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FIGURE 2-2: The longer you hold stocks, the more likely you are to make money.
Pare down holdings in bloated markets
Perhaps you’ve heard the expression “buy low, sell high.” Although I don’t believe that you can time the markets (that is, predict the most profitable time to buy and sell), spotting a greatly overpriced or underpriced market isn’t too difficult. For example, in the second edition of this book, published in 1999, I warned readers about the grossly inflated prices of many internet and technology stocks (see Chapter 5). Throughout this book, I explain some simple yet powerful methods you can use to measure whether a particular investment market is of fair value, of good value, or overpriced. You should avoid overpriced investments for two important reasons:
If and when these overpriced investments fall, they usually fall farther and faster than more fairly priced investments.
You should be able to find other investments that offer higher potential returns.
Invest new money elsewhere. Focus your investment of new money somewhere other than the overpriced market; put it into investments that offer you better values. As a result, without selling any of your seemingly expensive investments, you make them a smaller portion of your total holdings. If you hold investments outside of tax-sheltered retirement accounts, focusing your money elsewhere also allows you to avoid incurring taxes from selling appreciated investments.
If you have to sell, sell the expensive stuff. If you need to raise money to live on, such as for retirement or for a major purchase, sell the pricier holdings. As long as the taxes aren’t too troublesome, it’s better to sell high and lock in your profits. Chapter 21 discusses issues to weigh when you contemplate selling an investment.
Individual-investment risk
A downdraft can put an entire investment market on a roller-coaster ride, but healthy markets also have their share of individual losers. For example, from the early 1980s through the late 1990s, the U.S. stock market had one of the greatest appreciating markets in history. You’d never know it, though, if you held one of the great losers of that period.
Consider a company now called Navistar, which has undergone enormous transformations in recent decades. This company used to be called International Harvester and manufactured farm equipment, trucks, and construction and other industrial equipment. Today, Navistar makes mostly trucks.
In 1979, this company’s stock traded at more than $400 per share. It then plunged more than 90 percent over the ensuing decade (as shown in Figure 2-3). Even with a rally in recent years, Navistar stock still trades at less than $35 per share (after dipping below $10 per share). If a worker retired from this company in the late 1970s with $200,000 invested in the company’s stock, the retiree’s investment would be worth about $14,000 today! On the other hand, if the retiree had simply swapped his stock at retirement for a diversified portfolio of stocks, which I explain how to build in Part 2, his $200,000 nest egg would’ve instead grown to more than $5 million!
© John Wiley & Sons, Inc.
FIGURE 2-3: Even the bull market of the 1990s wasn’t kind to every company.
Just as individual stock prices can plummet, so can individual real estate property prices. In California during the 1990s, for example, earthquakes rocked the prices of properties built on landfills. These quakes highlighted the dangers of building on poor soil. In the decade prior, real estate values in the communities of Times Beach, Missouri, and Love Canal, New York, plunged because of carcinogenic toxic waste contamination. (Ultimately, many property owners in these areas received compensation for their losses from the federal government as well as from some real estate agencies that didn’t disclose these known contaminants.)
Do your homework. When you purchase real estate, a whole host of inspections can save you from buying a money pit. With stocks, you can examine some measures of value and the company’s financial condition and business strategy to reduce your chances of buying into an overpriced company or one on the verge of major problems. Parts 2, 3, and 4 of this book give you information on researching your investment.
Diversify. Investors who seek growth invest in securities such as stocks. Placing significant amounts of your capital in one or a handful of securities is risky, particularly if the stocks are in the same industry or closely related industries. To reduce this risk, purchase stocks in a variety of industries and companies within each industry. (See Part 2 for details.)THE LOWDOWN ON LIQUIDITYThe term liquidity refers to how long and at what cost it takes to convert an investment into cash. The money in your wallet is considered perfectly liquid — it’s already cash.Suppose that you invested money in a handful of stocks. Although you can’t easily sell these stocks on a Saturday night, you can sell most stocks quickly through a broker for a nominal fee any day that the financial markets are open (normal working days). Mutual funds offer daily liquidity any day the financial markets are open.Real estate is generally much less liquid than stock. Preparing your property for sale takes time, and if you want to get fair market value for your property, finding a buyer may take weeks or months. Selling costs (agent commissions, fix-up expenses, and closing costs) can approach 8 to 10 percent of the home’s value.A privately run small business is among the least liquid of the better growth investments that you can make. Selling such a business typically takes longer than selling most real estate.So that you’re not forced to sell one of your investments that you intend to hold for long-term purposes, keep an emergency reserve of three to six months’ worth of living expenses in a money market account. Also, consider investing some money in highly rated bonds (see Chapter 7), which pay higher than money market yields without the high risk or volatility that comes with the stock market.
Hire someone to invest for you. The best funds (see Chapter 8) offer low-cost, professional management and oversight as well as diversification. Stock funds typically own 25 or more securities in a variety of companies in different industries. In Part 3, I explain how you can invest in real estate