Safe passage

Entrepreneur, July, 1997 by Lorayne Fiorillo

Investing successfully in today's financial markets may seem as perilous as getting out of Casablanca. If your papers are not in order, you could be in for a rough time - not from the authorities but from the swings of stocks. But don't let the bad guys get to you. There are plenty of steps you can' take to assure safe passage.

When it comes to investing, risk counts as much as reward. Stocks generally have provided long-term gains, but the financial markets are still prone to slip-ups, corrections or even meltdowns. Past performance, as any astute investor can tell you, is no guarantee of future returns, and salvaging a ravaged portfolio is a lot harder than protecting one. If you're stretching to make all you can from your portfolio, you could end up with a nasty shock... at least in the short run. The key is to become "risk-ready," especially when the financial markets start to rock and roll.

Being risk-ready means knowing the types of risks inherent in different kinds of investments. There's inflation risk, when the return on your investments doesn't outpace the rate of inflation, and liquidity risk, which means you own an investment but can't sell it when you want to. These two types of risk are good reasons to choose stocks as part of a diversified portfolio. Historically, stock returns as represented by the Standard & Poor 500 Index have outpaced inflation as measured by the Consumer Price Index, and liquidity is very high in stocks traded on major U.S. and foreign exchanges. Strategic asset allocation and investment diversification can help you sleep better at night, but even diversification isn't an end in itself. The best defense is a good offense. With that in mind, here are seven steps you can take to get your house of investments in order.

1. As time goes by. If you're going to invest in stocks, keep in mind a trend is just a trend. In short, don't overreact by trying to time the market. While past performance is not a predictor of future returns, historical data shows holding stocks for the long run really cuts the risk. According to a recent study by Chicago stock research firm Ibbotson Associates, for all three-year holding periods since 1946, stock returns were positive 93 percent of the time, based on the S&P 500 Index.

Take this hypothetical illustration: If you invested $1,000 every year for the past 34 years and reinvested all dividends in the S&P 500 Index, your $34,000 investment would have earned $325,771 if, with the worst timing imaginable, you had invested at the market high of the year. Of course, if you had perfect timing, investing your $1,000 at the market low, you would have earned $365,880. The difference between the extremes? A mere 12 percent; that's less than 1 percent annually. As a long-term investor, you avoid the aggravation of trying to get out at the top and in at the bottom of the market's cycles.

2. The bears wore red; the bulls wore blue. As a rule, the blue-chip stocks of large, well established multinational companies are less risky than the stocks of small, little known, single-product firms. When the markets drop, investors often see a "flight to quality," with money going where investors feel safest: the stocks of big companies. No stock, large or small, guarantees investor protection, but large companies are less prone to sudden plunges and are often the first to rebound when the markets begin to turn up again.

3. Don't be misinformed. Get your research from a reliable source - crystal balls and fishing buddies don't count. In-depth research involves the big picture, including political, economic and demographic factors as well as specifics of individual companies.

Technical analysis - using charts and computer programs to identify price trends - provides other information to help you make informed decisions. Base your research on facts, not feelings, hunches or tips.

4. Round up some unusual suspects. Smart investors use overall asset allocation to ensure their portfolios include different classes of securities, such as stocks, bonds and cash. In addition, no stock portfolio should consist of just one or two companies. Diversification means building a multistock portfolio, including domestic and foreign holdings, blue-chip and OTC (over-the-counter) shares, as well as companies in different industries.

5. The start of a beautiful friendship. If you're a risk-ready investor, you keep your eye on several traditional measures of investment value, including price-to-earnings (P/E) ratios, price-to-sales ratios and book values. All other things being equal, a stock selling for 60 times earnings is riskier than a stock selling for 10 times earnings. Growth stocks come from companies experiencing accelerated earnings growth; they often sell at high P/Es because investors expect that higher earnings will result in higher share prices. Value stocks are generally shares of long-established companies, often those familiar as household names with predictable long-term earnings growth rates. As you build a diversified portfolio, emphasize both value and growth stocks to protect it from excessive risk.