If you’re an average observer of Wall Street, it may be easy to think that most everybody is losing money. I don’t blame you. We’ve lived through the housing crash, the dot com boom and bust, and the “lost decade.” We’ve seen banks that were too big to fail and banks that failed anyways.
The horror stories are the only ones we hear. During hard times it seems like everyone around us is losing their homes and their jobs. I get it, Wall Street is a scary place.
I remember when I felt left in the dark about the stock market. I remember feeling like someone had to give me an “in” if I wanted to succeed. I want to tell you that this isn’t true. You can easily learn the basics.
Everyone wants to focus on finding the biggest winners. So much money, energy, and time is wasted on looking for the next Tesla or Google. But you can do just as good, if not better, by just avoiding the bad stocks.
When you lose money on a stock, you have to work twice as hard as before. If you lose 50% on any stock, suddenly you have to make an 100% gain just to break even. As you can imagine, it’s much easier to lose 50% than to gain 100%.
Diversification is always key. But one of the best things you can do for your portfolio is identify bad stocks before everyone else does. It’s easier than you realize.
How to Avoid Bad Stocks: Cisco
When Internet stocks soared in the late 1990s, everyone was jumping aboard. The stock craze was everywhere, and ordinary people and celebrities were buying and winning. If you know anything about recent history, you know that these people had short term wins that quickly disappeared after the party stopped.
Their losses were easy to prevent. If those people would’ve stayed away from high P/E stocks, like I constantly preach, the heavy losses would’ve been avoided.
In the year 2000, Cisco (CSCO) was the 3rd biggest stock in the United States. It had seen revenue growth of 48% but was trading at $108 with a P/E of 109. A P/E of 109! That is absurd! The average P/E for a company is 17, and CSCO was more than 6x that.
Yet investors neglect this basic fundamental, claiming that the price has been rising and so it must continue to rise. These type of valuations always correct, and people learn the hard way. They then curse the market and say it is rigged. Yet you never hear the story of the disciplined investor who knew to stay away.
When Cisco’s impossible expectations finally caught up with them, the stock crashed down to $18, a loss of 83.4%. The same typical excuses were all thrown out there, but really investors would’ve been safe if they understood the danger of a high P/E.
How to Avoid Bad Stocks: Lehman Brothers
People who lose will come up with the most ridiculous excuses. Remember when Lehman Brothers went bankrupt, and the whole world was in an uproar. It seemed like no company could be trusted. There was an accounting scandal with the company– they were manipulating their balance sheet.
Yet even with the manipulation, there was an obvious red flag that would keep a smart investor away from the company. While the company had a low P/E and great valuations and numbers otherwise, one glaring difference exposed its inevitable downfall.
The company had total liabilities of $668,579 million. While this number by itself means nothing, you have to compare their equity with this number to evaluate risk. I’ve talked before about using the Debt to Equity ratio. In this case, the company’s Debt to Equity was 29.73!
To put that into perspective, most companies will have a Debt to Equity ratio of around 1 – 1.5. Financial companies like Lehman Brothers carry a lot more debt than other companies due to the nature of their business, yet the average for the past 2 decades has been around 10. Lehman Brothers had almost 3x as much debt, leaving no room for error!
You can see how even just one ratio can expose a troubled company well before Wall Street is able to react.
YOU NEED TO LEARN THE BASICS
It amazes me that people will work all of their life, yet won’t take more than 5 minutes to decide what to do with their life savings! You can’t just push a button, investing isn’t like a microwave!
Reading just one book to decide what to do with money that took a lifetime to accumulate is too much? I hope people aren’t turning on their T.V.’s and listening to the advice they hear on there.
You see investing is different than other things in life. You could buy a stock, see that it is going up, and think you are making progress. This is the wrong way to think.
You need to educate yourself, and learn basics. A 5 minute segment with an “expert” on T.V. won’t teach you all you need to know. Reading just one of my posts won’t teach you all you need to know. It takes you a lifetime to accumulate wealth, and you need to spend at least a couple hours learning how to keep that wealth intact [and growing!].
A good investing book teaches you much more than any other medium.
Consider this, an average person will spend 80,000 hours in their life to work and earn money. Yet they won’t spend more than an hour thinking about managing it? Come on people. You don’t spend $20,000 on a car without spending $30 to get its oil changed, or $50 to gas it up.
You don’t need to become a guru, but you do need to learn the basics of finance. You can easily avoid bad stocks, but you need to know what you are doing.
**You Can Easily Avoid Bad Stocks – WW #29**
**All Rights Reserved. Investing for Beginners 2013**
**Photo shown above can be found here: Photo Attribution**