Q: I bought Cablevision cvc thinking it was a sure winner, but the stock is down 30% from what I paid. Should I bail out?
A: It pains me to get questions like this.
Too often, investors buy individual stocks not aware of the risk they're taking. Then, if the stock falls, these investors hold onto it, hoping it will bounce back.
They vow to be a "long term investor" while losses remain modest. It's only after the loss gets big, like 30%, that they decide the stock is too risky for them and consider dumping it. If this happens once, it's not a big deal. But some investors do the same thing again and again, dooming themselves to losing money and getting frustrated.
At this point, with your 30% loss in Cablevision, there's not much anyone can do to help you. Practically speaking, you could consider selling the stock and taking a capital loss. You can deduct up to $3,000 a year from your ordinary income on your federal income taxes. That way, you can at least turn this loss into something positive come tax time.
So, let's learn from your misstep and try not to repeat the error in the future. You've experienced firsthand why for most individual investors, buying low-cost mutual funds and exchange traded funds (ETFs) are a better option than individual stocks. You can spread your risk among many investments so you can afford to hang on and ride through short-term turbulence.
If you are already diversified, and you decide to buy an individual stock, you should put it through four important tests. Let's use Cablevision as an example:
Step 1: Risk vs. reward. When you take a risk on a stock, you want to make sure you're properly rewarded. Downloading Cablevision trading history back to 1986, we see the company generated an average annual compound rate of return of 23%. That is a solid return and about 130% greater than the long-term average annual return of the Standard & Poor's 500 index.
But to get that return, you accepted considerable risk — standard deviation of 65 percentage points. That's more than 200% greater than the S&P 500's long-term risk. That's tremendous risk, especially considering you're only getting a 130% higher expected return. Most investors should stop considering the stock right there.
Step 2: Measure the stock's discounted cash flow. Some investors decide if a stock is pricey by comparing its current price to the present value of its expected cash flows. It's a complicated analysis made simple with a system from NewConstructs. When we run Cablevision's stock, we find it's rated "dangerous." In other words, the current stock price is greater than what the company is expected to generate in cash over it's lifetime. If you're looking for a bargain, you're not getting it with Cablevision at these prices.
Step 3: Compare the stock's current valuation to its historical range. BetterInvesting's Stock Selection Guide usually can help. But, the Stock Selection Guide is based on price-to-earnings ratios. If the company loses money, as Cablevision does, there are no earnings and therefore no P-E ratio. Cablevision has lost money every year since at least 1990, according to Standard & Poor's Capital IQ. So, it's impossible to evaluate Cablevision using this test.