Investing: Throw Out the Old Rule Book
For the first time in a decade, investors are feeling real pain. They're used to sell-offs that are sharp but short-lived, but now a rebound seems ever more distant. For sure, the U.S. economy is not going off a cliff, and the market will turn around eventually. Still, financial advisers say it's time to take a fresh look at ways to ride out the storm.
What do they suggest? There's always the safe havens of money-market funds or Treasury securities, but in exiting the market, you risk watching from the sidelines as a comeback takes place. A better bet may be rejiggering your equity holdings. That could mean lightening up on tech stocks, broadening your holdings, and seeking out the market's sweet spots, especially small- and mid-cap value stocks. Some even advise turning to publicly traded options that put a floor on a stock's losses.
LETTING GO. Of course, the toughest decision in investing remains when to sell. It's tempting to hold on to a stock whose price has already lost more than half its value on the premise that things can't get any worse. But they can. What drives a stock's price isn't how much it has already fallen, but market expectations for future earnings. If the economy continues to slow and companies and Wall Street analysts continue to lower profit forecasts, a stock that appears cheap now could look pretty pricey a few months down the road.
Consider Sun Microsystems Inc. (SUNW ), whose share price has fallen 69% since September, to near $20 recently. Wall Street analysts who follow Sun still expect earnings to grow an average 23.6% a year over the next five years. Plug that assumption into a widely used valuation model and Sun looks fairly priced. But if the analysts are even a little too optimistic and the growth rate is only 20%, the stock's value drops to $15--implying a further 25% price drop.
Pruning tech and telecom would help diversify your portfolio. By introducing other kinds of investments, your wealth becomes less dependent on a few companies or sectors. It also becomes somewhat less volatile. That concept was often ignored--or misunderstood--during the high-flying bull market. "New clients come in and say: `I'm diversified. I own Cisco (CSCO ), Microsoft (MSFT ), and GE (GE ), Fidelity Magellan, the Janus Fund, and an S&P 500 index fund,"' says Mark E. Balasa, a financial planner in Schaumburg, Ill. "They don't realize their portfolio is all in large growth stocks."
Value stocks, those in more mundane sectors of the economy such as finance or energy, which have been holding up better than the growth stocks in the market rout. Even in the growth-stock area, Wall Streeters say there are better opportunities among small- and mid-cap companies than among the giants. Despite plunging prices, many big caps still trade at high price-earnings ratios.
Indeed, while much is being made of the so-called profits recession on Wall Street, those who follow smaller companies say they see no such thing. Donald G. Berdine, chief investment officer at PNC Advisors, says 2001 operating earnings for small- and mid-cap companies should be up 21% and 14%, respectively. But here, too, caution is advised. He suggests investors stick to mutual funds for small- and mid-cap stocks, a safer bet than buying individual issues.
Granted, some investors are reluctant to unload their largest holdings. Christopher Cordaro, a Chatham (N.J.) financial planner, suggests a "collar" for investors who have 20% or more of their portfolio in one stock. Here's how it works: If the stock's price is $100 a share, you buy put options that give you the right to sell the stock at $90 over a period of time, typically the next 12 to 24 months. To offset the cost, you also sell call options that grant the buyer the right to purchase your stock for $120 during that same period.
The cost of the put and the proceeds from the call should net out and you benefit whether the stock falls or rises. If the stock falls to $50, you exercise the puts and collect $90 a share. If the stock instead rises to $150 and you want to hang on to it? You can buy back the calls so you don't have to sell the stock.
Financial advisers say the biggest challenge these days is getting investors to take action. After all, most people's past experience rewarded them for waiting out the slumps. That could well pay off again. But until the economy and earnings prospects improve, a more defensive strategy will likely pay off better.
By Susan Scherreik in New York