The recent tech collapse has sucked up not only your money, but most likely your pride too. You’re probably feeling foolish about how you let greed take over your typically sane investment psyche.
Now, move on. The smarter investors will learn from these errors and use that newfound knowledge to actually make money the next time a bubble bounces into town.
Because another bubble is on the way. While we can only speculate when it will come and in what sector it will be (optics stocks have been looking pretty pricey, no?), we want to make sure you don’t make the same mistakes again.
There are some lessons to be learned — in no particular order — from this recent market frenzy so you don’t deplete your investment confidence again.
Valuations Do Matter “Most investors don’t know the businesses they’re invested in. They just know it’s hot,” says Deena Katz, a certified financial planner with Evensky Brown & Katz in Coral Gables, Fla.
Just because a stock goes up doesn’t mean things are necessarily good. “You have to pay attention to valuations. You can’t disassociate a stock with the company that’s behind it,” says Bob Olstein, the manager of the Olstein Financial Alert, and a former accounting firm consultant.
Red Hat is the perfect example: The stock rocketed as much as 450 percent after its November 1999 initial public offering, even though the company had no cash on its books. (Red Hat is down 86 percent this year.)
So know your company. Read the financial statements. Try to gain an understanding of how management thinks by listening to management interviews, surfing corporate Web sites and reading press releases. Then if the stock goes down, you may have a good understanding why.
Never Buy on Margin “We’re almost better off not having margin in the market,” says money manager Ashok Ahuja, of Icor Capital. Investors who trade on margin are taking a loan to buy shares. They use the securities they have in a brokerage account as collateral to borrow more money so they can buy twice as much as they can afford.
So if you don’t have the funds to buy 500 shares of what you believe is the new hot stock, you can pay for 250 shares and buy the rest on margin, using your current account holdings as collateral. Hopefully, if the stock rockets, you make a bundle and you easily can pay back your loan.
If the market slips, the value of the securities in your portfolio may, too. But those securities are part of your collateral. If their value falls below a minimum level — typically 50 percent of the borrowed funds, although firms can require more — the account may no longer be enough to guarantee your loan. Then you may get a dreaded margin call, where your broker requires you to bring your account back up to the required levels by either depositing additional funds or securities into the account or making full payment on your margin loan.
But if the market is down, odds are good that your money is all tied up in fallen stocks, so you could find yourself in desperate straits — actually owing more money than you initially put up for the loan.
An overabundance of investor optimism caused too many investors to get hit with margin calls. Of the more than 2,400 people that responded to our recent online broker’s survey, almost 40 percent said they had faced a margin call at some time. They were forced to ante up more cash for their positions or dump shares of stock into a falling market.
Don’t ever let yourself get into this position.
Learn How to Hedge A hedge is just an additional investment used to reduce the risk of precarious price movements. To create a hedge, an investor would take an offsetting position in a related security such as a short sale or option as a type of insurance.
While hedging can be expensive and sometimes complicated, there are instances where it can be beneficial. We offer two different approaches below, although there are many different hedging techniques.
Short-Selling When you enter a short sale you borrow a security from a broker and then sell it. Later, you buy the stock back, hopefully at a lower price, and return it to your broker. It’s a bet that the stock will fall.
So if you hear bad news on a company, assuming it’s an industry-wide problem, you may consider shorting other stocks in that sector. For instance, back when Nokia warned that handset sales were going to be slow, it might have been a good time to short a company related to Nokia’s business, say, National Semiconductor , a major supplier of chips for cell phones, suggests Ahuja. (It would’ve been a good trade because National Semiconductor recently fell almost 40 percent after it said fiscal second-quarter and third-quarter sales could fall short of first-quarter results.)
But be careful. Just because one stock warns does not mean the whole industry is in peril. Determine that it’s a sector problem, not a company issue, before you start shorting peers.
Of course, if you misjudge the direction of your short stock and it rises, you’ll find yourself in a “short squeeze.” You’ll have to actually go out and buy more shares at the higher price to cover your position. So your short position could cost you most than you initially spent to create it.
Options Everybody owns car insurance and hopes to never have to use it. Think of options — specifically put options — in the same way. “Use options as catastrophic insurance on your portfolio,” says Terry Haggerty, senior staff instructor at the Chicago Board Options Exchange.
A put option is the right, but not the obligation, to sell a specific amount of a given stock at a specified price by a certain date. One option contract typically represents 100 shares of stock and it expires on the third Friday of each month.
In periods of turmoil, put options can help you sleep at night without necessarily dumping shares into a falling market. “So if you’re concerned that you’ve got a large gain in a stock and don’t want to sell it, buy a put to protect yourself in the near term,” suggests Haggerty.
Let’s say General Electric were trading around $52 and you owned 100 shares, but you fear it will start to tank. You decide to buy some insurance to cover yourself from now until the middle of January. Let’s assume a $50 put trades for a $3 premium. That would give you the right to sell your shares at $50 each. For $300, you could protect more than $5,000. Then, if the stock were to tank, you would have secured the right to sell your shares at $50, no matter what the market price is.
If the stock didn’t fall, you spent $300 to protect yourself, but at least you were able to sleep at night. “Do you know anyone who weeps openly that they didn’t use their fire insurance?” asks Haggerty.
Keep in mind that you don’t always need to buy an option on one specific security. If you own 30 stocks, instead of buying 30 different options, consider buying a put option on the Dow Jones Industrial Average, or the QQQ, suggests Haggerty. You’ll insure a bulk of your portfolio with one option and thereby save some money.
Check out the Chicago Board Options Exchange’s Web site for more information on options. For more on using put options in rocky times, check out this earlier Options Forum.
Keep Expectations in Check It was a hard not to be overwhelmed with optimism when stocks like theglobe.com ran up 606 percent on its first day of trading.
“But it was not a sustainable pace. If you step back and study the market, you see that rarely ever can you sustain these levels,” says Bryan Olson, director at Charles Schwab’s Center for Investment Research. The market does not just move in one direction in the short term.
There will be downturns and your portfolio needs to be prepared for them. This recent volatility is a great eye-opener, even if it is eating away at your gains. (theglobe.com is since down 94 percent. Revisit the section on shorting again; it may help if IPOs get crazy again.)
So here’s what you should’ve learned: Don’t fall in love with outrageous returns. They may not be real. They will go away as fast as they’ve come. Either take some money off the table or don’t pay attention to the fiction.
In addition, “there is no monolithic market anymore,” says Ahuja. We have multiple markets that do not necessarily move in the same direction. One sector may be in a bear market while another is enjoying bullish times. “Be prepared for major dislocations,” warns Ahuja.
Stick to Play Money It’s trite advice, but diversification is key. You need a core portfolio that tracks all the asset classes so you’re not overweighed in highly speculated areas, reminds Olson.
Then “play” with a small portion of your portfolio. And don’t expect to keep it. “It’s the same thing as saying you want to take $10,000 and go to Las Vegas,” says Katz. “If you make money, great, but at least we didn’t bet the farm on it.” If you were lucky — or unlucky — enough to partake in theglobe.com’s IPO, you should’ve used your play money — not a portion of your core portfolio.
Any Final Thoughts? We all could use the help so that we don’t waste any more time kicking ourselves for making asinine investment blunders.