to greater risk than well-established stocks. If you hold too many speculative stocks, you run a far greater risk of loss during a market downturn.

You could see double- or triple-digit profits, even in a turbulent market. Discover how you can profit regardless of which way the market moves in Pat McKeough's The Successful Investor newsletter.

3. Buying too many “stocks that everybody likes”: Some stocks stay popular for years, if not decades. They can be very profitable during those periods. But if you invest too much of your portfolio in stocks like these, you’ll wind up getting aboard some just as they reach their peak. When these stocks fall out of favour, the drop in your returns can be breathtaking. It can also take years for such stock market investments to recover.

4. Disregarding subtle signs of high risk: These include an unusually high dividend yield or an unusually low p/e (the ratio of a stock’s price to its per-share earnings). High yields and low p/e’s are good, but only within limits.

If a stock’s yield is extraordinarily high, it usually means there is some risk that the company will have to cut or even eliminate its dividend. If the p/e is extraordinarily low, it usually means there is some risk that the company’s earnings are about to fall. Or worse, that the company is using “creative” or deceptive accounting to seem more profitable than it is.

Instead of seeking out the highest yields and lowest p/e’s, look at a wide variety of measures, rather than just one or two financial ratios.

5. Putting too much faith in trends: It pays to keep in mind that the stock market anticipates things, and no trend lasts forever. Stocks put on lengthy downturns due to business and economic problems. The downturns go into reverse long before the problems get solved.

Remember, a highly dramatized story is far more entertaining than a straight explanation of facts, and more absorbing. But don’t let entertainment value, or your degree of absorption in the story, warp your judgment.

You can get our latest updates on issues that affect your investments, plus buy/sell/hold advice on stocks you may be considering buying (or selling) in our Successful Investor newsletter. Click here to learn how you can get one month free when you subscribe today.

The Securities and Exchange Commission (SEC) is investigating the drop, but an exact cause has not yet been found.

No matter what caused the crash, some of the trades that occurred between 2:40 p.m. and 3:00 p.m. eastern time have already been cancelled. The New York and Nasdaq exchanges have cancelled all trades that occurred during that window that were more than 60% higher or lower than the stock’s price just before the plunge.

Investors whose trades are not cancelled and whose stock market trading strategy involved the use of stop-loss orders could be among the biggest losers.

Stock market trading strategy: How stop-loss orders work

Stop-loss orders are a direction to your broker to sell a stock if it falls to a specific price. For example, if you own a $12 stock, you might tell your broker to sell it “on stop” if it hits $10. This may limit your losses if you paid more than $10. If you paid less, it may preserve some of your profits.

However, the triggering of a stop-loss order doesn’t automatically mean you will sell the stock at $10. Instead, your stop-loss order becomes a “sell-at-market order.” But if other investors don’t bid anywhere near $10, you could lock in a sale at a much lower price. You can put a limit on a stop-loss order, but that defeats your purpose in a swift market decline.

You could see double- or triple-digit profits, even in a turbulent market. Discover how you can profit regardless of which way the market moves in Pat McKeough's The Successful Investor newsletter.

May 6, 2010: A “perfect storm” for stop-loss investors

The May 6 market decline provides a good example. Let’s say you held Procter & Gamble (symbol PG on New York), one of the stocks we cover in our Wall Street Stock Forecaster newsletter, and had told your broker to sell it “on stop” if it fell below $50. (Before the drop, Procter was trading at around $63.)

At the height of the crash, Procter had fallen to $39.97, for a 37% drop. That’s what you may have sold your Procter shares for if you had a stop-loss order on the stock. What’s more, now that Procter has rebounded back to around $63, you wouldn’t have enough cash from the sale to buy back your holdings.

To top it off, if you originally bought Procter for less than $39.67, you would have to pay capital gains tax on your profits.

Stop-loss orders: A stock market trading strategy that may force you to sell too early — even in less volatile markets

Even without the extreme market conditions of May 6, 2010, stop-loss orders can force investors out of their best stock picks too early. After all, if a stock is going to rise from, say, $10 to $100, there’s a strong possibility that it will go through many short-term downturns along the way. Some may be $2, some $10, $20 or even more.

Investors may avoid some losses with stop-loss orders. But they increase the likelihood that they will sell their strong performers when they’re just getting started.

Stop-loss orders may be useful for speculative stocks

At times, mechanical investing aids like stops can work. But most investors who rely on them wind up losing money in the long run. That’s why we’ve long recommended that investors avoid using stop-loss orders, especially on any sort of habitual basis.

However, with speculative stocks, it’s better to use a stop-loss order than to buy and forget it. You can get away with the “buy-and-forget-it” approach for a time, if you buy high-quality stocks like those we recommend in The Successful Investor. But few speculatives ever reach that degree of investment quality.

That’s why we think you would be far better off sticking with our three-part program of investing in well-established companies, spreading your money out across the five main economic sectors and avoiding stocks in the broker/public-relations limelight.

This system requires more attention and effort than stop-loss orders. But it will serve you much better in the long run.

You can get our latest updates on issues that affect your investments, plus buy/sell/hold advice on stocks you may be considering buying (or selling) in our Successful Investor newsletter. Click here to learn how you can get one month free when you subscribe today.

Focusing on targets puts too much emphasis on predictions

We don’t publish targets for several reasons. The main one is that they may lead investors to rely too heavily on predictions, which are the least reliable part of the investment decision-making process.

Big bets on predictions or opinions will always produce inconsistent results. That’s why successful investors recognize that predictions are of limited use in investing profitably.

Instead, we continue to recommend that you focus on investment quality and diversify by following our three-pronged investing philosophy. (See below for more on how this strategy can help you improve your stock market trading profits and lower your risk.)

Selling too early can cause you to miss out on some big stock market trading gains

Another drawback of price targets is that they can spur investors to quit buying or even sell their best picks way too early. By definition, after all, your best picks are those that do way better than you ever expected.

You could see double- or triple-digit profits, even in a turbulent market. Discover how you can profit regardless of which way the market moves in Pat McKeough's The Successful Investor newsletter.

To make serious profits in stock investing, you need to hang on to your best performers for years. That’s because even good stocks sometimes go sideways for decades, while others turn out to be “ten-baggers,” with gains of 1,000% or more. If you are too quick to sell stocks that have gone up, you may avoid some 20% setbacks. But you’ll also miss out on some 200% gains.

Targets do tend to push up your stock market trading activity and commission expense, because they give you a rationale for selling whenever a stock you own hits its target. This helps explain the popularity of targets in brokerage research.

Use our three-pronged approach to help lower your stock market trading risk

Instead of relying on stock-price targets, we recommend that you follow our three-pronged investment philosophy. That is, invest mainly in well-established companies; spread your money out across most, if not all, of the five main economic sectors (Manufacturing, Resources, Consumer, Finance, Utilities); and downplay stocks that are in the broker/public relations limelight.

That way, you protect yourself from an unforeseeable industry downturn. You also increase your chances of stumbling upon a market superstar — a stock that does much, much better than average.

After all, if it was so easy to predict share-price movements ahead of time, investing would be incredibly profitable and nobody would have to work. Of course, the universe isn’t built that way.

If you’d like me to personally apply my time-tested approach to your investments, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.

You’ll find our ratings displayed next to every stock we recommend in our newsletters — including our flagship publication, The Successful Investor. They’re designed to help you quickly and easily identify companies that have the ability to survive a business setback and go on to greater success when conditions improve.

Here are three factors we take into consideration before awarding a rating. We think they can help you improve your returns and lower your risk when you invest in the stock market:

1. A long-term record of dividends: We continue to recommend that you hold the bulk of your portfolio in well-established, dividend paying companies. That’s because a dividend-paying company with a long-term record of dividends provides a measure of safety. Dividends, after all, are much more stable than earnings projections. More important, dividends are impossible to fake — either the company has the cash to pay dividends or it doesn’t.

A couple of decades ago, you could assume that dividends would contribute up to a third of your long-term investment returns, without even considering the tax-cutting effects of the dividend tax credit. Earlier in this decade, dividend yields were generally too low to provide a third of investment returns. But now that yields have moved up, it’s realistic to assume they will once again contribute as much as a third of your total return.

You could see double- or triple-digit profits, even in a turbulent market. Discover how you can profit regardless of which way the market moves in Pat McKeough's The Successful Investor newsletter.

2. Canada-wide or multinational operations: One way to cut your risk when you invest in the stock market is to look for companies with operations in different provinces or countries. That lets these firms benefit from a recovering global or national economy, as well as a return to prosperity in their home markets. They also give your portfolio valuable geographic and, in the case of multinationals, currency diversification.

3. Products or services that profit from habitual behaviour: These are firms that sell products that consumers must buy, no matter what the economy is doing. These companies can add stability to your portfolio. Food producers, such as Canada Bread (symbol CBY on Toronto), a stock we cover in The Successful Investor, are good examples of these types of firms.

Outside of the consumer sector, we like to see companies that benefit from steady revenue streams from high-quality assets, long-term contracts or other reliable sources. For instance, computer-outsourcing firm CGI Group (symbol GIB.A on Toronto) typically signs contracts with its clients that last 5 to 10 years.

You can get our latest updates on issues that affect your investments, plus buy/sell/hold advice on stocks you may be considering buying (or selling) in our Successful Investor newsletter. Click here to learn how you can get one month free when you subscribe today.

Here are 3 ways you can benefit from borrowing to invest. (We’ve also compiled a list of 6 ways to tell if your personal circumstances favour this strategy. See below.)

1. Today’s low interest rates favour borrowing to invest: Today, you can borrow for as little as 3.25% if you use your home as collateral. Over long periods, the total return on a well-diversified portfolio of high-quality stock market investments runs to as much as 10%, or around 7.5% after inflation. So you can expect to earn more than your borrowing cost.
2. You can use your dividends to pay your investment loan interest: If you borrow to buy well-established, dividend-paying stocks (or mutual funds that invest in these stocks), like those we recommend in our Canadian Wealth Advisor newsletter, these investments will give you regular dividend income and cash flow to pay the interest on your investment loan.
3. Borrowing to invest can cut your tax bill: Borrowing to invest can be a highly effective tax shelter. That’s because you can deduct 100% of your interest expense against your current income. Plus, the investment income you earn comes with three key tax advantages: you get the dividend tax credit on qualified Canadian stocks and you only pay tax on 50% of your capital gains.

   In addition, you are only liable for capital gains when you sell; if you buy high-quality stock market investments, you’ll wind up holding some of them for as long as you live. It’s a great tax-deferral technique. And it’s perfectly legal.

You could see double- or triple-digit profits, even in a turbulent market. Discover how you can profit regardless of which way the market moves in Pat McKeough's The Successful Investor newsletter.

Borrowing to invest is not without risks. The amount you owe on your investment loan will stay the same, regardless of what the market does, so every dollar your portfolio loses will come out of your equity. In addition, if you take out a variable-rate loan, the interest rate you pay could eventually rise.

That’s why borrowing to invest only makes sense if all 6 of the following apply:

1. You are in the top income-tax bracket and expect to stay there for a number of years;
2. Your income is secure;
3. You have 10 or more years until retirement;
4. You follow our low-risk investment approach;
5. You have the kind of temperament to sit through the inevitable market setbacks without losing confidence at a market bottom and selling out to repay your loan;
6. You have already made your maximum RRSP contributions.

For our latest views on lower-risk investments suitable for borrowing to invest, you should subscribe to our Canadian Wealth Advisor newsletter. Click here to learn how you can get one month free when you subscribe today.

So you can get a sense of how the service works, and how it can help you make better stock market investments, I’d like to share an example of the kind of question Inner Circle members ask, along with our response. I hope you enjoy and profit from it.

Q: Pat: I bought Teck Resources on your advice in early 2009. At the time, I bought Teck’s class A voting shares, which were trading around $10. They’re now around $40.

The class A shares are trading higher than the class B shares, though the spread has narrowed lately. Still, I’m wondering if it’s worth selling the class A shares and buying a larger number of class B shares with the proceeds.

A: Teck Resources $37.36, symbol TCK.A on Toronto and $36.86, symbol TCK.B on Toronto (Shares outstanding: 589.1 million; Market cap: $21.7 billion), is one of many Canadian companies that have two classes of common shares.

The exact terms and names vary, but the main difference between common-share classes is that one gives the holder voting control over the company, while the other has little, if any, voting power.

Both stock market investments usually pay the same dividend, though sometimes the non-voters pay as much as 10% more. As well, non-voting shares usually trade more actively than voters. Most voting shares also have a one-way conversion feature that lets their holders exchange them for non-voting shares. Non-voting shares have no such option.

You could see double- or triple-digit profits, even in a turbulent market. Discover how you can profit regardless of which way the market moves in Pat McKeough's The Successful Investor newsletter.

In a takeover, the voting shares may get a better offer than the non-voting shares. However, in order to ensure that all investors get equal treatment, most companies have a “coat-tails” provision that gives non-voting investors a limited right to convert to voting shares. But coat-tails provisions may have exceptions and loopholes.

When choosing between voters and non-voters, we mainly recommend that you buy the one that’s cheaper. However, it’s usually worth paying up to 5% more to buy the voting shares. You’ll almost always get this back (and sometimes more) when you sell these stock market investments. At times, you may want to pay up to 10% more, but that’s only rarely worthwhile.

Teck’s class A common shares have 100 votes per share, and the class B shares each have one. Holders of class A common shares also have the option to convert to class B. As well, the shares also have a coat-tail provision: in the event that an offer to purchase class A common shares is not made at the same time as an identical offer to purchase class B shares, each class B share will be convertible into one class A common share.

The class B shares trade at a 1.3% discount to the class A shares. The discount has remained quite narrow lately, but in May 2009 it was 19%, and in February 2009 it was a very wide 52%.

We don’t think you should be in a hurry to sell your class A shares. You might want to wait for the discount to widen. The exception would be if you want to nail down a capital loss. In that case, you could sell your class A shares and buy more class B shares at a lower price. But this wouldn’t apply in your situation, because you have a 275% or so gain on your Teck shares.

If you have investment-related questions, or if you’d like to ask me about stocks you’re considering buying (or selling), you should join my Inner Circle service. Click here to learn more.

(To get all the details on our stock market strategy, and how it can help your portfolio, don’t miss our free report, “Canadian Stock Market Basics: How to Trade Stocks and Make Good Investments in Canada.” Click here to download your copy and get started right away.)

More on the stock market strategy that helps us routinely spot takeover candidates a little further on. But first, here are just a few recent takeover targets we’ve recommended. All rewarded our readers with big gains:

A history of huge profits in takeovers

• Fording Canadian Coal jumped 163.2% in five months on a takeover offer after we recommended it to Successful Investor readers in January 2008.
• In April 2006, we issued a “buy” recommendation on Sleeman Breweries at $11.40 a share. In August 2006, Sleeman accepted a $17.50-a-share all-cash takeover offer from Japan’s Sapporo Breweries. That’s a gain of 56.4% in just five months.

You could see double- or triple-digit profits, even in a turbulent market. Discover how you can profit regardless of which way the market moves in Pat McKeough's The Successful Investor newsletter.

• Another of our recommendations, Alcan, jumped 68.7% in just two months when Rio Tinto Ltd. made a successful takeover bid for the company after recognizing it had access to cheap electricity, a key component in aluminum production, at a time of rising energy prices.
• And most recently, in February 2009 we issued a “buy” recommendation on Petro-Canada at $28 a share in The Successful Investor. When the company accepted a friendly offer from Suncor Energy Inc. in March, it was trading at $34.68, for a 24% gain.

Like corporate acquirers, our stock market strategy focuses on hidden value

A company’s takeover prospects are just one thing we look at when we choose stocks to recommend in our newsletters and investment services. An equally important part of our stock market strategy is looking for companies with what we call “hidden value” — hidden or widely overlooked assets.

By hidden value, we mean valuable assets that are not getting the attention they deserve from investors. When a company’s assets are wholly or partially ignored or hidden, the stock trades for less than it’s really worth, so you get to buy at a bargain price.

Hidden assets offer the prospect of a takeover — and cut your risk

Companies that launch takeovers also tend to look for hidden assets. That’s why so many of our recommendations get taken over. Of course, hidden assets are no guarantee of a takeover, but they cut long-term risk, and make a takeover a lot more likely.

If a stock with hidden assets gets cheap enough, it attracts buying by value-oriented investors. Its low price may also trigger a takeover that otherwise might never have happened.

Sometimes, of course, hidden assets stay hidden for a lengthy period. But as long as a stock has more obvious appeal, such as long-term growth prospects, a reasonable per-share price-to-earnings ratio or an attractive dividend yield, you have what we call the best of all possible investment worlds: a heads-you-win, tails-you-break-even situation.

If it works out well, it can be extraordinarily profitable; if it works out poorly, you really won’t lose that much.

As a member of TSI Network, you may have already seen Canadian Stock Market Basics: How to Trade Stocks and Make Good Investments in Canada. If you haven’t yet read this new free report, click here to download your copy today. I’d also encourage you to share the report with a friend. It’s my “thank you” just for signing up for my free daily updates.

That’s why, in our newsletters, we simply provide the return since our first recommendation, and leave more detailed calculations to independent sources, particularly The Hulbert Financial Digest. (We recently posted returns that were far higher than an index of all publicly traded U.S. stocks — see below for further details.)

Hulbert is the “bible” of stock market newsletter performance measurement

The Hulbert Financial Digest is published by a unit of Dow Jones Co., publisher of The Wall Street Journal. Hulbert is generally thought of as the bible of investment newsletter performance measurement.

Hulbert’s independence makes us particularly proud of that publication’s latest review of The Successful Investor, our flagship publication.

The Hulbert Financial Digest devoted one full page in its October issue to its analysis of a portfolio made up of all of our Successful Investor recommendations. It calculated returns on that portfolio and compared them to returns on the Wilshire 5000, an index that aims to measure all publicly traded stocks in the U.S.

You could see double- or triple-digit profits, even in a turbulent market. Discover how you can profit regardless of which way the market moves in Pat McKeough's The Successful Investor newsletter.

Our stock market newsletter was far ahead of the Wilshire 5000 index

In the year ended September 30, 2009, The Successful Investor’s recommendations posted a 5.0% gain, compared to a 6.4% loss for the Wilshire index. Over three years, we had a gain of 15.8% (5.0% annualized), compared to a 13.8% loss (minus 4.8% annualized) for the Wilshire index. For five years, we had a 93.6% gain (14.1% annualized), compared to a 9.1% gain (1.8% annualized) for the Wilshire.

Hulbert only began monitoring our performance at the start of 2002. From then through September 30 of this year, we had a 199.1% gain (15.2% annualized), compared to a 16.0% gain (1.9% annualized) for the Wilshire index.

The service calculates gains and losses in U.S. dollars, so a part of our gain is due to the rise in the Canadian dollar. However, in most years our stock market newsletter beat the Wilshire by a substantial margin that was larger than the gain in our dollar compared to the U.S. dollar.

The sole exception was 2008, when we lost 41.3%, compared to a 37.2% loss for the Wilshire. However, the U.S. dollar gained 25.5% against the Canadian dollar in 2008, whereas the Wilshire 5000 only beat The Successful Investor’s recommendations by 4.1 percentage points.

Now you can put The Successful Investor’s profit-making advice to work on your portfolio right away. Click here to learn how you can get one month free when you subscribe today.

How to build a winning stock market trading strategy using margin

If you could buy on margin when the market hits bottom, stay margined as the market rises, and sell out at the peak, you could very quickly build a large fortune. But of course, no one has the sense of superhuman timing necessary to consistently succeed in that.

That’s why we continue to recommend that if you are going to use margin to invest, it’s all the more important to stick with our three-part stock market trading strategy: mainly invest in well-established companies; spread your money out across the five main economic sectors; and avoid stocks that are in the broker/public relations limelight.

If you rigourously follow that advice and expand your portfolio using margin, you stand to make money over long periods.

You could see double- or triple-digit profits, even in a turbulent market. Discover how you can profit regardless of which way the market moves in Pat McKeough's The Successful Investor newsletter.

Increased leverage magnifies your profits — and your losses

The main risk of buying on margin is that it increases your leverage. Leverage works two ways: It magnifies your profits when the market moves in your favour, but it magnifies your losses just as effectively when the market moves against you. That’s because the amount you owe on your investment loan stays the same, so every dollar your portfolio loses comes out of your equity.

Tax benefits are a plus when buying on margin

Buying on margin can help you cut your tax bill. That’s because you’ll be able to write off your margin interest in full against ordinary income in the current year. However, you’ll pay less than ordinary income-tax rates on dividends from Canadian stocks, thanks to the dividend tax credit.

Above all, you’ll defer all capital gains taxes until you sell, and only pay taxes on capital gains at half the rate you pay on ordinary income.

3 ways to tell if investing on margin is for you

Here are three things to keep in mind when considering investing on margin. If you meet all three, you may be a good candidate for buying on margin:

• you are in the top tax bracket and expect that you’ll remain in it for the foreseeable future;
• you follow our conservative three-part investing approach (see above);
• you invest consistently over a number of years, and resist the temptation to increase your margin borrowing when stocks have risen, or reduce it when prices have dropped.

You can get our latest updates on issues that affect your investments, plus buy/sell/hold advice on stocks you may be considering buying (or selling) in our Successful Investor newsletter. Click here to learn how you can get one month free when you subscribe today.