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This program last aired August 9, 2013.
NEW YORK (TheStreet) -- Every time you think you've seen it all, Wall Street comes up with the new twist to make you think that investing is just not worth the trouble, Jim Cramer told his "Mad Money" TV show viewers as he dedicated the entire show to helping home-gamers avoid the most common investing pitfalls. Cramer said that scandals are not new to Wall Street, but that doesn't mean that investors can't protect themselves.
The unfairness of the markets has been racheted up of late, Cramer told viewers. As if the self-induced great recession wasn't bad enough, Wall Street came up with the flash crash of 2010, and more recently, the hideous Facebook (FB) initial public offering in 2012, as two more examples of why investors should take just their money and go home.
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Cramer said Facebook could have been a wonderful opportunity to lure investors back into stocks, but instead, greed took over, sending the IPO into total chaos and overvaluation. The "flash crash" was also an embarrassing black eye for the markets, he said, as it proved to the world that no one on Wall Street, and especially the regulators, has any idea what's actually happening.
Then there are the scandals involving fund managers gone wild, cases like Raj Rajaratnum and Bernie Madoff, which all but prove that the game is rigged against the little guy.
Cramer said scandal can't be stopped and there will always be down markets, but by following just a few simple rules, investors can have a fighting chance.
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His first rule: Know what you own. He said by knowing what you own and why you own it, investors can see events like the flash crash as an opportunity to buy more, and they certainly won't be duped into buying an overhyped IPO like Facebook or the unrealistic returns offered by Rajaratnum and Madoff.
Questions like, "How does this company do?" and "How do they make money?" go a long way, said Cramer. How can you ever know to cut your losses if you don't know why you bought it in the first place?
Don't Buy on Margin
Cramer's next lesson on investing: Never buy stocks on margin. Cramer said that unlike homes, which provide you a place to live while you pay the mortgage, stocks are nothing more than pieces of paper, and that makes borrowing money to own them just dangerous. He said that while margin can allow you to make a little bit of money go a long way, it's also a great way to wipe yourself out in the blink of an eye.
Lesson number three: Never use market orders. Cramer explained that market orders are when you call your broker and tell them to buy or sell a stock without naming a price. "Would you go to the supermarket and say I'll buy this lettuce at any price?" Cramer asked. Of course not.
Cramer said the limit orders, where you tell your broker what price you're willing to pay or sell for, are the way to go. In a case like the flash crash of 2010, where stocks were inexplicably falling for no reason as the machines went haywire, Cramer said limit orders would have prevented you from selling a stock for half of what it was actually worth. He said the limit orders are how you protect yourself from getting hosed.
You Can Own Too Many Stocks
Cramer outlined four more rules that he said will help investors from losing more money than they have to. First up, never own too many stocks.
Cramer explained that individuals are not mutual funds, and they should never own more stocks than they have time to research and understand. Homework takes time, and investors should commit to spending at least one hour per week for every stock then own.
"There's no good reason to own 30 stocks when 10 high-quality stocks will do just as well," he explained. Having 20 stocks in a portfolio is equivalent to having a part-time job, he said, and that's more effort than most home gamers can muster.
Second on Cramer's list: Don't own too many low-dollar stocks. Cramer said while speculation is a good thing, stocks trading at less than $10 a share are by nature risky and no portfolio should have more than one. "No company's stock falls below $10 because things are going well," he reminded viewers. Single-digit stocks can fall to zero, he said, and take your portfolio with it.
Cramer's third rule: Diversification. Cramer said he cannot preach enough the importance of diversification in a portfolio. He said no more than 20% of any portfolio should be in a single sector. "Just ask the people who doubled down on tech in 2000," he said, "only to lose it all." By staying diversified, even if some stocks go down, others may go up and save you.
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Cramer's final rule: Dividends. Cramer said most people don't realize the importance of dividends, especially when the markets are getting killed day after day. He explained that when stock prices fall, dividend yields go up, making them more compelling to investors. This "cushion" helps stocks paying dividends go down less, and rebound quicker. "Accidental high yielders," as Cramer calls them, should be a part of every investors' portfolio.
"Stocks go down for many reasons that have nothing to do with the underlying companies," Cramer told viewers, as he explained how understanding risk is also an important lesson in investing.
Cramer explained that in the old days, if a company did well its stock was rewarded; if it didn't, its stock fell. But in today's global market, with ETFs, futures and high frequency trading, this is simply no longer the case. Cramer said that makes understanding why the your stocks are falling crucial.
Cramer said in a really tough market it seems like all stocks are trading in lock step, with the good, bad and the ugly all heading lower. Why is this the case? Cramer said it's because ETFs and hedge funds, along with the futures markets, have turned stocks into commodities, baskets that can be traded at will, despite the underlying fundamentals.
But, Cramer noted, when the selling is done and the panic is over, the fundamentals begin to matter again, which is why stocks with great fundamentals are important. He said the "paper risk," or risk that stocks can go down for any reason, is always present in today's market, and investors need to be aware.
Cramer also warned against risks from short-sellers. He said when the Securities and Exchange Commission discontinued the uptick rule in 2007, it allowed short-sellers to gang up on stocks like never before. He said short-sellers have contributed to the failure of banks in 2008 and are at it again, selling European bonds.
Then there are also the double- and triple-levered ETFs, the ones Cramer has railed against many times in the past. He said these funds serve no purpose but to allow big money to make quick gains at the expense of the rest of the market. He said funds like the UltraShort Financials ProShares (SKF) have cost uninformed investors big money because they don't work as advertised.
Cramer said his bottom line is that stocks are not cash, and they don't act that way. Investors need to be aware of market risks, paper risks and the risks of short sellers, before the invest their nest eggs.
You're on Your Own
Cramer said his final words of warning to investors in this choppy market is to always remember that there is no lifeguard on duty at the Wall Street pool. He said the SEC, which should be working to level the playing field and protect individual investors, isn't doing its job.
Cramer said the SEC seems to favor the big money hedge funds and the high frequency traders who turn over their portfolios 11 times a second, over the home gamers trying to invest their 401(k)s.
He said today's SEC bears little resemblance to the Arthur Levitt SEC from 1993 to 2001. He said during that era, the SEC worked hard to make the markets safe for individuals. But under the laissez-faire Bush-era SEC all that changed, and President Obama has done little to roll back the the damage.
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Cramer said the SEC does not "have your back" when it comes to investing your IRA or 401(k). He said investors need to protect themselves from the Bernie Madoffs of the world who offer returns that truly are too good to be true. He said the technology has outpaced the human's ability to deal with this newfound firepower. "We don't have to like it," he concluded, "but we do have to get used to it."
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-- Written by Scott Rutt in Washington, D.C.
To email Scott about this article, click here: Scott Rutt