5 Hints for Navigating Mr. Market’s Movements – Throwback Thursday

This was originally published in April 2009, titled “5 Things to Remember as the Market Turns the Corner.”  It has some helpful hints that are true in any market environment.  This week for Throwback Thursday we will revisit those hints.

1.  Prices may fluctuate as Mr. Market sways his opinion, but values only change with earnings results.

A value of a company should be based on the earnings that it has achieved, and the present value of future earnings.  We use the past 10 years of earnings to determine an anticipated growth rate for a company, then use a normalized earnings per share amount to calculate the present value of that earnings per share grown in a perpetuity discounted at 11.78%.  This is the basis of Benjamin Graham’s formula from The Intelligent Investor, and you can easily calculate it yourself with the use of our valuation calculator.

2.  Diversification is your friend.

We don’t always buy into the whole modern portfolio theory idea that the market is efficient (at best it is semi-strong efficient), but the fact remains that by diversifying across a number of investments and industries you can lower your risk. In football you don’t want to have to gain all 10 yards in one play. You want to gain 4 yards per play on average because then you will easily get more than the 10 yards you need every 4 plays. The same idea comes into play with diversification. You don’t want to have the risk that your single chance at gaining will come from one company. You could fail with that investment and end up with nothing. We favor diversification across a small field of 10-15 companies for the enterprising investor or the use of ETFs for a very passive defensive investor.

3.  Rebalance your equity/bond ratio.

Last fall as the market was coming down we had a number of people tell us they were taking money out of their equities and putting them in bonds. I cringed every time I heard it. They should have been doing the opposite – take money out of your bonds now and put them in equities! Sure, this downturn hasn’t behaved exactly the way that it should (bonds rise as stocks fall) but equities will rise more when the market recovers. For an easy way to keep balance between bonds and equities in your portfolio, rebalance every 6-18 months (depending on your own preferences regarding capital gains taxation), and strive for a set ratio of 110-your age=% of portfolio in equities. For example, a 30 year old should have 80% of his portfolio in equities while a 60 year old should have a 50/50 split.  In The Intelligent Investor, Benjamin Graham suggests a 50/50 split, with flexibility of moving to a 25/75 split (in either direction) depending on the individual’s expectations of the market.

4.  Rebalance your individual investments.

When you rebalance your equity/bond ratio, do it with your individual investments. If you want to diversify across 10 investments, each one should constitute 10% of your overall portfolio. Over time, some investments will rise faster than others leading to them taking up more than their share of your portfolio. By rebalancing them back down to 10% you lock in some gains and are able to put those funds towards the investments that have taken longer to rise (and may be due for a quicker rise).

5.  Dividends can make or break a portfolio.

For both the defensive and enterprising investors, we think that dividends are an extremely important part of the investment screen. One reason is that companies that make dividend payments tend to be more established and stable businesses. Another reason is that a constant dividend stream lowers the risk of capital depreciation. As Warren Buffett says, “The number one rule in investing is to not lose money.” If you invest in a company that has a dividend yield of 3%, you can face losing some capital in the price of the company over time without actually losing any money.