The Basics

Staying Calm When the Market Pushes the Panic Button

One of our favorite ways to judge current sentiment in the market is an index that tracks the Chicago Board Options Exchange. It’s known as the Volatility Index, with the U.S. ticker symbol VIX. The Volatility Index is constructed using a wide range of options, including puts and calls, on the S&P 500 index, and it indicates what the market is expecting in the way of 30-day volatility.

The VIX is also known as the “fear gauge,” although we prefer to think of it as the pulse of the market. It races when investors get scared and slows down at calmer times. Options get more expensive when investors become fearful about the market, and they get cheaper when investors become more optimistic. People buy options to reduce risk, and that’s the basis of the way the VIX trades. It’s similar to insurance rates, which go up when the insurance company thinks there is a bigger risk.

For example, if stock in company ABC is at $10 a share, and investors don’t think that ABC stock will have much volatility in the near future, any given (hypothetical) ABC option could be trading at $2. But if there is important news that could affect company ABC, such as possibly being taken over by another company or having a major drug approval by the FDA pending, the same exact option could be trading at $4 instead of $2, as the implied volatility goes up.

You can actually invest in the VIX by purchasing shares in an ETN (exchange-traded note) called the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX). The investment seeks to replicate, net of expenses, the S&P 500 VIX Short-Term Futures Total Return Index. The index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500 Index at various points along the volatility forward curve. (The index futures roll continuously throughout each month from the first month VIX futures contract into the second month VIX futures contract.) When you buy shares of VXX, you’re expecting the market to increase its volatility, and you can actually benefit on days when your other holdings might be declining.

On May 6, the VIX lived up to its nickname as the fear gauge, when the U.S. market had its biggest intraday drop since 1987.  Fears about the spread of Greece’s debt problems led to escalating losses in all the U.S. stock indexes, which accelerated as the day went on, aided by automatic electronic trading. The VIX climbed more than 60% just before the stock indexes plunged briefly as much as 9% before climbing back to losses under 4%. Shares of VXX didn’t climb as much, but they did gain more than 30% at one point before retreating.

For those whose portfolios showed wild declines during that afternoon, owning shares of VXX was a certain consolation. At least something in the portfolio was going up as fast as other shares were going down.

Volatility can work both ways, of course, and just days after the market’s intraday plunge, the benchmark indexes for U.S. and European stock options both headed for record drops after Europe’s leaders unveiled an almost $1 trillion loan plan to end the region’s sovereign-debt crisis, and global stocks soared. The cost of options dropped as optimism rose, and the VIX fell 32 percent to 27.67 as of 10:16 a.m. in New York, retreating sharply after its record weekly gain the previous week. And so those who had been happy the previous week with their VXX shares watched them go down, but they had the consolation of the rest of their portfolio going up.

It wouldn’t hurt to own some shares of VXX during volatile times, but we find the VIX most useful as a gauge of market sentiment in the near future rather than as a way to take out insurance for our portfolios.

May 13, 2010 • The Basics

The Secret to Safe and Easy Portfolios

We’re going to reveal one of the best-kept but most important secrets of investing. This is one that most brokers and fund managers would prefer that you not know.  It’s simple, it’s easy, it’s safe, and it’s cheap. It’s used by some of the richest people in the country.

Here it is: Index Funds.

The best way to diversify, minimize risks, and limit your expenses is to buy index funds or ETFs (exchange-traded funds) that allow you to equal the performance of the market. And that’s something that hardly any active mutual fund managers have been able to do over a long period of time. (By active, we mean funds that are not simply tracking an index.)

To learn what we mean by indexes, go to our previous workout called How Are We Doing, which explains the different benchmarks used to track the performance of the market, such as the S&P 500. You’ll be using these indexes to build your quick and easy portfolios.

The Lazy Woman’s Portfolio

This basic portfolio of three funds has been called by various names: the Margaritaville portfolio, the Coffee House portfolio, and the Couch Potato portfolio. These names indicating the small amount of time and concern expended in this investment. We prefer to call it the Lazy Woman’s Portfolio, which is no insult to those who prefer to take this shortcut to investing. It’s more likely that those who prefer this simplified approach are simply too busy to take more time with their investments. Or they might prefer to be having a massage. Whatever.

Most variations of this portfolio have three funds: a total market index fund, a total international index fund, and a total bond index fund or a treasury-bond index fund.

We’ve used funds from Vanguard, which is widely regarded as the powerhouse of index funds. It has a sterling track record, and its expenses are minimal.

You’ll need a minimum investment of $9,000 to create this portfolio. (Vanguard requires a minimum investment of $3000 in order to buy a fund.) If you don’t have $9,000, start with one fund and then add the others as the money becomes available.

33% Vanguard Total Market Index Fund (VTSMX): $3,000
33% Vanguard Total International Index Fund (VGTSX): $3000
33% Vanguard Total Bond Fund or Vanguard Inflation-Protected Securities (VIPSX): $3000

This ultra-basic portfolio gives you exposure to the total array of stocks in the U.S. market, as well as exposure to the other important world markets. You can choose either the index of relatively safer inflation-protected securities (the Treasure bonds called TIPS) or a more volatile index of the total bond market. During a bull market, you’ll be resenting those dull, boring bonds. But during a downturn, you’ll be glad you have them. 

The Slightly Less Lazy Woman’s Portfolio

For a slightly more diverse approach, based on portfolios followed by a number of institutional investors, including Ivy League universities, we have a six-fund portfolio that gives you exposure to the key indexes in the world and U.S. markets. It includes exposure to U.S. Treasury as well as corporate bonds.

15% Vanguard 500 Index (VFINX): $3,000
15% Vanguard Extended Market Index (VEXMX): $3,000
15% Vanguard Emerging Markets Index (VEIEX): $3,000)
15% Vanguard Complete World Market Index (VGTSX): $3,000
20% Vanguard Complete Bond Market Index (VBMFX): $4,000
15% Vanguard Inflation-Protected Securities (VIPSX): $3,000
Bonus: Add the Permanent Portfolio Fund (PRPFX): $1,000

This portfolio would cost you a minimum of $16,000. And if you’re a more aggressive investor, willing to take more of a risk for a higher return, you can get exposure to the volatile real estate market by adding $3,000 to the Vanguard REIT Index (VGSIX).  We recommend an addition to this portfolio outside the Vanguard family. This is the Permanent Fund (PRPFX), which has a conservative mix of treasuries, gold, and Swiss francs. It’s a no-load fund (no front-end cost) with a minimum purchase of $1,000.

The Other Great Secret

Once you’ve established your basic portfolio of index funds, you can use the other great secret of investing to build on it: dollar-cost averaging. Vanguard and other mutual-fund companies will allow you to add monthly additions to your funds with as small an amount as $50. You can arrange for your monthly contribution to be automatically drawn from your bank account, so you won’t notice the pain. And the great advantage of buying in regular small amounts, through thick and thin, is that you’re buying when the price is down as well as up. You won’t be driven by emotion, and your portfolio will continue to grow. Those of you who have gardens know about the value of patience. It may take years for your planned garden to fill out and become lush and green. But it’s worth waiting for.

The Bargain-Basement Version of the Ultra Deluxe Lazy Woman’s Portfolio

We love to buy designer-quality clothes at bargain-basement prices, without having to fight the crowds at Century 21 (that’s the fabulous bargain-crazed store in lower Manhattan where we’ve purchased some world-class designer items at fire-sale prices). And so we also love the fact that we can put together a very inexpensive version of the index portfolios used by some of the country’s wealthiest families and institutions. And the way we do it is by using ETFs, the relatively new exchange-traded funds that track indexes, sectors, etc. You can buy an ETF for as little as the cost of a single share, though obviously, that would be a little silly, given your transaction fee. (We recommend a minimum of $500 per ETF to start with, though just get started with whatever you can afford.) You can purchase ETFs the same way you do stocks. We’ve looked at the model portfolios used by the leading money managers and financial advisors in the country and put together what we think is the best of the best and then tweaked it very slightly to make it even better.  We’ve included a closed-end fund for an exposure to gold and silver, but it’s purchased in the same way as an ETF. And we’ve just added an optional ETN (exchange-traded note that trades like a stock) that allows exposure to commodities. We think that because of growing demand from developing countries for basic commodities, from agriculture to metals, the demand for commodities is going to remain high indefinitely.

20% ishares Russell 1000 (IWB) or ishares S&P 500 (SPY) or ishares KLD Social Index (KLD)
15% Vanguard Extended Market ETF (VXF)
20% ishares MSCI EAFE, Diversified Foreign Stocks (EFA)
10% ishares Emerging Markets (EEM)
5% Vanguard REIT (VNQ)
10% iShares Lehman TIPS Bond (TIP)
15% ishares Corporate Bond (LQD) or iShares Lehman Aggregate Bond (AGG)
3% Lehman Short-Term Treasury Bonds (SHY)
2% Canadian Central Fund, gold and silver (CEF)

Please note that we have added KLD, a “green” alternative ETF to the major indexes tracking the Russell 1000 or the S&P 500. We find that the KLD Social Index performs as well as the S&P, and you get the added advantage of sleeping better at night. (See the workout on green investing for further information.)

For added zing, add the Elements Exchange-Traded Note based on the Rogers Commodity Index (RJI), established by commodities guru Jim Rogers.

Important Note: These percentages are based on an investor forty years old or younger. If you are older than forty, and particularly if you are even thinking about retiring within a few years, you should up your percentage of bonds!!!!!!

February 01, 2010 • The Basics

Lessons in Trend Watching: A New Culture of Thrift?

The crash in the economy that began at the end of 2007 has created something many of us thought we’d never see: a culture of thrift. Neither a borrower nor a lender be, as Shakespeare’s Polonius put it. And that should influence the way we look at stocks.

The U.S. consumer has put the brakes on spending, and it looks as though the American way of living on debt may be changing. Evidence? U.S. consumers reduced their debt for the seventh straight month in August, according to the Federal Reserve. Total seasonally adjusted consumer debt fell $11.98 billion, or at a 5.8% annual rate, in August to $2.46 trillion.

Consumers have retrenched since the financial crisis hit in full force last September. Credit has fallen in every month except January. Economists surveyed by MarketWatch expected consumer credit to decline by $12.5 billion. In the subcategories, credit-card debt fell $9.91 billion, or 13.1%, to $899.41 billion. This is the record 11th straight monthly drop in credit card debt. Non-revolving credit, such as auto loans, personal loans and student loans fell $2.10 billion or 1.6% to $1.56 trillion.

What’s more, that trend should be reinforced by the ongoing hemorrhage in jobs that we’ve witnessed. The 7.2 million jobs lost in the recession won’t return until 2012 or beyond, according to a new survey of top business economists. Economists surveyed by the National Association for Business Economics said any recovery is likely to be so gradual that these jobs won’t return to the labor market for three years.

Even with the increase in savings and decrease in credit card debt, the country is still burdened with massive debt, which will work like a ball and chain on growth for many years.

We can’t look to Baby Boomers to spend us out of this situation, as they have in the past. For one thing, they’re exiting their peak earning years, and they are worrying like crazy about retirement after watching their savings and retirement accounts shrink with the downturn. They’re not likely to be going on many spending sprees except for necessities.

We’ve seen not only a decline in affluence, but a decline in “aspirational” affluence, in which consumers borrow to buy big-ticket items beyond their means.

October 12, 2009 • The Basics

What Do You Do with a Winner?

After the market has gotten such a battering, it’s a relief to talk about what to do when you have a winner in the market, a stock or ETF (exchange-traded fund) that has gained substantially since you bought it. Fortunately, we do have several of these in our Fairest Shares portfolio. Do we just let them ride, hoping they’ll keep climbing?

Well, it depends. Do you think the company still has potential for growth, or has it begun to slow down in its momentum? Is the market about to head south? Many investors have a rule of thumb that when their initial investment doubles, they sell enough shares to cover at least the initial cost of the investment, or the “nut.” That way, any further gain is pure gravy, and you’re sure not to lose. Another strategy is putting in a stop loss that will follow the price of the stock upward. That’s called a trailing stop loss. Again, you’ll be making sure not to let your gains fade away if the stock starts dropping.

Here’s an example. Let’s say that we bought 100 shares of Acme Rocket at $5 a share, and the shares begin to rocket upward, going up to $10 a share. Each time the stock made a gain, we changed our stop loss to reflect the gain. When it went up to $6, we could have put in a stop order at $5.40, ten percent below the stock price, so that we wouldn’t lose our gains. Then when it went up to $7, we’d put in a stop order at $6.30, again ten percent below the current price. And so on. If you need a refresher in using stop losses, look at the section on how to sell a stock here in the Investment Gym. You can put in a simple stop order, or you can use a stop limit order, specifying the lowest price at which you’ll be willing to sell the stock. 

May 05, 2009 • The Basics

Starting an Investment Practice: It’s Time

A friend wrote today and said she was ready to start an investment practice, and we were delighted. She was thinking about investing in the way we usually do about starting an exercise program or a meditation practice, which means setting aside some time and mental space for self improvement. Thanks, Ann, for helping us put what we do in that thoughtful perspective.

For many, many women (and men, too), who are feeling frazzled, afraid or insecure about their money, their savings or retirement accounts, it’s time to start an investment practice. What does that mean? First of all, it means deciding that we’re no longer going to put off or avoid thinking about our investments in the way we put off going to the dentist or getting a medical checkup.

It’s time to start taking charge of an area of your life that is as crucial for your health, happiness and well being as your weight, your cholestrol or your self esteem. And it can actually be a lot more fun than going on a diet or getting on a treadmill.

Yes, you do need to look at your investing and retirement accounts to understand exactly what you have and what you’ll need to do with what you have in order to get the best returns. If you are using an investment advisor or money manager, it’s time to schedule an appointment to talk to them and get a complete explanation about where you stand.

Before you do that, however, take time to familiarize yourself with the basic terms of investing. You’d be surprised how many folks don’t know a stock from a bond. Click on the button on our home page that says “Free starter kit” and you’ll be on your way to understanding the basics of investing. Then look on the lower left side of the home page and click on the section that says “Basics.” Browse through these easy-to-read sections that cover the basics in a little more detail, including how to buy and sell a stock.

Start watching companies whose stock you may already own, or which look promising to you. Find the Web site for that company and read all about it. Then look up the company on the Yahoo finance page or another source that you may prefer, and learn what the analysts think about the company. Look at what competition or problems the company may be facing, or what advantages it may have over other companies in its field.

Start a dummy portfolio on the Yahoo Finance page, and you can get started investing without having to spend a penny. Just watch what happens to the stocks you like, without worrying about actual profit or loss. Track how your stocks are doing when compared with the major stock indexes like the Dow, the Nasdaq or the S&P 500 (all explained in our getting started and basics sections). You’ll see if your stocks are equaling the performance of the market as a whole.

You’ll also learn the value of “lazy” portfolios, which actually track the market itself. You won’t beat the market that way, but you’ll equal it, and you’ll recover when the market recovers. Here at Woman with Portfolio, we want you to sleep well at night, and we think you’ll be able to doze off more easily when you feel more in control of your financial well being.

March 19, 2009 • The Basics

Bonding with Bonds: Looking Ahead for Safety

This past year has proved to be the year of living dangerously when it comes to investments. There was no place to run and hide, even in the bond market, which usually provides a safe refuge. Although bonds did not decline as agonizingly as stocks, they did take some serious hits. Individuals and fund managers alike were dumping corporate bonds and heading for treasuries.

Bond experts that we respect think that bonds were more oversold than stocks, and that they are currently undervalued. So it may be time to take a look at bonds again. Several diversified bond funds have actually held up fairly well, in large part because of they include treasuries in the mix.

Given the extreme volatility of the stock market, and the historically wide credit spreads in the bond market, the likelihood of another big sell-off in stocks is higher than another big downturn in bonds. So for low-risk investors who are at a stage in their investing when they cannot take more losses in stocks, it could be time to think about investment-grade and high-yield bonds as a substitute for what would normally have been their stock allocation. This is particularly true for those who are close to or already in retirement.

With bonds, as with stocks, it’s crucial to diversify. But it’s difficult and expensive to buy enough individual bonds, with laddered maturity dates, to ensure a safe diversification. So investors looking for a quick and easy way to safety can anchor their portfolios with a fund or combination of funds with low expenses that contain broad exposure to high-quality government-backed, corporate and mortgage-backed bonds with short to intermediate-term maturities.

The cheapest and easiest way to get exposure to a diversified array of bonds is an index fund or ETF (exchange-traded fund). The Vanguard Total Bond Market Index fund (VBMFX) is up nearly five percent this year, and its expenses are as low as they get, at .07 percent of assets. You can get similar exposure through its ETF equivalent (BND) or the Barclays equivalent, AGG.

We have included the Vanguard Total Bond Market Index fund and the ETF (BND and AGG) in our Lazy Woman’s Portfolios.

December 30, 2008 • The Basics

Good News and Bad News: Stock Picking Paradise Predicted

There is some good news to be gleaned from all the bad news we’ve been hearing about the economy. An article in the latest Barron’s predicts that the market is getting so used to bad news that the shock value is diminishing. When bad news is expected, there are fewer surprises. The result is a great opportunity for stock picking, according to the article. And Woman with Portfolio agrees.

Here’s an excerpt from the article:

“In a market where a deep recession has become rooted as consensus, where central banks are flailing very publicly in their fight to fend off disaster, bad news ultimately loses its ability to shock.

The market’s feral swings could persist through the first half, and Dean Curnutt, president of Macro Risk Advisors, thinks three powerful forces will keep investors guessing and stocks volatile: “ongoing and unpredictable government intervention, the process of deleveraging, and the unfolding economic contraction and its impact on corporate profits.” But all three catalysts themselves are now firmly on traders’ radar, and all that scrutiny lessens the sting of surprise.

‘A peak in volatility will coincide with the peak in correlation’—essentially stocks’ tendency to move as one unified block, says Michael Hartnett, Merrill Lynch’s global emerging market strategist. The result, as correlation subsequently eases, is a ‘stock-pickers’ paradise,’ he says. ‘You will see differentiation in winners and losers, and active managers will really outperform.’”

December 22, 2008 • The Basics

Some Cold Comfort with the Market under Siege

A fellow market watcher has revived an old saying from Wall Street that applies very well to current conditions:  the war can only end when the last of the generals have been shot. After the market action of the last few weeks, we can safely say that none of the generals have survived this latest battle.

What that means for investors is that a bear market for stocks won’t end until the only stocks that have been making money (the last generals) have been sold off along with everything else. In this wretched market of 2008, the only stocks making real money were commodity-related companies. And so our own generals, including the agriculture sector, have begun to bite the dust, despite healthy profits.

The customary last refuge, US Treasury bonds, have been bid up so high that they were recently yielding, at under 3.6%, less than the most recently reported inflation rate. There is more cash sitting in money market funds than at anytime in history. There are vast reserves of liquidity stashed under mattresses, though no one is really sleeping well.

So now that there are no safe havens, no sector where investors can make money, what will happen? If history is a guide, all that cash stashed away is fuel for the next rally. Once the stock market starts to move up, everyone sitting on cash will notice that their return is only 2% annually, less than the inflation rate, and the market is making more than that in a day. But a movement out of cash requires a catalyst, whether it’s an end to bad news, the bottom of the credit crunch, or even the drop in oil that has led energy stocks down.

However, bull markets usually begin stealthily, without any obvious catalysts, and despite public pessimism. By the time the public notices that the market is actually rallying off the bottom, it could be six months and 1000 Dow points later. In other words, bull markets begin not because everyone starts buying, but more because the last of the sellers are done dumping their shares.

So what is the best strategy to minimize losses but to be ready when the market actually starts to move up? Our old friends, the index funds, will make sure that you don’t miss the movement back up. And usually it’s the small-caps and mid-caps that lead the way, so you’ll need more than an S&P 500 index. Take a look at our lazy woman’s portfolio to check out some possibilities for diversifying.

September 11, 2008 • The Basics

RISKY BUSINESS: Learning your risk tolerance

Do you like roller coasters, or do you prefer the merry-go-round? If you won a junket to Las Vegas, would you prefer watching a show to rolling the dice? Do you like rock climbing? Or would you rather just bask on a rock while everyone else is sweating it out on the side of the cliff? With investing, as with sports and entertainment, it’s important to know how much risk you can tolerate. Particularly when the market is making just about everyone queasy these days.

First of all, you should know that with investing, as with sports, the same old saying holds true: no pain, no gain. No risk, no reward. The market is always going to have its ups and downs, so if you have zero risk tolerance, you should rethink your plans to get into the market. (As long as you realize the biggest risk of all is outliving your savings and not keeping up with inflation.) You should also know, however, that the market has always recovered from what seemed at the time the worst of blows. Folks who got out of the market after the terrible tragedy of September 11th, 2001, locked in losses and failed to benefit from one of the best buying opportunities of the recent past.

The science of neuronomics has been giving us some interesting insights into the way our brains and emotions work when it comes to investing. We hate losing, for example, even more than we like winning! So if you take on more risk than you can deal with, you won’t sleep well at night, and you might do the kind of things people do when they panic. You might bail out of the market when it’s at a low, when your portfolio is down. And that means you’ll lock in your losses in stocks, bonds or mutual funds that probably would have recovered if you’d just had the patience (and fortitude) to give them time. If you have index funds, which follow various segments of the market, they would definitely recover, as the market comes back up. But not if you panicked and sold at the bottom.

Here’s a little quiz to test your risk tolerance:

1. If the market dropped fifteen percent tomorrow, you would:

a. Sell everything and put your money in cash.
b. Wait and see what happens before taking action.
c. Put more money in, taking advantage of the bargain prices.

2. If you were an animal, you would be:

a. Turtle, slow and steady.
b. Coyote, watching for opportunities.
c. Cheetah, letting it rip.

3. What do you think the future holds?

a. The outlook is scary, and I’m hunkering down for the worst.
b. I’m not sure, but I can cope.
c. I’m a cock-eyed optimist.

4. What is your primary goal in investing?

a. Protecting what I have.
b. Trying to beat inflation.
c. Trying to maximize my gains.

5. If you had to choose between investing in Microsoft, Apple and a CD with a three percent return, you’d choose:

a. the safe CD
b. Microsoft, the steady blue chip
c. Apple, the upstart with the cool stuff

Okay, for each a., give yourself one point. For each b., give yourself two points. For each c., give yourself three points.

If your score is between 5 and 6, your risk tolerance is low to nonexistent, and you should probably stick with Treasury bonds and CDs. If it’s between 7 and 11, you’re ready to take some moderate risks, and you’re ready for index funds. If it’s between 12 and 15, you’re considered an aggressive investor, and you’ll probably want to be investing in individual stocks.

June 29, 2008 • The Basics

Tricks of the Trade, Part II: All About Selling Stocks

We know that parting is such sweet sorrow, as Shakespeare said. But when it comes to stocks, it’s better to remove the rose-colored glasses and forget the romanticism. DON’T fall in love with your stocks.  Most savvy investors will tell you that knowing when to sell a stock is just as important as knowing when to buy it. Investing, like dating, can be emotionally charged, and you might be inclined to hang on too long. Or you might dump a good prospect too quickly.

If you’re working with a broker, financial advisor or money manager, you should be clear about what their guidelines or policies are with regard to selling. And if you’re managing your own investments, you should ask yourself that question as well. Because you might not actually have a clear policy, and that’s a liability.

Here at Woman with Portfolio, we try to minimize our trades in order to cut costs, taxes – and mistakes. One of the fastest ways to cut into your profits is to run up trading costs and capital gains taxes. But on the other hand, we sometimes need to sell. Obviously, in the best of all worlds, you buy low and sell high. The rule of thumb is “let your winners run and cut your losers.” But sometimes that’s not so simple. You also need to decide if the stock is a long-term buy-and-hold, which will let dividends accumulate and build your position in the stock, or whether it’s a short-term stock, which you’re buying, you hope, at the sweet spot, at a price that will increase to a trigger point where you’re ready to sell and take your profits.

So what are the tell-tale signs when it’s time to say good-by to a stock? For a boyfriend, there may be a strange shade of lipstick on the collar. For a girlfriend, an unusual spending spree on new lingerie. For a company, there are several warning signs that can tip you off to changes that may mean the price is headed south.

Be Aware of the Balance Sheet

If the company’s fundamentals (sales, debt, cash flow, etc.) begin to show signs of stress, it may mean something has changed that will negatively affect the stock’s price. In this case, don’t wait for the market to panic over a decline in revenue or another key fundamental. Be prepared to unload the stock while you still have a healthy profit.

Don’t forget the FUD Factor

Sometimes fear, uncertainty and doubt (FUD) affect the market, and your stocks along with it. If your stock is falling along with the market, that’s not enough reason to sell. If its performance is worse than that of the market, that’s a reason to consider selling.

Beware of Bad News or Hype

Bad news can send a stock price plummeting, sometimes permanently, but sometimes just temporarily. Try to decide if the bad news affecting your company is something that will pass, or whether it will have a lasting effect on a company ‘s bottom line. On the other hand, too much good news can sometimes be as bad as bad news. Watch out for hype. If a stock you own becomes a media darling and gets a lot of buzz, it may be time to look at taking a profit. These kinds of stock feeding frenzies attract herd-following investors who bid up prices only to have the market collapse when the hype dies. If you’re not careful, you can watch the price fall right past your profit line.

Selling the “Nut”

Some investors have a rule of taking partial profits when a stock reaches a certain price – say, doubling in price. You can sell a third of your holdings or at least enough to cover your initial investment, so that anything else the stock gains will be pure gravy. It’s also a way to make sure you have some profits locked in.

Using Stop Losses

Many investors set a floor on the stock’s price so that if it falls below a certain level, they sell. Some investors even have a set rule that if a stock falls a certain number of percentage points, that will trigger a sale. The limit can range from 5 to as much as 20%. You can keep adjusting that limit upward as the price of the stock goes up – that’s called a trailing stop. Be aware, however, that there are vulture traders out there who do nothing but try to scoop up stocks that have been set with automatic stop losses that fall within the stock’s trading range. The price may dip down to the limit for just an instant, but that’s enough for the vulture to swoop in and grab it. You can lose a good stock that way.

In order to set up your automatic sale at a certain limit, you fill out a sell order, filling in the “stop” price, meaning that when the stock falls to that price, it will trigger a sale. You then set a “limit” price, meaning the lowest price at which you are willing to sell. We have to warn you that the stop limit strategy can fail when a stock is falling so fast there is no one to buy the stock at your price limit. You can set a time limit for your sale as well, either daily, monthly or “unlimited,” which usually means three months.

You can also set an upper limit that triggers your sale. Let’s say that you’ve set a target price, following the target price set by a trusted analyst, or your own assessment of what the stock should be worth, and you’ve decided that you are willing to sell when the stock reaches that level. The rationale here is that you may be afraid that the stock will have a difficult time supporting a market price above a certain level and any hint of bad news will send the price into a nosedive. However, it’s important to “let your winners run,” so you should keep resetting your upper limit if it looks as though there is further room for growth.

June 23, 2008 • The Basics