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. 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 proven 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. Use your knowledge as a lifelong consumer as a tool to boost your portfolio.
Strong brands allow for premium pricing and superior margins. The strength of their brands and the resulting fat margins give companies like Coca-Cola and Altria
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 Baidu.com
If you want to gamble, go to Vegas. We're talking about your retirement, your kids' education, and your life savings. If you're serious about limiting your losses, don't overpay for growth when reasonably priced dividend payers like Pfizer
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 set of strategies. So while there is no way to eliminate losses in the market, you can minimize your risk of loss and earn market-beating returns.
The Fool's Income Investor investing service, to which I was a charter subscriber myself before becoming a full-time Fool, has followed its own dividend-focused strategy en route to market-beating returns. If you'd like a few of our top dividend stock ideas, you can now try the service free for 30 days.
This article was originally published on Aug. 31, 2007. It has been updated.
Fool editor Joe Magyer does not own shares of any companies mentioned. Sonoco and UPS are Income Investor recommendations. Pfizer and Coca-Cola are Inside Value recommendations. Baidu.com is a Rule Breakers recommendation. The Motley Fool's disclosure policy pays dividends.