3 Investment Tips From a Trading Pro
The "do-it-yourself investor" is kind of a misnomer.
Sure, it means you're not leaning on an advisor to make your investment decisions…but rarely are you completely on your own. Many DIYers still look across the internet and social media for how-tos, news, and investment tips—data, information, and wisdom gathered by other people so other investors can make informed decisions and not be doomed to repeat their mistakes.
And one of the most important virtues of that advice is perspective.
The Tea
If you look around the investment-focused corners of the internet, you're going to find a lot of quotes. Not stock quotes—well, there are plenty of those, too—but lists of quotes from famous investors. Warren Buffett. Peter Lynch. Benjamin Graham. Bill Gross.
These quote collections are popular hunting grounds for new and inexperienced investors to scrape out investment tips. After all, who better to learn from than the best?
And it's true—part of what makes those quotes valuable is the success those investors have enjoyed. But part of it is perspective.
Peter Lynch managed Fidelity's Magellan Fund between 1997 and 1990. Benjamin Graham's heyday was from the 1930s to the 1950s. Warren Buffett famously started investing when he was 11, in the 1940s, then had various investment-related jobs until 1970, when he became CEO of Berkshire Hathaway, where he has made his most famous investments.
YATI Tip: A timeless piece of advice? Always look for deals when you're opening a brokerage account.
Where, how, even when they invested all shaped their perspectives. In The Psychology of Money, Morgan Housel discusses a Financial Times interview where Bill Gross—a man once dubbed the "Bond King"—admitted that, had he been born a decade earlier or later, his life would have been considerably different. "Gross's career coincided almost perfectly with a generational collapse in interest rates that gave bond prices a tailwind," Housel writes.
That's why, as much as we love talking about our own experiences in investing, we realize the importance of providing other perspectives. Simply put: Other people know what we don't know. And it's useful to make sure that readers also hear other perspectives that could put them on the path to successful investing, saving, spending and financial health.
The Take
Earlier this week, we had the opportunity to have a wide-ranging discussion with a trader who brings a different perspective.
Steve Chappell is Global Head of Trading Systems Development at VectorVest, an investment service that helps investors find opportunities by combining fundamental and technical analysis. And Chappell has a technological foundation you don't find in all traders, having earned MCP, MCSE, Net+ and A+ computer certifications from Advanced Computer Technology Training.
As the title suggests, he now leads the development for VectorVest's trading systems, but he also provides education through webcasts, investment workshops, and trade shows worldwide.
While we hit on several investment- and trading-related subjects throughout our conversation, today, we wanted to focus on three insightful investment tips that the buy-and-hold readers among you can put to use (And traders, stay tuned: In a few weeks, we'll pivot his advice on trading).
1. P/E isn't enough
Price-to-earnings (P/E) is one of the most basic stock valuation metrics out there. It's simply calculated as
Price per share (P) / Earnings per share (E)
Investors typically look at one of two P/Es:
- Trailing P/E, which looks at the trailing (past) 12 months' worth of earnings.
- Forward P/E, which looks at estimated earnings for either the current fiscal year or the next fiscal year
I'll always argue that forward P/E is more useful than trailing P/E. While trailing P/E is certain (we know what the company has already earned) and forward P/E is not (they're just estimates), you shouldn't invest on where a company was, but where you expect it to go. And while Wall Street analysts might not get it perfect every time, typically, they're collectively close enough that it's a fair enough gauge to use.
YATI Tip: Stock screeners can help you find value stocks based on several different valuation metrics.
Chappell, however, argues that P/E isn't even an indicator of value, but merely a reflection of the cost of shares—and that you need to tack on a little something extra to really suss out value.
"It comes down to the denominator. The great Peter Lynch said you needed to add another element to E, which is earnings growth. Even in isolation, even if you're comparing the P/E of one semiconductor stock to another, you can get some sense of whether a stock is trading higher than its peers. But what you can't tell is what direction E is going—and that's the most important part. Earnings is the engine that drives stock prices higher."
That's why Chappell says "We put the G (growth) before the PE."
Of course, if you want to value stocks while really including growth, you'll actually put the G right after PE—as in PEG, or price/earnings-to-growth. It's calculated as
Price per share (P) / Earnings per share (E) / Earnings per share growth rate (G)
PEG revolves around the number 1. If a company's PEG is 1, that means the company is fairly valued. Lower than 1 means it's undervalued, and higher than 1 means it's overvalued. And because PEG includes growth rate, it's as applicable to utilities as it is to technology companies as it is to financial companies as … well, you get the point.
Even then, PEG isn't perfect, and it's all relative. According to data from Yardeni Research—one of the foremost providers of market data—the S&P 500 has only ever traded below a PEG of 1.0 across a handful of months between 1995 and today. It typically sits between 1.0 and 1.5. Even by those standards, though, it's easy to argue that the S&P 500, at a current PEG of 1.8, is pretty pricey today.
2. Own more than one stock…but don't own too many
Here at Young and the Invested, you'll frequently hear us talk about the importance of diversification when you're managing your portfolio. Effectively, that just means "don't put all your eggs in one basket." Why? Well, if all of your money is tied up in one stock, and that stock bombs, your portfolio is in big trouble. But if you own numerous stocks, one failure won't set you back as much.
There are different ways, and different extents, of accomplishing that.
- You can own several stocks in multiple sectors (e.g., technology, energy, financials).
- You can own several stocks in one sector, but multiple industries (e.g., semiconductors, software, IT services).
- You can own several stocks from several countries (e.g., the U.S., developed markets, emerging markets).
- You can even own several different assets—not just stocks, but also bonds and alternative investments such as real estate or precious metals.
However, in addition to managing risk, some level of diversification can actually help your chances of owning a high-performing stock.
"The best way to control risk is to own more than one stock. You want to be more toward about 10 as you can possibly get. The idea here is if you spread it out, you have more of a chance to get that high performer," Chappell says. "I know a lot of great great money managers who don't have more than a 50% success rate, who are only north of 40%, but because they let their winners run and they cut their losers early, by spreading out to multiple investments, it gives you the chance to get the winners that pay for the losers."
But you can own too many stocks, too.
"Once you start to get around 30 stocks, you're not an investor—you're an index," says Chappell, who says the sweet spot is between 10 to 20 stocks. "The [Dow Jones Industrial Average] is 30 stocks, and it's a broadly diverse index of cyclicals. So when you approach 30, you shouldn't expect to substantially outperform the market."
Good general advice for long-term, buy-and-hold investors? Use diversified funds to establish the "core" of your portfolio, then hold some individual stocks if you want to try to generate outperformance.
3. Use similar-sized positions
Simply owning a group of stocks isn't enough to be truly diversified.
Chappell gave an example of holding 10 stocks, but 80% of the portfolio is invested in one stock, and the remaining 20% is spread among the other nine.
YATI Tip: Worried about doing stock research yourself? Consider leaning on these top stock picking services.
"What happens if the one stock you have 80% of your capital in goes down? It submarines the whole thing," he says. "It's an egregious example, but it's one that people should understand."
If you analyze your portfolio and see that kind of lopsided stock exposure, that's called being "overweight," and it puts you at undue risk. And one way to avoid that risk is by taking similar-sized positions for everything you hold.
"I like the idea of always having a similar monetary exposure in every position all the time," Chappell says. "Let's say you start with a portfolio of $10,000. You want to own about $1,000 of each of the 10 stocks when you start. So if you say to yourself, 'I'm going to cut bait if I lose any more than 20% in any position,' that means you don't want to lose more than $200 in any one of those positions."
You might be wondering to yourself, "What happens as my portfolio grows?" Fortunately, this is an idea that's easily scalable.
"Anytime I make a new purchase, I keep it relevant to the average value of the stocks that remain," Chappell says. "If that $10,000 portfolio becomes $12,000, my new stock purchase is $1,200."
Another tactic is keeping your cost basis exactly the same until you hit a critical mass. So, for instance, you might keep buying $1,000 positions until your portfolio reaches a certain size, and at that point, you can decide to buy, say, $2,000 positions, $5,000 positions, etc.—whatever makes sense as your portfolio grows.
As always, we thank you for spending some time with us, and we hope you'll be back again to read our next edition of The Weekend Tea.
Riley & Kyle
Young & The Invested (Soon to be WealthUp)
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.