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 Centre for Neuroimaging at University College, London.
So, if losing money causes us pain -- and we don't like pain -- we should avoid losing money, right?
Right
I hate to disappoint, but despite my mischievous headline, there's no guaranteed method for eliminating stock market losses. But even in today's choppy markets, we little guys aren't completely defenseless.
Here are four steps you can take to shore up your portfolio's defenses, while still allowing for hearty capital gains. 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 drive 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. If you know the strategy works, why mess with success?
OK, so what traits should you look for in a winner of a dividend payer? As a jumping-off point, make sure the dividend is secure by confirming that the company has a history of 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, providing companies like Procter & Gamble, Colgate-Palmolive, and PepsiCo
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's easy to get swept up in the greed-induced euphoria offered by ubergrowth situations like Amazon.com
If you want to gamble, go to Vegas. If you're serious about limiting your losses, don't overpay for growth, especially when attractively priced dividend payers such as Target
4. Diversify
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 only own 10 stocks, well, watch out.
Let's review
So, again, that's:
- Take shelter with dividends.
- Invest in strong brands.
- Avoid sky-high valuations.
- Diversify.
It's a simple, defensive, and profitable approach to investing 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 owns shares of Cemex and Corporate Executive Board. US Bancorp is an Income Investor recommendation. Amazon.com, Corporate Executive Board, and Cemex are Stock Advisor recommendations. Cemex is also a Global Gains recommendation. Corporate Executive is an Inside Value pick. The Motley Fool has a disclosure policy.
