Jul 02 2009

Tips on Speculating in the Stock Market.

I usually feel more in line with value investor Ben Graham’s line of thinking, but after reading Jim Cramer’s Real Money, I have come to see that there is a time and place for some of the speculator’s techniques.

Just because favor one school of thought, doesn’t mean another doesn’t have techniques that prove useful in certain situations. To that end, I’d like to share some tips on speculating that I’ve learned from Cramer and others.

Tip #1. Time and inclination.

Handle your investment portfolio only if you have the time and inclination to do the work required to be successful. If you’d rather be fishing, get a professional planner to handle your investments. Cramer’s rule of thumb for the time required is 1 hour/week for each stock in your portfolio. This seems reasonable.

Tip #2. Focus on your strengths.

You can’t be an expert on every industry or sector. Pick a few that interest you most, and master them. Maybe you’re employed in the health care industry or technology industry. In those cases the health care and tech sectors might allow you to be successful with less effort. If you have a good understanding of what makes or breaks businesses in your industry, then you are likely ahead of the game when it comes to analyzing similar companies.

Warren Buffet is famous for saying he only invests in businesses he can understand. Buffet’s a smart man when it comes to investing – learn from his example.

I’m not saying you can’t invest in different industries, but just recognize that you won’t have an innate advantage in those sectors. This also piggy backs on Tip #1. Time and inclination, in that it will most likely take you less time to keep up to date on companies in your industry. You’ll also know with less effort when a company’s earnings take a hit from sector-wide downturns vs. problems specific to that company.

Tip #3. The Forest, not the Trees.

Focusing on your sectors of strength is essential, but don’t lose sight of the world beyond. It is just as important to step back and see the big picture, so that you can understand what factors beyond the company fundamentals can move the price up or down. For example: Pay attention to the Federal reserve and interest rates!

Certain sectors of the economy do well when interest rates rise, and others do better when rates falls. You should know which group your stock(s) fall into. This also plays into sector rotation theory . Similarly, some companies actually thrive in a recessionary environment, while most do not. Knowing the difference can mean the difference between prospering and falling behind.

Tip #4. You need less than you think to be diversified.

Studies have shown that diversification can be attained with as few as 5 stocks. Cramer himself recommends between 5 and 10, while more than 15 and you are your own mutual fund. The key isn’t the number, but the sector. For example, don’t pick a blue chip tech stock and a small cap tech stock – if you only hold 5 stocks in your portfolio, this would put you at 40% in technology.

Tip #5. DON’T speculate on retirement.

Your retirement savings are too important to risk on speculation. Besides, you have many years to amass enough savings for retirement income. Speculation should be done with discretionary income. Only after you’ve set aside some money for retirement each month and you have an emergency fund and paid all your bills can you safely use what’s left to speculate.

Many people will say they don’t have anything left over at the end of the month, but I say it’s all a matter of priorities. You may have to decide for yourself whether you’d rather spend money on  stocks with the potential of earning more with that money or spend it on the movies, going out to dinner or any one of the other distractions on which people often fritter their incomes away.

Tip #6. Speculation is best left to the young.

Remember tip #5: DON’T speculate on retirement? That’s because retirement is too important to risk on speculating. Hand in hand with this line of thinking is that you should do more of your speculating when you’re younger because you have more time to make up for losses and mistakes. Much of that time is (hopefully) time that you will be gainfully employed and thus still be able to earn more money. If you speculate too close to retirement and make a wrong move, you’re in trouble. You won’t be able to increase your income in retirement!

Tip #7. You don’t have to be a millionaire to speculate!

Jim Cramer states in his book, Real Money, that $2,500 is enough for a speculation portfolio of 5 stocks. This is provided that you add to it over time with new money. He recommends  $500 for each stock. If your stocks are from different sectors, then this would provide you with an equal weighting and ensure that you don’t put too many eggs in one sector…er, basket. :)

Tip #8. Do your due diligence (homework).

Your work doesn’t stop with picking stocks for your portfolio. Once you’ve selected your stocks, you need to keep up on your homework.

Homework includes:

  • Keeping up on news that’s relevant to your stock or sector.
  • Read all SEC filings
  • Read analysts reports
  • Listen to conference calls (you can get these on yahoo! finance)
  • Keep up with news that affects your stocks

So what are you looking for on a conference call? I know, a lot of cynics out there will laugh this idea off. Who’s naive enough to think a company is going to come right out in an open conference call and say, “we’re in big trouble here!” The point is that your really looking to take the temperature, so to speak. You’re trying to get a feel for how things are going at the company.

You’ll want to know how the earnings and revenue growth are proceeding. You’ll want to know if the company is experiencing unexpected problems. Often times, management may try to push earnings problems off on greater economic conditions, but  keeping up with relevant news will allow you to know when the problems are systemic or local. For instance, if you owned a bank stock at the end of 2008, you would know that the financial sector as a whole was experiencing rough times, whereas if you held that stock in 2005 you would be suspicious of such claims.

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