From the market low of 6,433.27 in 2009 (at the end of the recession) through 2018, the markets had a fantastic ride. The Dow Jones Industrial Average had gained more than 258%—up some 16,000 points since then. As you can see from the following chart, the ride has not been without periods of volatility (including the sweeping highs and lows of 2018).
After the initial rebound following the recession, the market nosed down in the last half of 2011, again in 2015 and 2016, leaving investors wondering if the bull market was coming to an end. Of course, it wasn’t, and the markets have continued to set new highs since—albeit with some significant volatility, especially in 2018.
I’m no soothsayer, but here at the Financial Freedom Federation, we always pay attention to the markets. We can’t predict tomorrow, our fellow analysts are really good at interpreting market signals, and they saw the environment at the end of 2018 and early 2019 as a time to remain defensive in your portfolios.
As well, the expert contributors to my newsletters are investment pros with decades of profiting during wild market swings. In every issue, I include a sampling of their market views, including this one from Jon Markman, editor of Tactical Options, from one of my recent issues.
“Time to Trim Riskier Options. A combination of fast-rising bond yields and continuing trade fears has stirred investors to cut riskier stocks from their portfolios, who are worrying that the huge profit margins among many of these companies will fall.”
Jon was talking about rebalancing portfolios, a very important strategy to combat volatility.
We all love it when the markets go up, up, up, but inevitably, they also go down. And when that happens, many investors gather at one of two extremes: 1) Cash in everything; or 2) Do nothing. And both of those are usually the exact wrong moves during downturns.
Most investors who sell out of their portfolio will miss out on the up days and will get back in way too late to take maximum advantage of the market turn (which always comes!). And those who “stay the course” during the down days will needlessly suffer the emotional stress of what can be a very wild ride.
After my years in the investing world, I’ve decided that it’s just human nature—we hate to plan. And that avoidance makes us love to buy stocks and hate to sell them. When the market is in an upward trend, we often become so excited that we begin to buy stocks, willy-nilly, with no thought to a balanced portfolio. And when the market drops, we become frozen, not knowing whether we should continue to buy more, to take advantage of the lower prices or just bail out and sell everything.
The result is usually this: When under pressure, investors will generally make exactly the wrong decision!
So, it just makes sense to realize that what goes up must come down, and while my newsletters are all about finding fabulous—and profitable—recommendations for our readers, we would be remiss if we didn’t also offer ideas to protect your portfolios, in times of pullbacks or excessive volatility.
Bottom line: You don’t have to make the same mistakes mentioned above. Instead, with a little thought and planning, you can create an all-weather portfolio.
In 2018, investors saw some huge market swings. And in such volatile markets, it’s more important than ever that investors not only consider investing for gains, but also invest in protecting their existing portfolios.
Planning is no guarantee that you won’t ever lose money, because there are no guarantees in the stock market. But there are steps you can take to minimize your losses and also maximize your profits.
Step #1: Setting Price Targets
Set a price target the day you purchase your stocks. Your target should be based on the P/E of your stock, multiplied out by expected future earnings. I recommend that you at least think about what price your stock can achieve within 18-24 months. And that should at least be a 30%-50% gain. If it doesn’t have that potential, keep looking.
Going forward, when the stock hits your target, reevaluate it and determine if it has the ability to continue double-digit price gains or if you would gain more by cashing in now and using those funds to purchase a different stock with more potential. Many of the contributors to my newsletters make this decision easy for you, by providing targets for their recommendations, and often cash in just a portion of the holding to take some profits and let the remaining half ride toward a new target.
When I speak at Money Shows across the country, I am frequently asked about how I set my target prices. If it’s not the most common question I get, it’s certainly up there in the top five.
First of all, I can’t emphasize too strongly that it is essential to set a target at the time you buy a stock. If you don’t, then how the heck do you know when your stock has appreciated enough to sell it?
I always ask my workshop attendees how many set price targets on their stocks, and I never see more than two or three hands go up. That’s a shame, but I think it’s because folks just don’t know how to set targets, rather than them not wanting to. So, let me tell you how I do it. But keep in mind that, like all investing, it is not black and white. It’s a combination of science, art and experience. Most of all, it’s easy! No complicated math here—just a few assumptions.
Let’s walk through an example step-by-step. For this example’s sake, we’ll set your holding period at three years, max.
You’ve done your research and have selected the stock you want to buy—the Widget Co. The price of the stock is $10 per share, the company made $2 per share in the last four quarters, so its price-earnings ratio (P/E) is 10 divided by 2, or 5.
The company’s earnings have been increasing at a 20% annual growth rate for the past five years. With a little calculation, you can project out over the next three years, and if that same growth rate continues, the company’s earnings will look like this:
Year 1: 2.00 x a 20% increase = $2.40 per share
Year 2: 2.40 x a 20% increase = $2.88 per share
Year 3: 2.88 x a 20% increase = $3.46 per share
So, at year 3, your company is earning $3.46 per share. Now, if its P/E ratio remains the same (5), the projected price of the shares can be found by mere substitution into the P/E equation, and solving for P:
P divided by E (3.46) = 5. So, a little algebra later, P = $17.30. Wow—that’s a 73% gain! Most investors would be tickled pink by that.
However, should you believe that the company’s earnings may grow even faster than 20% annually, due to some event such as a tremendous new product, gains in market share, new markets, etc., or that one of those occurrences might drive the company’s price greater than $17.30 (even without the requisite earnings growth), you would be even happier.
To be on the safe side, it’s also smart to calculate what would happen should the Widget Co. not grow as quickly over the next three years as it had for the past three.
Easy as 1-2-3, right? OK, it’s time to practice this exercise. I’ve shown you each step of the process in the following worksheet (Figure 23), so you can see exactly where I got the data and how I’ve come up with these projections.
Figure 23: Price Targets Worksheet
Now, you can substitute those results into the following equations to obtain the projected price of the company’s stock in three years:
Expected Price = Current P/E x Year 3 EPS projection $_17.30____
Expected Price = Current P/E x Year 3 EPS projection $_19.55____
Expected Price = Current P/E x Year 3 EPS projection $_15.60____
And there you have it!
So, now you can use a similar methodology on all of your stocks. But remember, the targets are a result of the projections you estimate, and if you alter those estimates—even a little—you will change your results. After all, I did say investing was also an art!
I hope you’ll have some fun with this and also share it with your fellow investors. I think setting a target is one of the most important ingredients for success as an investor. The process will make you very familiar with your holdings, teach you to be disciplined, and help you determine when to sell your stocks.
Step #2: Setting Stop-Losses
Set a stop-loss limit the day you purchase your stocks. For aggressive investors, the stop-loss could be 30% or more. For more conservative investors, you might be happier with a stop-loss of 10%. The actual percentage is not as important as being disciplined in exercising the stop-losses. Sure, no one likes to lose money, but a stock riding momentum down can clean you out in no time, so it’s best to take your losses. If the stock bounces back, you can always buy back into it. Many of our advisors provide stop losses for you, but it’s always a good idea to consider your own investing strategies when setting your stop-losses.
A stop-loss is simply an order—either formally placed with your broker or a ‘mental’ reminder—to sell your stock when it reaches a certain price threshold.
It’s painless to place when you buy your stock through your broker’s website, or, if you prefer, you can just set an alert on whatever portfolio tracking website you use, so that if the stock reaches that price, you can make an instant decision on whether to cut it loose or keep it. That’s what I call a ‘mental’ stop.
I’m a big believer in stop-losses for one simple reason: If your stock doesn’t go the way you think it will (up, in most cases!)—for whatever reason—this little tool will limit your potential losses.
Sure, it’s true that if you’re diligent in the use of stop-loss orders, you can be stopped out of what could turn out to be a very good stock. But you know what? You can always get back in, and more importantly, stop-losses can also save you money—as well as lots of sleepless nights—if market or industry forces cause your stock to take a nosedive.
The actual percentage you set is up to you, according to your personal risk tolerance. Very conservative investors may want to place their stops at a level that is 10%-15% below their purchase prices. Moderate risk takers would probably feel most comfortable setting stop-losses at 15%-25% below their buy prices. And aggressive investors who have a longer time frame and the ability not to panic at short-term losses, may desire to set stop-losses at 25%-35% of their purchase prices. To easily determine your risk tolerance, use my Investor Profile Survey available at https://www.surveymonkey.com/r/S558Q3Z.
Here’s how it works: If you buy a stock at $3.00, and use a 20% stop, you would be stopped out at $2.40 (20% or $0.60 less, in this case, than you paid for it).
In normal times, I often find that a 20% stop is sufficient for most stocks; up to 35% if the company operates in a fairly volatile industry.
But in a bull market, you may want to use trailing stops—stop-losses that continue to move up as your stock rises—rather than stops based on the absolute value of your purchase price. A trailing stop is more flexible than an absolute stop, as it continues to allow you to protect your portfolio in case the price of your stock declines. But as the price rises, the trailing stop is based on the new price, helping you to lock in your gains and reduce your overall risk.
It works this way, using the above scenario: You buy a stock at $3.00 and place a 20% trailing stop. If the stock falls to $2.40, you are stopped out. But let’s say it rises to $3.50. Your new stop would be 20% of $3.50, or $0.70. So, if the shares then fall to $2.80 ($3.50-$0.70), your stop will kick in. But now, you see that instead of losing the $0.60 that you would have with the absolute stop, you only lose $0.20 (your original investment of $3.00 minus the stop price of $2.80).
There are plenty of advisors who don’t believe in stops. But I believe wise investors should use all the credible tools at their disposal. And I have found that stop-losses have worked very well for my subscribers and are a great tool for stemming potential losses.
With technology and biotech stocks—which tend to be more volatile than many non-tech companies—it’s a good idea to set your stop-losses a little wider. For example, with those kinds of stocks, I would usually suggest a 30% trailing stop. That way, if the market just causes the shares to slip a bit one day, it allows you to ride out a temporary drop, without inadvertently cashing out of a company with excellent long-term potential.
Step #3: Diversifying
Diversify your portfolio to reduce your overall portfolio risk, as well as volatility. That means creating a portfolio with non-correlating assets, which, theoretically, results in assets that react differently to market catalysts. When market action causes some of your assets to decline in value, others should rise, effectively providing protection against your entire portfolio declining at the same time.
Consequently, you should own small-, mid- and large-cap stocks; companies in different sectors; and value and growth stocks.
And while you may think you are properly diversified because you have 10 different technology stocks that operate in totally different segments, remember that they are all still technology stocks—companies that tend to do very well when the economy is steaming ahead, and folks have plenty of money to upgrade, but don’t fare as well in a stumbling economy.
You should also have exposure to international stocks, either through owning multinational companies, mutual funds or via exchange-traded funds. See sections 5 and 7. And don’t forget about fixed income investments. In rising rate cycles bonds can be attractive. As well, some investors may want to add currencies, commodities and real estate to their portfolios, as hedges against stock market volatility.
And if you choose to subscribe to my newsletters, with 40 or more recommendations coming your way each month in Wall Street’s Best Digest, you won’t have any problem choosing stocks from almost every industry to help you diversify your holdings.
Of course, the actual composition of your portfolio will depend on your personal investment goals, your age, and your risk profile, so make sure you know the kind of investor you are so that your portfolio will match up to your goals.
Step #4: Dividends
Put some dividend-paying stocks in your portfolio. See section 3. They are a great hedge against inflation and provide terrific portfolio gains in down market cycles. Years ago, during the tech boom, I began adding dividend stocks, such as regional banks and Real Estate Investment Trusts to my portfolio. The payoff was great! When the tech stocks hit the dust and the market took a downturn, I was still earning some great returns on my dividend stocks. Many investors neglect these companies as they think they are too boring. But, what’s boring about making money?
With so much cash available to companies over the past few years, stocks from every genre—including technology and emerging markets—will often pay a dividend. And that just adds to your profits.
Step #5: Rebalancing
Rebalance and reposition your portfolio. This is a step that so many investors ignore—to their peril. During the tech boom of the early 2000s, technology companies were chased to the stratosphere by investors who had no idea what they were buying; they just saw triple-digit overnight gains, and jumped right in. But the signs of the bust were everywhere. I saw price-equity ratios as high as 1,500.
Tellingly, Warren Buffett stayed out of the fray, cautioning investors not to buy “what they couldn’t explain to their grandmothers”. I interviewed a founder of the Real Estate Investment Trust industry during those heady days and asked him if he was buying any properties in the Silicon Valley area. He laughed, and said, “No, I wouldn’t touch them with a 10-foot pole. Companies in the high-tech corridor have no cash; they want to pay rent with their stock options!”
So, pay attention to the sectors in your portfolio, too, and load up on steadier stocks in more mundane industries during periods of volatility, while trimming your positions in riskier assets. Taking a flyer on speculative stocks is often a lot of fun, but it’s best to keep those to a small portion of your holdings—especially during erratic markets.
Step #6: Options
Consider buying put options as insurance in case any unrealized gains you have don’t turn into losses. As I mentioned in section 10, these options provide protection by betting that the underlying stock will decline. They give you the right (not the obligation) to sell the stock at a certain price at a specific future time. Most investors don’t use options, because they can be expensive and complex and have a reputation as risky. As well, employing options requires a more-active style of portfolio management that many investors do not want to undertake. But simple options can also help protect your portfolio on the downside and also improve your returns in a bull market.
There are additional methods for portfolio protection, including trading the VIX, a volatility index, which trades at a low price in steady markets and increases in value in volatile times. And leveraged ETFs have also found a spot in portfolios in which investors are seeking protection against downside risk. However, both of these protections are best left for more experienced, sophisticated investors who are willing to be active managers of their portfolios.
Wrapping it All Up
For most investors, following the above six steps will help you create a portfolio that will thrive through normal up-and-down market cycles. While an undiversified portfolio can give you tremendous gains—IF you are lucky enough to choose only “home-run” stocks—the plain truth is investors, individual or professional, don’t have a crystal ball. And stocking your portfolio with just one type of company or sector—no matter how promising—is a recipe for failure, long-term.
Do yourself a favor and take advantage of the tools that are available. With today’s technology, it’s never been easier to take command of your investments.