Stock Trading Blog
Sometimes holding a portfolio of stocks that you buy and sell just isn’t enough. Whether you’re looking for risk management, higher returns, or just something to add a little excitement to your investment activity, options are a great addition to your investment strategy.
By combining your stock portfolio with a few choice option trades, you can greatly reduce the overall risk to your investments or boost returns to a level that would be difficult to achieve with stocks alone. While many investors think of options as being risky profit-enhancing tools, in actuality they often help reduce risk by providing hedges or allowing speculation on a stock without committing a large amount of capital.
Getting started with option trading
Options come in two forms – calls and puts. A call gives investors the right, but not the obligation, to purchase 100 shares of a stock at a given strike price while a put is an obligation to sell 100 shares of a stock at a given strike price should the put be exercised. To simplify, you buy a call if you’re bullish and buy a put if you’re bearish.
Options can also be sold giving investors upfront cash from the sale. However, this action comes with an obligation for calls and puts. Selling a call means you must buy 100 shares of a stock at a given strike price if exercised and selling a put means you must buy 100 shares of a stock at a given strike price.
One of the first option strategies investors usually practice with is the covered call. In this type of strategy, you sell a call with a strike price higher than the current price of a stock that you already own 100 shares of. This gives you upfront cash but limits your total upside potential should the stock rise above the call’s strike price.
Using options can also make short-selling less risky by using a covered put. For this strategy, you short-sell a stock that you’re bearish on and sell a put at a lower strike price. The upfront cash helps hedge against risk but limits your total profit potential if the stock falls below the put strike price. If you want an even better hedge, you could also buy a call while shorting the stock to limit your losses if the stock moves higher unexpectedly, although this means your breakeven point will require the stock to drop below a certain price.
Not every option strategy requires you to actually own the underlying stock. Other combination strategies involve using just options as a way of speculating on a stock without having to buy 100 shares of it. Others are designed to profit from a stock that’s trading sideways – not moving up or down. Once you start to get comfortable with adding options to your stock investments, you’ll be ready for a more advanced kind of trading that gives you access to even more strategies.
Investing isn’t for everyone. The lure of making money from the simple act of buying a stock and selling it at a high price is hard to resist though. It doesn’t take much time to open up a brokerage account, fund it, and start making moves in the market.
But as with most any activity, trying to play something without having any rules is bound to devolve into a nonsensical endeavor that might result in quitting altogether. But following a small handful of rules can reduce your stress and the amount of risk you take on and help you become the best investor you can be.
10 Rules to live by
Diversify – It’s the most repeated investment phrase for good reason. Diversification means minimizing risk to a single investment and allows for some forgiveness when you make mistakes.
Think Long-Term – Investing isn’t a race; it’s a marathon. Interest works best when it’s compounded over time. Short-term fluctuations happen, but having a long-term goal in mind makes it easier to weather the storms.
Don’t Invest All At Once – Allow yourself to establish a position over time. That will give you a chance to see how the stock performs based on your research and minimize losses if you’re wrong.
Cash Is An Investment Too – Keeping cash on the side may seem counter-intuitive, but it also gives you the ability to invest at a moments notice should you find a time-limited opportunity.
Homework Is Key – Successful investing means putting in the time to research stock picks before you buy. Due diligence means understanding the stock’s financials and plans for the future that will result in a higher stock value.
Buy What You Know – One of the most common mistakes investors make is investing in stocks they don’t understand. If you don’t know how a company makes money, you can’t honestly say whether a company will earn more or less in the future.
Cheap Isn’t Good Enough – Buying a stock simply because you think it looks cheap is a poor reason to invest. You need to be able to explain why the stock will go up in price.
Stick To The Plan – Investing takes strategy. If you’re a conservative investor focused on steady income stocks, it doesn’t make much sense to buy a high growth tech company, even if you think it’s a good buy.
Don’t Panic – No one makes good decisions when they’re panicking. Down markets and sell-offs are scary for any investor, but keeping calm could mean that you end up buying valuable stocks at a cheap price instead of selling on a whim and losing money.
Pigs Get Slaughtered – There’s a saying on Wall Street, “bears make money, bulls make money, and pigs get slaughtered.” Basically, it means that once you achieve the profits you anticipated in a stock, it’s time to get out before you lose out. If you’re still bullish, you can always just cash out your initial investment leaving nothing but your profits at risk.
Now that you have a base to go on, you can start adapting your own rules as they come up. Lessons are best learned through practice as you’re bound to hit a few speed bumps along the way. But as long as you stick with these 10 simple rules, you should be equipped to handle Wall Street.
Value investors pride themselves on being able to identify out-of-favor or misunderstood stocks and take advantage of its price difference relative to its intrinsic value. Oftentimes, this means buying a stock near a 52-week low or after a sustained drop in price. But timing is everything – buy too late and you’ve missed out on the rebound, buy too soon and you could lose money or be forced to wait longer than anticipated.
Value investors can get fooled into buying too early if a stock begins to climb after a recent fall. In an effort to hop on board before the stock completely recovers, value investors may be tempted to buy as soon as a stock shows positive gains again. But all too often these stock recoveries are only temporary and value investors that jump the gun are left with a falling stock price and an unknown recovery time.
The market is a trickster
The stock market may behave in certain patterns, but it’s not always easy to see what those patterns are and what path the market will take before a cycle can be observed. Corrections are a normal part of the market’s life-cycle as are long periods of sustained gains. Bear markets can creep up unexpectedly as well making it challenging to accurately predict when a correction is just part of a normal bull market or the beginning of a bearish reversal.
One of the biggest illusions in the market is the ‘dead cat bounce.’ This is when a stock shows positive gains after a recent decline but quickly sheds those gains to resume its downward momentum. Many investors have fallen into this trap only to realize too late that they’ve bought into a false premise of recovery.
Investors worried about getting caught in a ‘dead cat bounce’ need to look for the signs that a recovery may be just an illusion. One of the most common reasons for the temporary spike in value after a decline is short covering activity. Investors that bet against the stock by selling it short need to buy back their shares in order to close out their positions. This buying activity can boost the price of the stock for a limited time before the underlying fundamentals that contributed to the original decline take over again.
The key to avoiding the ‘dead cat bounce’ trap is sticking to your initial analysis of the stock. Stock prices move up and down for a number of reasons, many of which have nothing to do with the actual value of the underlying company. If you see a possible value play and understand at what price the stock should be purchased, then you shouldn’t be tempted to buy before the stock hits that level.
Patience is one of the hardest things to learn as an investor. A stock on a value investors watchlist that suddenly starts to reverse course can send the message that ‘it’s now or never.’ One of the most repeated phrases on Wall Street is that “no one makes money by panicking.” Trust the fundamentals and don’t let other investors fool you into making a mistake.
There’s no lack of economic indicators for investors to look at when it comes to gauging the current health of the economy. From unemployment figures to GDP estimates, investors have access to virtually any type of data they could want. But one of the most under-represented indicators is the 10-year treasury yield.
The yield on the 10-year treasury is used as the basis for interest rates in the US. Investors can use it to track historical trends and easily determine if rates are rising or falling and how quickly or slowly it’s happening. More importantly, though, the yield can be used as a proxy for overall interest rates, mortgage rates, and other important types of interest rates.
The 10-year treasury as a fortune teller
The 10-year treasury is noted as being the standard for analyzing bonds and bond yields. There is an inverse relationship between yields and bond prices; when yields rise, bond prices fall and vice versa. When investor confidence in the markets is high, bond prices fall and yields rise along with stock values. However, low confidence in the markets means more investors chasing safe haven assets causing bond prices to rise, and yields to fall.
The market usually behaves in a pattern. These observable inter-market relationships can help investors anticipate where the market is going and build portfolio strategies to take advantage of it. For example, when currencies rise, a chain of events begins starting with a fall in commodities prices. Bond prices will then rise while yields fall and finally, stocks will rise thereby completing the cycle.
Another important aspect of the 10-year treasury yield is how it can help investors track changes along the yield curve. Typically, debt obligations with a long maturity pay a higher yield because their investment is tied up for a longer period of time. Longer maturity bonds are also more volatile and sensitive to changes in rates. However, the yield curve can become inverted where shorter-term yields are higher than longer-term ones. This happens most often when yields are expected to decline over time and is considered a precursor to an economic recession.
Finally, the 10-year yield is helpful when compared to inflation which helps investors track real yields and determine whether rates are keeping up adequately with inflation or if deflation is becoming a concern.
Investors should note that market changes don’t always happen on a predictable time-table. While asset classes do interact with one another, changes can take place quickly or slowly depending on a number of different factors. Other considerations like inflation also need to be taken into account to give context to the numbers. A macroscopic view of yields will help investors make smarter decisions in their portfolios.
When considering a stock for investment purposes, there are usually a number of qualities that always need to be addressed – price-to-earnings, sales, profit margins, dividends, EPS growth, debt, and other items. But one of the things that tend to get overlooked far too often is stock buyback programs.
Stock buyback (or repurchase) programs are a way the companies have to mitigate price declines and reduce the number of overall shares on the market. Usually a company buying its own stock is seen as a positive thing – after all, if the company believes in their own stock, maybe investors should too.
Pros and cons of a stock buyback program
It’s not too difficult to find a stock that has an active share repurchase program. You can usually find out if a company has an active program through a simple Google query or simply check the company’s 10-K statement to find out definitively.
Investors normally view stock buyback programs as a positive thing in a potential investment. It means that the underlying company is literally investing in their own brand sending a message to investors that management is “all-in” on the company’s future. It also creates a price support level for investors – an important takeaway in bear markets since it creates an extra layer of support to prevent the stock from falling too far too fast.
Not all stock buyback programs are a good thing for investors though. Sometimes companies use them to hide poor ratios and skew financial data. Because stock buybacks mean fewer outstanding shares, it makes the earnings per share figure go higher if all other things stay the same. For companies looking for a quick EPS boost, buying back stock can inflate that number without actually doing anything meaningful to the business. It also boosts the stock price since a large number of shares are being purchased. While it’s not necessarily a negative thing to watch a stock you own jump higher, it could just be a way for insiders to sell their shares at a higher price.
Depending on an investors’ needs, a share repurchase program can be a great boon to any portfolio. Having a built-in safety net means lower price volatility, especially during bear markets. But investors should keep a careful watch for companies who are only using buybacks to artificially boost prices or inflate EPS figure.
While stock buyback programs are generally a good thing for investors, they should always follow up to see how and when the stock is actually repurchased. Many times a company will announce a stock buyback program but not actually use it in an attempt to lure investors. Simply announcing a buyback program isn’t enough – investors should always follow up and check to see the company’s history of such programs and whether or not share are actually being bought back.
There are four main types of assets investors trade in – equities, bonds, commodities, and currencies. Equities and bonds are relatively easy to invest in while commodities can be done through mutual funds and ETFs, but investing in currencies is usually the domain of large institutional investors.
While there are a number of currencies investors can trade, the largest is without a doubt the US dollar. But other than simply holding cash in hand, investors may not be aware of how to actually take advantage of the ups and downs that the value of the US dollar experiences.
Betting on the dollar
As a global standard of trade, the US dollar is held by virtually every country in the world. As such, the value of the dollar is important not only to the US but also to other countries that own US debt – a drop in the value of the dollar means a drop in the value of those assets. As of the beginning of 2018, the total amount of US debt held by foreign governments surpassed $15 trillion with another $5 trillion owned by the US government itself through trust funds dedicated to programs such as social security and Medicare.
One way to invest in the dollar is through the same medium foreign governments use – treasuries. These government-backed debt securities are 100% backed by the US dollar so its value is tied to the strength of the dollar. However, treasuries come with low yields compared to other types of investments so only very conservative investors should consider trading in treasuries.
Another way to invest in the dollar is through ETFs. Instead of trying to play the futures market themselves, investors can take advantage of ETFs which establish positions in futures contracts without investors needing to take on that kind of risk. And because ETF’s trade like stocks, it makes them a popular option for investing in the US dollar.
Forex trading is one of the most popular ways to trade currencies. But it’s dependent on trading the dollar relative to another currency. Unless you’re familiar with foreign interest rates, central banks, and strategies like a carry trade, investing directly in currencies is a highly risky maneuver.
Of course one of the simplest ways to invest in the dollar is to invest in companies that are primarily dependent on the US economy. Focusing on domestic companies means taking full advantage of US dollar strengths – however, during times of dollar weakness, it may be best to invest in international holdings or companies that derive their profits from overseas instead.
One thing investors need to keep in mind when investing in the US dollar is how it is valued relative to other currencies. The US dollar can’t grow stronger or weaker in a vacuum – it can only do so against a foreign currency. Keeping abreast of interest rates in other countries could help you gain an edge when investing in the US dollar.
Building the right investment portfolio is a dynamic process. There’s no perfect solution that fits every investor’s needs, and even a well-designed portfolio will need adjusting on a regular basis in order to minimize risk and maximize profits. At some point, one might even consider adding in leverage to boost profits and take advantage of certain opportunities.
Using leverage in your portfolio can be a great way to boost overall returns if you have the risk tolerance to deal with higher volatility. But making the choice to add these types of funds to your portfolio shouldn’t be taken lightly. There’s a significant impact that it can have on your overall investment goals. There’s also a significant difference in the behavior of a traditional portfolio and one that includes leveraged and inverse funds that could mean changes to your investment strategy.
Using leverage in your portfolio
A leveraged or inverse fund is an ETF or mutual fund that uses leverage or short positions in its trading portfolio. Leveraged funds use margin accounts and futures contracts to generate an amplification of 2-3x what the benchmark index produces. In other words, if an index rises 1%, a leveraged fund might rise 2% or 3%. However, it also means losses are just as amplified, generating losses that may be too much for more conservative investors to withstand.
Inverse funds work on much of the same principles as leveraged funds but are designed for short positions. If an index falls, an inverse fund will profit and vice versa. Unlike pure leveraged funds, inverse funds are meant to be temporary and not long-term holdings. Investors can use inverse funds to hedge their portfolio against downside risk, but since markets tend to rise over time rather than fall, holding on to an inverse fund over a long period of time will likely result in losses.
Leveraged funds can also be used temporarily to take advantage of new opportunities. For example, if you believe that the technology sector will outperform other sectors over the next year, you may consider adding a leveraged technology fund to your portfolio for the next 12 months. Used sparingly, leveraged and inverse funds can greatly boost portfolio returns while reducing the level of risk normally associated with them.
Investors should take extra caution when adding a leveraged or inverse fund to their portfolio. Unless investors can identify a real need for such a fund, they may want to consider more traditional alternatives. Inverse funds, in particular, should only be used in select circumstances. They require active management to know when to buy and when to sell to avoid unnecessary losses. Investors who understand due diligence may find that leveraged and inverse funds have a role to play in their portfolio, but investors who don’t have the time to commit to their investments should avoid using them.
Stocks haven’t done much so far this year. The S&P 500 is up just 2.8% while the Dow Jones is actually down around 1.4%. Volatility has ranged from extreme lows to extreme highs this year alone but currently stands at a mild 13.37. The stagnation of US markets has led some investors to think outside of the country for profits.
Going international instead of staying domestic could open up new possibilities for investors. There are additional benefits gained by broadening your investment environment, such as diversifying against interest rates and economic events that impact only the US. But it also opens you up to new risks like foreign exchange currency loss. Understanding the risks and benefits of both strategies will help you maximize your profits while keeping risk at a minimum.
There are a lot of benefits to be gained by staying in the US for your investment portfolio. For one, you are far more likely to be familiar with domestic companies and economic policies that allow you to employ strategies like sector rotation in your portfolio.
Diversification can be attained in a domestic portfolio by holding stocks of different sizes in various sectors. Additionally, many US companies derive much of their income from overseas operations, giving investors international exposure without having to invest directly in foreign markets.
It’s also more difficult to invest in foreign companies as opposed to domestic ones. Financial information can be harder to come by, while accounting practice differences can make analysis a challenge.
There are a number of advantages investors gain by broadening their investment portfolio to include international stocks. They reduce the risks of negative economic events that affect only the US and gain the diversification of foreign economies.
Investors can also take advantage of different economic growth rates. The US is a large well-established economy, which makes it stable but also gives it a relatively small GDP growth rate. Foreign economies may have much higher GDP growth rates, giving investors higher returns.
It also adds a new layer of diversity to an investment portfolio. Different interest rates and political environments reduce the risk that a US-only portfolio has. Severe domestic market drops can be counter-balanced with a well-diversified international portfolio.
For investors that choose to stay domestic for their portfolios, it could be helpful to add at least a few international assets to the list for diversification purposes. Noted investor and founder of Vanguard John Bogle is known for his belief that investors don’t need to seek out international holdings for diversification reasons, but the advent of globalization may make this an outdated notion. Investors should carefully weigh out the pros and cons of staying domestic or going international and decide which best suits their investment goals.
Investors don’t have to look very far to find investment advice. From the tip given by a co-worker to the myriad of financial advisors available, there’s plenty of material on the subject out there. But unless you fall into the standard risk tolerant category, you might be missing out on a more efficient investment plan.
Some investors discover that standard portfolio design doesn’t suit them. Moderate returns and a relatively stable account balance can sometimes lead to boredom and apathy. Investors may decide to do something else with their money after a while and give up on the idea of investing altogether. Instead, they need a more aggressive strategy to keep them involved.
If the idea of extreme volatility, swings of 10%, 20%, or more, in your portfolio doesn’t keep you up at night, you might fit the description of someone who should be investing aggressively. The risks might be higher, but so are the potential returns.
Not for the faint of heart
Aggressive investors sometimes have a harder time designing a portfolio than conservative ones. That’s because there are far more resources and articles geared towards balanced or conservative investors. Professional advisors also tend to discourage aggressive strategies in an investment portfolio. While they might design something they consider to be aggressive, it often falls short of what more risk-tolerant investors have in mind.
One of the key aspects of aggressive portfolios is their stock-to-bond mixture. A hard and fast figure for how much stocks and bonds should be weighted in a portfolio is hard to give because an investors time horizon plays a large role in how much risk should be taken. The longer the maturation date of the portfolio, the more risk can be taken.
A simple rule of thumb is to subtract your age from 120 and the resulting figure is the percentage of your portfolio that should be in stocks. For example, if you’re 35 years old, you should have 85% of your portfolio invested in stocks and 15% in bonds.
Of course, there’s another strategy that’s considered extremely aggressive and incredibly easy to set up. If you have a long-term investment horizon, twenty years or more, you could simply invest in an S&P 500 index fund. Returns over its entire 90-year history have averaged out to be 9.8% on an annualized basis. Considering that in the past 20 years stock mutual funds have only averaged 5.19%, there’s a strong case to be made for index investing.
Even the most aggressive investor needs to stay diversified. While some noted investors like Warren Buffett don’t actually follow a diversification strategy, unless you have sophisticated market knowledge and can analyze stocks on a professional level, you might want to hedge your bets. Being aggressive in your portfolio shouldn’t mean that you resort to gambling.
There’s a new frontier market opening up with unlimited opportunities for virtually every sector of the economy. It’s still unrealized as of yet and very few companies have even begun exploring its endless possibilities. It’s the new economy of outer space.
Like the paradigm-shifting industries of electrical power and computer technology before it, space is the next stage in human development. It’s an untapped goldmine of new opportunities and ideas with very few companies actively engaged in it. But it’s not just going into orbit that offers possibilities; space can also inspire new technologies and applications back on Earth.
Space as an industry
The idea of space as a commercial opportunity is a relatively new one. Until recently, space travel was solely seen as the realm of governments and science experiments. But space has already yielded a number of commercial successes via NASA spinoffs. Memory foam, cochlear implants, LASIK, solar cells, freeze drying, and much more all owe its existence to space exploration. These discoveries have led to a number of products and services in virtually every segment of the economy and contributed to everyday life on Earth.
Numerous companies and industries have benefited from space travel and new technologies are developed every year. Space is becoming more accessible to the public now, too, thanks to companies like CubeSat which allows for a cost-effective way to get science experiments and other projects into orbit around Earth.
Companies like SpaceX, Virgin Galactic, and Blue Horizon are the current leaders in space commercialization but still primarily caters to agencies like NASA to service the International Space Station. Other companies like Orbital ATK are also heavily involved in space by manufacturing satellites for communications, scientific pursuits, and defense purposes. For investors though, there are few, if any, pure plays on space travel at the moment.
While still somewhat far-fetched, other companies are preparing for a future in resource mining. Planetary Resources and Deep Space Industries are two companies built on the idea of mining asteroids. Despite data that shows even a single asteroid can contain more gold or platinum than has ever been unearthed in human history, the real mining operations would likely be for water and other gasses used in rocket propulsion.
The economics of space is heavily limited by the cost involved in accessing it. Breakthroughs in propulsion mechanics and launch capabilities will undoubtedly drive its popularity for the mainstream investor for the next decade or so. But as we expand ever further into space and begin building permanent habitats outside of Earth’s atmosphere, the business of space will become more commonplace. In a few decades, space may become a standard segment of the economy alongside industries like technology and consumer staples.
There a number of well-known metrics investors use to determine whether or not a stock should be purchased. Price-to-earnings analysis, dividend discount models, and modern portfolio theory are all commonly used by investors to place a value on a prospective stock. But there’s another metric that’s slowly taking over as the preferred method for valuing a stock – free cash flow.
Evaluating a company based on how much free cash flow (FCF) is available often gives investors a better representation of how the company is actually managing its finances and what investments the company is making into its future growth. Rather than just looking at basic P/E and PEG ratios, investors use the free-cash-flow yield in place of the price-to-earnings ratio to value a stock.
The basics of FCF valuation
Free cash flow is a measurement of how much money a company has left over after all expenses and capital expenditures (funds that are reinvested) are calculated. There are several ways FCF can be calculated but the simplest is to subtract capital expenditures from cash flow from operating activities (earnings before interest and taxes plus depreciation minus taxes).
To get the FCF yield you only need to divide FCF per share by the current price per share. The higher the ratio, the more attractive the investment and vice versa. Because FCF analysis takes into account capital expenditures and other operating costs, many investors prefer it over earnings since it paints a more accurate picture of a company’s finances.
Positive FCF means that the company has room for future growth and the ability to reinvest profits back into the business. A negative FCF means that the company doesn’t have enough income to manage its current expenses. However, investors should note that many fast-growing companies may start out with a negative cash flow until the company grows large enough to take advantage of things like economies of scale.
FCF is also harder to manipulate. Earnings can be manipulated more easily through things like share buyback programs which lower the number of total outstanding shares and thus make earnings per share seem higher. For these reasons, investors tend to trust FCF analysis more than EPS analysis.
As with any metrics used to value a stock, investors shouldn’t rely on just one method. While FCF helps investors get a better and more accurate reading of a company’s fundamental performance, it still works best when used in combination with other valuation methods. While a high FCF yield is usually a sign of strength for a company, growth stocks may not have a high FCF yield – it may even be negative. Investors should keep in mind what metrics are most important when evaluating a potential investment.
It takes more than simply following the ups and downs of the S&P 500 or Dow Jones in order to be a successful investor. You need to be aware of current events and track changes as they occur in order to know where the economy is and where it might be headed. Failure to do so could result in unexpected losses due to a changing economic environment that could have otherwise been avoided.
One way investors can check in on the market is by paying attention to economic indicators. These reports essentially take the temperature of the market and tell investors where the economy is currently at as well as giving them clues as to what might happen next. But with dozens of reports released in any given month, it can be a full-time job keeping up with them all. Luckily, there is only a handful that investors really need to pay attention to.
Creating an economic watchlist
There are numerous economic reports and charts available to investors that make it difficult to know which ones are important and which are merely informative. Investors should tune out most of the reports that come in and focus instead on those that really matter. Reports that show the current strength of the US economy, workforce, or marketplace are the ones that will make the most difference in a portfolio.
Here’s a list of the top three economic indicators investors should watch out for:
GDP – Arguably the most important piece of data an investor can have is the most recent GDP (Gross Domestic Product) report. This report is a macroscopic view of the US economy and gives investors a look at where the economy was at and where it might be headed. It’s a lagging indicator meaning it gives investors a solid look at where the economy was in the past quarter or so but also helps chart out long-term trends.
Unemployment – Another critical piece of data for investors is the unemployment numbers. The number of jobs added or lost in the US economy gives investors an idea of how strong the market is. Jobs gained generally indicate a growing economy whereas jobs lost could indicate economic weakness.
Inflation – Inflation is one of the trickiest indicators to understand but also essential in order to design an appropriate portfolio. Rising inflation indicates a healthy economy that’s growing, but too quick of a rise can also spell trouble for stocks that might not be able to keep up with the changes. Conversely, falling inflation is usually an indication of an economic contraction and investors may want to prepare by investing in defensive stocks.
Investors should be careful not to put too much emphasis on any one indicator. Oftentimes economic indicators can tell conflicting stories about the economy. Investors should take all the information presented and filter out the inconsistencies to paint a clearer picture of what’s going on economically. Taking a long-term view will help smooth out trend inconsistencies and help you become a better investor.
Picking the right investment for your portfolio isn’t always easy. You want to keep diversification alive by selecting stocks from different economic sectors. And while most investors cycle through various sectors as the economy ebbs and wanes, there’s one sector that seems to make it into almost any portfolio – gold.
Gold, along with silver and platinum, are popular investment choices for investors. Their use as a safe haven asset means that precious metals stocks can be part of a defensive portfolio while mining companies can often make for solid dividend-paying stocks.
Precious metals can play a number of roles in your portfolio. Understanding how they provide value is the key to maintaining healthy profits.
Key metrics for precious metals
While ratios like price-to-earnings or price-to-sales are important for most stock sectors, they don’t mean much when it comes to precious metals. Instead, inflation, interest rates, and the US dollar become the primary considerations.
One of the biggest misconceptions about gold is what economic factors actually make it relevant as an inflation hedge. As a safe haven asset, gold is used as a default investment to protect investors against virtually all types of risks ranging from geopolitical to economic. But gold is most often quoted as being the go-to inflation investment.
However, gold isn’t an appreciable investment like a stock. Gold doesn’t produce earnings or yield dividends – it simply holds value in a way that’s separate from currency. Precious metals are best used as wealth-protectors that aren’t correlated with the economy or market performances.
As far as being an inflation hedge, most investors pick gold and silver without giving it a second thought. But precious metals are only good as inflation plays when inflation is higher than interest rates. As long as interest rates are higher than inflation, investors are better off investing in assets that actually appreciate in value. But if interest rates can’t keep pace with inflation, then precious metals like gold are the better option since wealth preservation takes precedence over price appreciation.
One of the most overlooked aspects of investing in precious metals is the difference between mining companies and junior mining companies. It’s a critical difference that can mean boom or bust in your investment portfolio. A mining stock derives income from their operations, whereas a junior mining stock is an exploration company that seeks out new locations for ore. The latter is far more risky since there’s a lot of money that goes into the process considering that a potential mine site could turn out to be worthless.
Mining stocks aren’t the only way to play precious metals though. ETFs and mutual funds are also viable options. They might invest in an index of mining stocks to help you stay diversified, or they might invest in futures contracts. Regardless of the path you take, adding precious metals into your portfolio can be a good risk mitigation strategy that will help your portfolio stay afloat in difficult economic times.
The stock market is a dynamic entity. It lives and breathes like an organic being, but instead of oxygen and water, it feeds off of the business cycle. Certain sectors outperform or under-perform depending on where the business cycle is at which gives investors an opportunity to profit by following along.
One of the most common investment strategies is known as sector rotation. Stocks are bought and sold as certain sectors move in and out of favor correlating with the business cycle. Regardless of what stage the economy is in, there are always certain sectors that stand out as being clear winners while others typically lag behind and should be avoided.
For investors, following the business cycle eliminates some of the guesswork involved in investing and can help mitigate risks in their portfolio.
The business cycle and the market
The business cycle is what economist call the change the economy goes through over time. It happens in several stages: early cycle, mid-cycle, late cycle, and recession. For each stage, certain sectors of the economy benefit more than others making it a good baseline for portfolio design. Below is a breakdown of each stage and what sectors outperform or under-perform:
Early-cycle phase: This phase is marked by economic recovery, usually from a recessionary phase with economic growth turning positive. Monetary policy eases and credit becomes lighter. Business sales growth rises while inventories are generally low. Sectors that outperform during this phase include consumer discretionary, technology, and industrials. Under-performers include energy, telecommunications, utilities, and consumer staples.
Mid-cycle phase: The mid-cycle phase is usually the longest phase of the economic cycle and is defined by consistent economic growth while business inventories and sales reach an equilibrium. This phase doesn’t have many clear winners or losers but technology and industrials seem to perform better than most while materials historically lags.
Late-cycle phase: In this stage of the business cycle economic activity can be described as “overheating” with high inflation and tighter monetary policies aimed at restricting growth. Materials, energy, and healthcare are the best performing sectors while consumer discretionary and technology tend to lag the most during this phase.
Recession phase: The recession phase is arguably the easiest to identify as economic activity turns negative while credit becomes difficult to procure and business profits fall. Sales growth stagnates while businesses burn off high inventories in anticipation of a turnaround. Sectors that benefit during a recession are consumer staples, healthcare, telecommunications, and utilities. Industries to avoid include technology, industrials, and materials.
One of the oldest investment strategies “buy and hold” seems to fly in the face of sector rotation since stocks are held over a long period of time regardless of what stage the economy is in. There are several competing theories that favor one strategy over the other, but ultimately it comes down to investor preference. If you have the time and ability to dedicate to your investment portfolio, sector rotation may be something to consider. However, if you don’t have that kind of time and you have a long-term investment horizon (a decade or longer), then buy and hold may be a better choice.
Designing a portfolio usually involves a mixture of stocks and bonds. While other asset classes can be added to the mix, a typical investment portfolio is broken up by these two main asset types. Stocks offer greater returns but carry a higher degree of risk while bonds have a lower risk profile but come with lower returns. Getting the right mix is where many investors run into trouble.
Having a portfolio that’s too heavily weighted in stocks can result is greater-than-expected losses and volatility which can quickly derail a retirement plan. On the other hand, loading up on too many bonds means that your portfolio will likely under-perform expectations leading to a lower retirement balance than planned. That can mean having to work for more years to compensate or reducing your retirement plans.
In order to figure out the right balance, you’ll need to figure out what your goals are, when they need to be realized, and how much risk you can handle.
Figuring out your risk tolerance baseline
Life is not static – it’s a dynamic progression that changes and grows as you approach retirement. Plans change, sometimes for the better and sometimes for the worse. As such, you need an investment plan that allows for adjustments but still helps you reach a long-term goal.
One classic rule of thumb to figure out what stock/bond allocation is right for you is to subtract your current age from 100. Whatever the result is should tell you what allocation to use. For example, if you’re 40 years old, you should have a portfolio with a 60% stock and 40% bond mixture. But that’s for more conservative investors. Those with a higher risk tolerance should subtract from 115. That would give the same investor an allocation of 75% stocks and 25% bonds.
Subtracting from 100 or 115 will help you design a portfolio based on your age, but it’s not a catch-all for risk tolerance. There are numerous free risk assessments online like this one that can help you determine what your actual tolerance really is. There’s nothing that says you can’t adjust your allocation to be even more or less aggressive than the age-based model.
Finally, you can do a quick calculation to figure out what allocation you need by estimating the expected returns from stocks and bonds and what return you need to have. For example, let’s say you need to achieve an 8% return to reach your investment goals. If your stock portfolio should give you a 12% return and your bond portfolio will give you a 5% return, then some quick math tells you the right allocation is 43% stocks and 57% bonds.
While getting the right allocation helps you reduce risk while meeting your long-term investment goals, there’s nothing wrong with changing the formula. You may find yourself more or less risk-averse later on meaning that the plan needs to change to compensate. The rule of thumb based on your current age is constantly being readjusted and many advisors now recommend being more aggressive as you approach retirement than they used to. Don’t be afraid to switch gears as needed in order to reach your investment goals.