Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific stock market advice that will help you develop a successful approach to investing. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.
Today’s tip: “Relying on just one or two indicators to help you choose stocks can increase your risk rather than diminish it.”
Investors are always looking for simple ways to avoid risk in their investments. They want a rule that is easy to follow, foolproof, and compact enough to fit on a T-shirt.
The easiest and surest of these is to keep your money in T-bills or other short-term, government-guaranteed investments. T-bills avoid virtually all risk—but they also avoid most profit. In fact, at today’s interest rates, the after-tax return on a T-bill will barely keep you even with inflation.
Interest rates will tell you something about the economic and market outlook. However, with interest rates at today’s historically low levels, fixed-return investments have limited appeal. The gap is simply too wide between today’s interest rates and the long-term returns on stocks, which run in the 8% to 12% range.
When they choose stocks, many investors zero in on one or at best a handful of indicators. This can do more harm than good. For instance, many investing newcomers get the idea that you should only buy stocks that trade at a below-average p/e ratio (the ratio of a stock’s price to its per-share earnings).
This prejudice ensures that you will avoid some stocks at precisely the best time to buy, or buy others that you should avoid.
For example, the best time to buy mining stocks is when the price of the metal they produce is depressed. But at such times they make little money if any, so they trade at sky-high p/e ratios. When the price of the metal rebounds to more normal levels, the mining company’s earnings will shoot up too. That will make its stock go up, but earnings are likely to rise faster. Its p/e may drop to between, say, 10.0 and 20.0.
That lower p/e may make the stock seem like a safer buy. But by the time the p/e comes down to attractive levels, the stock may have already doubled or quadrupled. If you focus strictly on p/e’s, you will miss out on that rise.
Another problem with focusing on low-p/e stocks is that many disasters-in-waiting go through a low-p/e period prior to their eventual collapse. This low-p/e period occurs because people close to or involved with the company recognize that it has serious problems. They sell their own holdings and they tell their friends and relations to do the same.
These problems can be due to a weakness in the business model, doubts about the quality of the company’s management or insiders, or involvement in a business or industry that is headed for a downturn. When a stock has the kind of latent problems that can lead to a precipitous drop, it’s better to sell three years early than three days late.
To get any real value out of p/e’s, you have to look at them in the context of everything else that’s going on, in the market and in individual stocks.
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Mathematically or academically oriented investors may instead zero in on a stock’s “beta coefficient”, or “beta” for short. This is a measure of a stock’s volatility, relative to the market, based on how it has performed relative to the market, generally over the previous five years.
When a stock has a beta of 1.0, that means it is just as volatile as the market. If the beta is below 1.0, the stock is less volatile than the market. Beta enthusiasts say this is the kind of stock to load up on when you have qualms about the market outlook. A beta above 1.0 means a stock is more volatile than the market, and you will of course want to own high-beta stocks when you are optimistic about the market.
I’ve always found betas to be of limited use if any. They provide a general idea of what to expect from a stock, but you should already have that from looking at the stock’s fundamentals. The notion is absurd that you can buy low-beta stocks when the market is going to be weak, and high-beta stocks when it is going to be strong. After all, if you knew when the market was going to be strong or weak, you wouldn’t need to waste time with betas.
More important, betas can change without warning. The beta for Enron stood at a well-below-average 0.85 at the end of 1999. Yet the company was on its way to an ignominious collapse.
An investor’s only real source of safety and ongoing profit is to build the kind of portfolio that we talk about and create for our portfolio management clients. This kind of portfolio emphasizes investment quality and diversification. Stripped to these essentials, however, that simple rule makes for an awfully dull T-shirt.
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What indicators do you use to measure risk in stocks? Which ones have been successful for you? Which ones have not worked? Let us know what you think in the comments section below. Click here
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