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: “If you rely on one or two simple rules to cut your risk when you pick stocks, you may simply cut your profits.”

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 pre-tax return on a T-bill will barely keep you even with inflation.

Like most portfolio managers, I look at interest rates all the time. They 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.

Stock market advice: Take a broad view to find your way to success

When they choose stocks, many investors try to cut their work load by taking a narrow view. Rather than look at a wide range of information, they prefer to 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). Some go so far as to reject any stock that trades above some arbitrary cut-off, such as 10 times 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 even faster. Its p/e may drop to between, say, less than 10.0.

That drop in the 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. (This pushes down the ‘p’ or price of the stock, lowering the p/e ratio.)

These problems can be due to a weakness in the business model, rising competition, 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 one or more of these problems flares up, it can devastate the company’s earnings overnight and send its p/e ratio sky-high.

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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A message from Pat McKeough

Many people tell us that finding an advisor they can trust is one of the biggest problems they face as investors. That’s one reason why I offer personal portfolio management advice to a private group of investors, my Wealth Management clients.

You can have me build you a portfolio that’s tailored to your specific goals, temperament and financial situation. I’ll work to protect your money during times of market turbulence—and maximize your profits when the market rises.

You will be in very secure hands. We have an outstanding team of experts. They contribute an enormous amount of time and research to our Successful Investor Wealth Management service. But I personally approve every transaction in every portfolio. If you’d like to know more, just drop us an email. Click here to learn more about Successful Investor portfolio management services.
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A measurement of volatility that has limited use—if any

Here’s another tidbit of stock market advice that fits on a T-shirt, but has little if any place in your investment planning. This is a stock’s “beta coefficient”, or “beta” for short. It’s 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. You will of course want to own high-beta stocks when you are optimistic about the market.

Betas give you a general idea of what to expect from a stock, but you should already have that from looking at the stock’s business history and 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 waste time with betas. You’d simply trade stock index futures and get vastly rich overnight.

More important, betas can change without warning. In one classic case from the end of the 1990s bull market, 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, value and diversification.

These three simple concepts make a dull T-shirt message, but they can make you a lot of money in the course of an investing career.