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"Fire Your Stock Analyst" by Harry Domash
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7 resolutions every investor must keep
Read this list and think back over the last year. Would you have saved yourself some heartache had you listened to this time-tested advice?
By Harry Domash
The new year is here, and you know what that means: Its time to examine ourselves and commit to doing better. Here are my resolutions, based on the simple, sage advice weve all heard time and time again.
I hate to think of the money I could have saved had I not forgotten or ignored them at crucial times. So let's plan for a more profitable 2004.
I will not let a small loss turn into a big disaster
Nobodys perfect! No matter how much research you do, some of your picks will turn out to be stinkers. Thats why William J. O'Neil, publisher of Investors Business Daily, along with countless other experts, extols us to cut our losses short and let our winners ride.
Lets look at some numbers and youll see why. Say you put $1,000 each into 10 stocks, but the market turned against you and only five went up, while the other five dropped.
Youd be down $500 on your losers if you followed a strict sell discipline and sold when they dropped 10% below your purchase price ($100 each times five stocks).
Now suppose that your five winners moved up 25% on average, giving you a profit of $1, 250 on the winners ($250 profit multiplied by 5 stocks). Despite your dismal 50% batting average, youre ahead $750 on the portfolio because you followed a strict sell discipline.
But most individual investors do the opposite, research shows. They dump their winners and hold onto their losers. Why? Its all about ego. Nothing is final as long as you hold onto your losers. But once you sell, it goes into your permanent record. Many investors cant bear that cross, and stubbornly hold losing positions for years in hopes that the stock will go back up to its original purchase price.
Dont fall into that ego trap. Avoid big losses by setting sell rules when you buy.
I will never average down
Its tempting to buy more shares when a stock youve recently purchased goes down instead of up. For instance, maybe you bought 100 shares of Acme Sausage Co. at $20, and the stock drops to $15. Adding another 100 shares at $15 brings your average purchase price down to $17.50, rather than having to wait for it to hit $20 again to break even. That process is called averaging down.
On the surface, averaging down may seem to make sense, especially if youve done your due diligence and are confident of your picks future prospects. But the stocks price action opens the possibility that there was something happening that hadnt been made public when you did your research.
Maybe the companys hot new product isnt working as expected, and insiders are dumping the stock before the company announces the bad news.
Thats not always the case. Sometimes stocks go down for benign reasons. But theres too much risk to justify doubling your bet. Ive found that its more profitable to add money to stocks that are moving up, not down.
I will not put all my eggs in one basket
If youre a growth investor, youll usually find your best candidates clustered in one or two hot sectors, say health care or technology. Thats how my portfolio got stuffed with chip and telecom stocks back in the bubble days. Back then, everybody, and I mean everybody, thought that the tech boom would go on for the foreseeable future.
Lesson learned: Nobody really knows anything, and it pays to diversify your portfolio in terms of sectors. There are no set rules, but certainly no more than 25% of your holdings should be in any single sector (e.g., financial services, health care, technology, transportation, etc.), and not more than 10% in any one industry such as networking or medical devices.
I will always check out the competition before I buy
Its discouraging to buy a stock and then watch in bewilderment when another stock in the same industry takes off, while your pick sputters. You can reduce the risk of that happening by checking out the competition before buying.
Usually, only one or two companies end up dominating an emerging industry, and their shareholders make the most money. Heres how I check out the industry to pinpoint the companies with the best chances of pulling away from the pack.
First identify your candidates industry, which you can find near the bottom of MSNs Key Ratios report. For instance, in this example, Apollo Group is in the Education & Training Services industry.
Then pick the three or four companies with the highest 12-month sales, and from those, look for the companies showing the fastest revenue growth and the highest pretax profit margins. Often, the same stock meets both of those tests.
Rather than looking up the data individually, its easier to use MSN Money's Deluxe Screener to list all stocks in the industry and, at the same time, display the revenue and profit factors. Heres a link to that screen set up for Apollos industry. To use it, simply click on the Value field and select your industry of choice. After youve run the industry screen, click twice on the 12-Month Revenue header to list the companies with highest revenues at the top.
I will never act on an inside tip
I dont know about you, but the inside tips I hear always sound like cant-lose propositions. They usually come from someone who heard from a high company exec that Redundant Tech is about to receive a major contract that will double its sales. Maybe telling me is a jinx, but somehow, these events never happen.
To make matters worse, by the time I buy, the supposedly secret inside tip has usually already driven the share price up, meaning that I automatically lose when everybody realizes theyve been had and dump their shares.
I will not buy a company blindfolded
Most of us would probably agree that the more we know about our stocks, the better our investing results. Then reality bites. Sometimes we get caught up in the excitement and buy stocks without much of an idea of the products or services they offer. That makes it impossible to evaluate the company's future prospects, and we end up flying blind.
You can start your research on a companys business by reading MSN Moneys Company Report. It gives a concise but comprehensive description of the company's main products and services.
I will not chase a stock
Lets face it. Were rarely the first to discover a hot prospect. Most stocks have already made a big move by the time we find them. Jumping on a fast-moving stock at that point can be dangerous. The good news is that many of these stocks periodically falter, retracing much of their gains. These retracements can offer good entry points.
Ive come up with an unscientific rule of thumb for quantifying when a stock has moved up too fast. I compare the latest share price to its 200-day moving average. I consider stocks 50% or more above their 200-day moving averages as risky. They should only be bought after careful consideration. Stocks 75% or move above their 200-day moving averages are absolute do not buys.
You can use a price chart to compare the price to the 200-day moving average, but its easier to read the values that are listed in the Stock Activity section of MSNs Company Report.
Yes, conventional wisdom says resolutions are made to be broken. Maybe so, but why not keep this list handy and at least make a note when you break one? Then you can look back at the end of 2004 and consider the rewards or consequences.
At the time of publication, Harry Domash did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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