slowing U.S. economic growth, Europe's massive debt woes and the dysfunction in American politics.
So what's an investor to do? Here's how you can become a better investor: 1. Have a Strategy: This might seem obvious, but too many investors select stocks haphazardly. Whether you're a short-term trader or a five-year investor, set a plan and stick to it. Some of my biggest investing mistakes came from selling a stock prematurely because I heard a rumor that was ultimately unfounded. Consider an investment in a stock for what it really is: a stake in a business. Given that, what's the basis for investing in this company? What are the catalysts that may propel the share price higher? What could go wrong? And will I sell if these things happen? Some other questions are: What's my timeframe for holding the stock? How much money do I want to make on this investment? 2. Don't Ignore Economic Events: You might think you're holding the next Apple in your portfolio, but if Greece or another country in Europe defaults, your stock is likely to fall regardless of its prospects. For many, this might be challenging to understand, but with investing comes the threat of financial contagion. Contagion is typically caused by the default of a large bank and. When it happens, diversification is less effective. Contagion (you can think of it like catching a cold) is a concern now in that problems in Greece are likely to spread and hurt other European companies. The worry is that the U.S. gets sick and puts the final nail in the coffin for an already struggling economy.
The U.S., while repairing its own wounds, can withstand some bad news from overseas, but it remains to be seen how it will play out. While it's hard to keep track of all the headlines, do your best but don't overreact. Remember the impact that other countries can have on the U.S., especially if your company has international ties. Finally, don't forget to pay attention to the credit markets. Credit default spreads (CDS) on banks in 2008 were hinting of problems long before Lehman and Bear Stearns vanished from thin air. Here in the U.S., we've seen recent CDS spreads on Bank of America exceed the highs reached in 2009. These indicators often can be a sign that there's more pain ahead. 3. Know Your Risk Level: If you can't stomach the possibility of a 5% drop in the stock market one day, or if you're biting your nails every time you watch CNBC, it might be time to consider a different strategy. If you're in your 20s or 30s, you should be able to assume more risk, but your risk tolerance might not be as high as you can handle. If you're a nervous Nelly yet invest in individual stocks or bonds, it might make sense to switch to a portfolio of sector exchange traded funds, high-yielding preferred shares or corporate bonds. 4. Dollar-Cost Average: If you're concerned with market gyrations and want to keep investing in stocks, consider dollar-cost averaging (DCA). Many use dollar-cost averaging with mutual funds in a 401(k), investing a set amount of money each month to smooth the volatility and attempt to maintain consistent returns. But it can also be done with stocks in the same way -- you decide on the investment amount and frequency -- and you would invest that amount in the same stock regardless of whether the price is declining or ascending. As an example, let's say you have $5,000 to invest in a particular stock. With DCA, you might have a one-year plan to invest 1/12 of that amount every month, regardless of the price.
Let's see how this would work with a couple examples and how it would compare if you invested a lump sum at the beginning of the year. (Fees aren't included here.) Invest $416 ($5,000/12) on the first of each month in Apple: Average purchase price, $353; gain, 14%. Invest $5,000 on Jan. 3 in Apple: Purchase price, $329.57; gain, 22%. Invest $416 ($5,000/12) at the first of each month in Bank of America: Average purchase price, $11.71; loss, 47%. Invest $5,000 on Jan. 3 in Bank of America: Purchase price, $14.15; loss, 56%. As shown, with a stock that's on the upswing, such as Apple this year, DCA can limit gains, since the investor is "averaging" purchases over the year and not getting in at the low price at the beginning of the year. Another criticism and weakness of the DCA strategy is the fees associated with making a new investment each month. In the above example, the DCA strategy would cost the investor an additional $110 a year (assuming a $10 stock trade). While I think DCA is a great option for many investors, it might not be for everyone. Many want to have more control over their investments. If you feel like you want to attempt to further time the market, begin by drafting a list of 10 to 15 stocks that interest you. Learn everything you can about the stock and the related industry. Follow the stock price and try to determine where you would consider a purchase. On your list, make four columns next to your stock. Write down "current price," "buy price," "sell price" and "doomsday." "Buy price" is the price you believe is a good purchase price, "sell price" is the price at which you would consider taking gains, and "doomsday" the price if everything goes wrong. This last number would be the worst-case scenario for the company. If your stock hits your "buy price," don't invest everything you have. Consider maybe a quarter or half stake. If the stock falls within a certain percentage of your bottom-case scenario (and the fundamentals of the stock still look OK), you might look to invest another 25%. But beware of the falling knife. Be sure to review the news and reassess your original thesis. Is the stock down because of market events or is there a company-specific problem you didn't predict. Maybe you purchased the stock and everything looks amazing -- earnings are up, guidance is higher. If the stock is higher, and the company is exceeding your original expectations, it might be time to put some more money to work. Don't be afraid to add to positions on the upside, especially if you think you're holding stock in an exceptional company.
5. Diversify and Use ETFs to Get Industry Exposure: The golden rule, which many seem to ignore, is a term that you should never, ever forget: diversification. True, diversification won't hold up well if financial contagion strikes again, but it's best to always remain diversified. Don't load your life savings into one penny stock because Uncle Tony told your mom that ABC Corp. is a can't-miss double. And don't fall in love with one or two stocks and leave yourself susceptible. By diversification, I mean owning stocks across various industries (bonds if appropriate for your risk level) and, if possible, across continents. Trust me, I know for the average investor, it's tough to maintain a portfolio of more than 10 stocks. If you don't have the time to do the research and follow the news on your investments, consider further diversifying your portfolio with the help of sector/industry ETFs. There's an ETF nowadays for pretty much any possible asset class or industry, so make sure you use them to your advantage. Check our ETF Ratings for help. And if you want some great educational advice and strategy help with ETFs, I highly recommend checking out our sister site, ETF Profits. Don't get discouraged. The market can be a scary place and the recent headlines have made investing a head-scratcher for many of us. Have a strategy, do your homework, remain prepared, stay diversified, and you should be well-equipped to navigate during these challenging times.
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