One Practical Way to Avoid Huge Losses

With no market bottom in sight, recent market volatility has wreaked havoc in many portfolios. Security prices that seemed cheap continue to go down, taking investment returns with them.

In market environments such as this one, any sort of rational behavior gives way to Mr. Market's emotional desires. In the short term, it is no longer safe to assume that a P/E ratio in the single digits or a cash-rich balance sheet is enough to keep prices from sliding further.

For example, rail car manufacturer FreightCar (Nasdaq: RAIL  ) currently fetches about $33 a share. This figure includes nearly $17 a share in net cash. So, for essentially $16 a share, an investor is getting a business that had earned $10 a share in 2006 and nearly $4 a share in 2007. While the company may never see another year like 2006, even much less substantial earnings would be enough to make such a low stock price intriguing.

Or what about Circuit City (NYSE: CC  ) , which at $650 million sits on $400 million in net cash and a book value twice that much? It's true that electronics inventory can lose value quickly, making book value a weak valuation metric. But the cash is real -- and with cash making up nearly half the company's book value, there is room for error. And it seems that Blockbuster (NYSE: BBI  ) saw that value, prompting ysterday's $1 billion buyout offer for Circuit City.

Even Wells Fargo (NYSE: WFC  ) , arguably one of the best-run financial institutions in the country, currently sells for less than 12 times earnings and sports a dividend yield of over 4%. Everywhere you look, good and bad businesses alike seem to be heading in one direction: south.

Let volatility serve you
When the view is pessimistic, fundamentals take a back seat to price volatility. At the slightest news of trouble, investors head for the exits, regardless of how serious or innocuous the news may be. General Electric (NYSE: GE  ) tumbled nearly 15% last week because it missed earnings. Who said a few pennies per share aren't worth very much?

So regardless of how sound a company seems to be for the long term, in the short term Mr. Market doesn't care. Instead of succumbing to this volatility and allowing it to decimate your portfolio, why not use it to your advantage?

It's OK to be average
You can't expect to get lucky and invest at the exact bottom of the market. One way you can take advantage of falling prices is by slowly adding to your investment holdings. In this type of market, where things can get worse before getting better, investors benefit by building their investment stakes gradually instead of jumping in all at once.

Whether it's next year or the year after next, many will consider this environment as a great buying opportunity -- perhaps not for all stocks, but certainly for many. Take advantage of this and improve your returns by buying little at a time.

Suppose you find a good business that you feel is a great investment trading for $25 a share. You decide that 1,000 shares is the right size for your portfolio. Rather than investing the full $25,000, purchase 300 shares (there is no science to the initial amount; use your own judgment). If next week the stock is at $22, buy another 300-400 shares. If shares continue to decline to $20, buy the remainder to complete your 1,000-share holding. Rather than having paid $25 for each share, your average cost will be around $22 or so (plus three commissions). With the stock at $20 a share, you're only down 10%, versus 20% if you had bought a big block at $25. If a year later the stock is at $40, your gain is higher because you invested at lower prices.

Be aware: Not all stocks are made equal
Obviously, the above process still hinges on the fact that you are buying good companies at attractive prices. Averaging down your buy price should not be done as an excuse for poor investment choices. Buying at lower prices won't help you if the price doesn't go up.

Ultimately, if you invest wisely, your holdings should appreciate over the long term. But by investing little by little in declining markets, you lower the potential losses and increase the future profit. And if the stock goes up after you buy, you still haven't lost any money.

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