What every investor should know
Before Money's veteran stock picker departs for academe, he shares his insights on investing.
(Money Magazine) -- I'm retiring and will soon be headed to Oxford University to begin my second act. So this will be my last column for Money. At a time like this, it's only natural to look back at one's career. So I've been reviewing my articles of the past 23 years to see where I've been right and where I've been wrong - and why.
I've come to a simple conclusion: There are certain things that you can know as an investor and other things that you can't. For example, I wrote in 1987 that stocks - based on the market's price/earnings ratio and other benchmarks - were 20% over-valued and vulnerable to a steep decline. My July 1987 column was right on target: Three months afterward, stocks were crushed by the 1987 crash.
A decade later I wrote that equities were again overvalued by 20% and warned readers to trim their stockholdings. But my August 1997 cover story wasn't as timely. My sell recommendation came more than two years before the tech bubble burst in early 2000.
The takeaway: While valuations are a key driver for share prices, it's impossible to predict the exact timing of market turning points. Though a trend may go to excess, that doesn't mean the pendulum will swing back quickly. Sometimes investors get caught up in market momentum. That's especially true during booms, when investors may keep bidding prices higher and higher.
Is it futile, then, to try to analyze the stock market? I don't think so. But you have to recognize from the start that it's impossible to time the market precisely. Nor can you anticipate the magnitude of market moves. And no investor can ever be fully prepared for shocks like 9/11 or any of the other surprises that can suddenly change the course of share prices.
On the other hand, there are some key trends you can monitor that will steer you toward making smart decisions and help you stay on track. Here are five basic things to pay attention to:
The direction of interest rates. The single most important factor driving the stock market is the Federal Reserve's interest-rate policy. Why? The cost of borrowing money helps determine how much consumers are likely to spend, the size of the mortgages home buyers can afford and the willingness of corporations to expand and create new jobs. And a healthy economy leads to growing profits, which get reflected in stock prices. Rising rates will eventually choke off even the strongest bull market. Falling rates, by contrast, encourage a boom, although not always right away. In July 1985 I concluded that expansive Fed policy was bullish, and in just over two years the Dow doubled. When I said the same thing about rate cuts in 2001, however, readers had to wait another 15 months before the rebound began.
Changes in government policy. Major shifts in government spending, regulation or tax policy can have a significant impact - not only on the broad market but on specific stock groups. A big increase in defense spending, for instance, helps the contractors who make tanks, ships and planes. Deregulation pumped up financial firms for the past few years, but when mortgage lending rules got too loose, it spelled trouble. In 2004 I wrote that the 2003 cut in tax rates on dividend income would be very positive for high-yield stocks. And indeed, such shares outpaced growth stocks over the next two years.
Economic trends run amok. When trends go to extremes, bet on a return to more normal levels. In the absence of fundamental changes, history shows, key economic variables eventually revert to their long-term averages. Take inflation. When it sank below 2% in 2004, that seemed too good to last. If you've gone to the gas station lately, you know it was.
Stock market valuations. As with all things you buy, prices matter when it comes to stocks. So when P/Es are abnormally low, as they are now, be a bargain hunter. Similarly, lighten up when prices seem too high. But don't move too fast - shares can remain overpriced for months or years.
Investing costs. There's only one thing you can know for sure when you buy a stock or fund - how much you're going to pay in expenses. And since a balanced portfolio of stocks and bonds may provide an average return of only 8% a year, saving a point or more will have a huge impact on your long-term results.
There's one other thing to be mindful of - your own core investing principles. During my career at Money, I've learned that for long-term investors, success comes down to a few tried-and-true rules that you've probably heard before but that are still worth adhering to.
- Don't try to trade in and out of the market. Over the years I've pointed out risks and opportunities so you could adjust your portfolio little by little over time. Yet it's worth repeating: Don't make major short-term bets, since it's impossible to predict peaks and troughs precisely.
- Do buy shares of high-quality companies with low debt. Large, established firms with above-average earnings growth tend to dominate their industries. And financially strong companies have an easier time borrowing when credit is tight and have cash to make acquisitions when valuable assets are on sale.
- Don't own too many stocks with P/Es above 24. Stocks that trade at P/Es more than 1.5 times that of the S&P 500 (typically 16, based on estimated current-year earnings) are vulnerable to big potential losses when the outlook turns sour.
- Do favor stocks with above-average growth (but don't get greedy). Studies have shown that stocks with earnings growth rates of 13% or 14% are more likely to beat the averages over the long term than are stocks with projected growth rates of 20% to 30%. Sooner or later, stocks with incredible numbers can't maintain them.
- Don't ignore dividends. Investors don't pay nearly as much attention to dividends as they did 50 years ago. But shares with above-average yields are more likely to be undervalued than the typical stock.
- Do stick with your plan, even when results are disappointing. Here's the most important concept I can leave you with: Over time, quality stocks will return more than almost any other investment easily available to individuals. While equities can be sluggish for long stretches, I've learned that periods of poor performance are often followed by "catch-up" recoveries. So don't dump your stocks if they disappoint you for a few years. Instead, invest in a diverse portfolio - and be prepared to stay the course.
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