Safe Passage

You must remember this: Preparing for the stock market's risks helps you come out ahead.
Magazine Contributor
8 min read

This story appears in the July 1997 issue of Business Start-Ups magazine. Subscribe »

Investing successfully in today's financial markets may seem as perilous as getting out of Casablanca. If your papers are not in order, you could be in for a rough time--not from the authorities but from the swings of stocks. But don't let the bad guys get to you. There are plenty of steps you can take to assure safe passage.

When it comes to investing, risk counts as much as reward. Stocks generally have provided long-term gains, but the financial markets are still prone to slip-ups, corrections or even meltdowns. Past performance, as any astute investor can tell you, is no guarantee of future returns, and salvaging a ravaged portfolio is a lot harder than protecting one. If you're stretching to make all you can from your portfolio, you could end up with a nasty shock . . . at least in the short run. The key is to become "risk-ready," especially when the financial markets start to rock and roll.

Being risk-ready means knowing the types of risks inherent in different kinds of investments. There's inflation risk, when the return on your investments doesn't outpace the rate of inflation, and liquidity risk, which means you own an investment but can't sell it when you want to. These two types of risk are good reasons to choose stocks as part of a diversified portfolio. Historically, stock returns as represented by the Standard & Poor 500 Index have outpaced inflation as measured by the Consumer Price Index, and liquidity is very high in stocks traded on major U.S. and foreign exchanges. Strategic asset allocation and investment diversification can help you sleep better at night, but even diversification isn't an end in itself. The best defense is a good offense. With that in mind, here are seven steps you can take to get your house of investments in order.

1. As time goes by. If you're going to invest in stocks, keep in mind a trend is just a trend. In short, don't overreact by trying to time the market. While past performance is not a predictor of future returns, historical data shows holding stocks for the long run really cuts the risk. According to a recent study by Chicago stock research firm Ibbotson Associates, for all three-year holding periods since 1946, stock returns were positive 93 percent of the time, based on the S&P 500 Index.

Take this hypothetical illustration: If you invested $1,000 every year for the past 34 years and reinvested all dividends in the S&P 500 Index, your $34,000 investment would have earned $325,771 if, with the worst timing imaginable, you had invested at the market high of the year. Of course, if you had perfect timing, investing your $1,000 at the market low, you would have earned $365,880. The difference between the extremes? A mere 12 percent; that's less than 1 percent annually. As a long-term investor, you avoid the aggravation of trying to get out at the top and in at the bottom of the market's cycles.

2. The bears wore red; the bulls wore blue. As a rule, the blue-chip stocks of large, well-
established multinational companies are less risky than the stocks of small, little known, single-product firms. When the markets drop, investors often see a "flight to quality," with money going where investors feel safest: the stocks of big companies. No stock, large or small, guarantees investor protection, but large companies are less prone to sudden plunges and are often the first to rebound when the markets begin to turn up again.

3. Don't be misinformed. Get your research from a reliable source--crystal balls and fishing buddies don't count. In-depth research involves the big picture, including political, economic and demographic factors as well as specifics of individual companies.

Technical analysis--using charts and computer programs to identify price trends--provides other information to help you make informed decisions. Base your research on facts, not feelings, hunches or tips.

4. Round up some unusual suspects. Smart investors use overall asset allocation to ensure their portfolios include different classes of securities, such as stocks, bonds and cash. In addition, no stock portfolio should consist of just one or two companies. Diversification means building a multistock portfolio, including domestic and foreign holdings, blue-chip and OTC (over-the-counter) shares, as well as companies in different industries.

5.The start of a beautiful friendship. If you're a risk-ready investor, you keep your eye on several traditional measures of investment value, including price-to-earnings (P/E) ratios, price-to-sales ratios and book values. All other things being equal, a stock selling for 60 times earnings is riskier than a stock selling for 10 times earnings. Growth stocks come from companies experiencing accelerated earnings growth; they often sell at high P/Es because investors expect that higher earnings will result in higher share prices. Value stocks are generally shares of long-established companies, often those familiar as household names with predictable long-term earnings growth rates. As you build a diversified portfolio, emphasize both value and growth stocks to protect it from excessive risk.

6. Play it again, Sam. Ups and downs in the market make you queasy, but you still have a financial goal you'd like to reach? Dollar cost averaging is a simple strategy used by investors to add to their holdings by investing a fixed amount of money at set intervals, such as every month or every quarter. This strategy doesn't assure a profit or protect against a loss in the case of a market meltdown, but it can help smooth out the effects of stock price fluctuations. Best of all, you can start with a small initial investment and make additional small, periodic investments in managed accounts.

The principle is simple: When the price of shares is lower, your investment dollars will buy more shares. When the price is higher, you'll buy fewer shares, but the prices of the shares you bought when prices were lower will have increased. The key here is sticking with the program.

Over the long term, assuming that stock prices continue to rise, the average cost of shares purchased through a dollar cost averaging plan will usually be lower than the shares' average price. How? Say you plan to invest $500 quarterly. If you make a purchase at $10 per share, for example, your $500 investment gets you 50 shares. If the share price rises to $20 during the ensuing quarter, your next purchase gets you 25 shares. After two quarters, your hypothetical purchases would total 75 shares bought at $15 each but with a lower average cost of $13.33 per share.

Because this strategy involves periodic investments, consider your financial ability and willingness to continue buying through periods of high and low prices.

7. I came for the stop orders. A stop order is an order to buy or sell a security at the market price once the security has traded at what is known as the stop price. If you're worried about market declines, consider putting protective sell stop orders in place. A stop order to sell is always set below the current market price and is usually designed to protect a profit or limit the loss on a security that you hold at a higher price. It works like this: Say you bought a stock at $40 per share, and now its price has increased to $60 per share. A sell stop at $50 means if your shares decline to $50, your order could possibly lock in a $10 profit, not including commissions.

While this may sound like an easy strategy, there is, naturally, more to it. The risk is that this type of stop order may be executed several points below the stop price because of market orders placed before it. These market orders could radically change your order's execution price. To be more certain of the price at which your order will go off, consider a stop-limit order. This kind of stop order becomes a sell order only when the specific stop price is reached. Unfortunately, the stop-limit order carries the risk of missing the market altogether since the specific price may never occur. In our above example, say you set a sell stop-limit order of $50, which is reached but delayed because of market orders ahead of it. If these market orders cause the stock price to fall below the $50 stop-limit, your stock will not get sold and you'll still own it at whatever price it reaches.

Setting stop orders is tricky business because sell orders can be triggered by temporary volatility. Cautious investors move stop orders up as stock prices rise, but the trick is to avoid setting them too close or too far from the price of the stock in question. Consult your financial advisor for more information on how best to use stop orders.

Volatile markets are the ones that separate the investors from the speculators, those who panic from those who profit. Whatever kind of investing you decide to do, make sure you and your portfolio are risk-ready. Here's lookin' at you, kid.

All figures are based on the S&P 500 Index and data from Prudential Securities for informational purposes only and should not be construed to represent a specific transaction or investment.


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