Losing money hurts. Literally.
The way humans process financial loss is similar to the way we process physical pain, according to a recent study by Dr. Ben Seymour from the Wellcome Trust.
So, if losing money causes us pain, and we don't like pain, we should try to avoid losing money, right?
I hate to disappoint, but despite my mischievous headline, there's obviously no guaranteed method for eliminating stock-market losses. But we little guys needn't be completely defenseless.
Here are four steps you can take to shore up the defenses of your portfolio while still allowing for hearty capital appreciation. And given the market's recent tumult, there's no better time to put these principles to work.
1. Take shelter with dividends
Dividend payers typically sport strong and growing cash flows, which also happen to be the drivers of a growing stock price. In The Future for Investors, Dr. Jeremy Siegel exhaustively argues that investing in dividend-paying stocks and reinvesting those dividends has proved to be a market-beating strategy over the long haul.
What traits should you look for in a winner of a dividend payer? For starters, make sure the dividend is secure and unlikely to implode on you. Also look for consistent payout ratios and earnings growth.
2. Invest in strong brands
Investing in unheard-of small caps is not the only path to outstanding returns. Some of the best investment opportunities are supported by branded products and services you already know and use. Your knowledge as a lifelong consumer is a personal competitive advantage. Put it to use.
Why? Strong brands allow for premium pricing and superior margins. Brand strength and the resulting fat margins give companies like Yum! Brands (NYSE: YUM ) and PepsiCo enhanced downside protection in bear markets. By seeking out companies with strong brands that offer secure, growing dividends, you're practically halfway to significantly lowering your portfolio's downside risk.
3. Avoid sky-high valuations
It doesn't take a battle-worn market guru to know that stocks with sky-high valuations have much further to fall. It is easy to get swept up in the greed-induced euphoria offered by a MercadoLibre (Nasdaq: MELI ) or Solarfun (Nasdaq: SOLF ) -like situation. Because they're trading at stratospheric valuations, though, the reality is that those companies' enviable expected hyper-growth is already baked into their shares. When these high-growth, high-priced companies slip, they fall hard, and investors like us are usually the last ones holding the bag.
Go to Vegas if you want to gamble. If you're serious about limiting your losses, don't overpay for growth when attractively-priced dividend payers such as SYSCO (NYSE: SYY ) , Waste Management (NYSE: WMI ) , and McGraw-Hill (NYSE: MHP ) are sitting in plain sight.
Investing in only a small number of companies might work for Warren Buffett, but running concentrated portfolios is not appropriate for the average investor. You can achieve diversification with funds, a broad range of individual stocks, or a mix of both. How many stocks should you buy? There's no perfect answer, but if you're balanced between an index fund and 10 stocks, you're OK. If you just own 10 stocks, well, watch out.
So, again, that's:
- Take shelter with dividends.
- Invest in strong brands.
- Avoid sky-high valuations.
A simple, defensive, and profitable approach to investing that you can act on yourself. So while there is no way to eliminate losses in the market, you can minimize your risk of loss and earn market-beating returns.
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This article was originally published on Aug. 31, 2007. It has been updated.
Joe Magyer does not own shares of any companies mentioned in this article. SYSCO is an Income Investor recommendation, while Waste Management and McGraw-Hill are Inside Value recommendations. The Motley Fool has a disclosure policy.