How to approach stock pricing and portfolio building in today’s market, from Jim Cramer’s Getting Back to Even by bestselling author James J. Cramer
Go Back to Portfolio Basics to Get Back to Even
You have to find the right stocks and analyze them before you can take advantage of prices that are too low or too high. And you have to understand how a portfolio of stocks is supposed to fit together before you can run off and start buying things. Good stock picking never happens in a vacuum. There’s the purely historical context to keep in mind, and a lot has changed on that front in the wake of the most calamitous crash since 1929. The market has now stabilized and I have no doubt that the worst is behind us, but the trauma of the crash will undoubtedly change the way stocks trade for years, if not decades to come, so we must adapt accordingly. The essence of investing is flexibility. Losses are your enemy. The enemy must be avoided or beaten. The market is more dynamic and fluid than ever, so we have to be as well. How should you approach stock picking and portfolio building in this new environment?
First off, it almost goes without saying that your situation in life — your age, your family, how much money you have, how much longer you plan on working — will dictate your goals and your risk profile (how much you are willing to lose) and depending on your circumstances you’ll want to adopt different strategies and favor different kinds of stocks. But there are some basic principles for managing your money that, no matter where you are in your life, you’ll have to use if you want to stand a chance of getting back to even. I’ll explain how to strategize depending on where you are personally later in the book. Right now I just want to give you the basic implements, tools, and tactics that you’re going to need.
Some things don’t change no matter how crazy or horrible the market becomes. Those of you who are familiar with my earlier books or my television show have heard some of this before, but it bears repeating here. If you’re going to manage your own money, then you must maintain a diversified portfolio of stocks. I will shout this point because diversification is the single most important key to staying in the game. You violate it, and you will not be able to take advantage of the good times that will inevitably occur again. Why not? Either because you will have lost so much of your remaining capital by making undiversified bets, or, more likely, because even the Dalai Lama lacks the inner peace and emotional fortitude to stay in the game after taking the kind of losses that are practically inevitable when you invest in an undiversified portfolio of stocks. In your eyes diversification may prolong the time it takes to get back to even, a ball and chain to your leg as you race to rebuild capital. But believe me, without diversification, just throw the book away. It ain’t going to happen. You are not getting back to even with that attitude.
All of your stock picks, every purchase or sale you make, should be evaluated through the lens of diversification. You’ll hear this term thrown around a lot because it is so important, but sadly, not many people truly seem to understand it. Diversification is one of those things that sounds simple in theory but can be hard to implement in practice. At bottom it’s about not putting all of your eggs in one basket. It’s a cliché — what could be simpler than that? You’d be surprised. Keeping your portfolio diversified is not as uncomplicated as it looks, and the financial consequences of getting it wrong could be catastrophic. That’s why every Wednesday night on Mad Money I play a game called “Am I Diversified,” in which viewers call in and tell me their five largest holdings, so I can tell them whether their portfolios are diversified, and if not, which stocks to sell and what to replace them with in order to get there. I keep playing it because people keep flunking it, including longtime viewers. They keep confusing the sectors the companies they own are in; they keep missing that some sectors trade with others, like the drillers and the oils, or the foods and the beverages. They often don’t even seem to understand what a company does. An aerospace company is a defense company. A software company and a hardware company are both tech companies and trade together. Drugs and hospitals may not seem to be the same, but it doesn’t matter. They trade the same way. When everyone gets hallelujah and not the buzzer button, I will quit this game. But I have been playing it ever since my radio show Real Money started in 2001 and callers still regularly flunk the diversification test.
At the most basic level, having a diversified portfolio means owning stocks that don’t overlap, so that if something happens to cause one of them to go down hard the rest will remain relatively unscathed or even go higher. You want to own the stocks of companies that belong to unrelated segments of the economy, or sectors. What’s a sector? Health care, real estate, energy, technology, raw materials, industrial manufacturing, and finance all fit the bill. So do aerospace, infrastructure, oils and oil drilling, retail, and restaurants. Look at how each company in your portfolio makes its money and make sure there’s no close overlap. (The annual report will break down the end markets, the customers, for you in a very easy and readable fashion. Make sure you read the annual report, or 10K, before pulling the trigger.) Look at how each stock has performed historically and try to find ones that tend not to go up or down at the same time. My rule is that you should never have more than 20 percent of your portfolio in any single sector, because if you concentrate any more of your money in the same area then all it will take to knock you out of the game is for a single calamity to befall that one sector, and believe me, you do not want to take those odds. What qualifies as a calamity? How about government cutbacks for health care or defense, higher gasoline prices that cause a slowing in retail, soaring foreclosure rates ruining real estate and banking, or a cessation of Chinese buying that devastates the raw materials companies. All of these plagues visited the stock market in 2007, 2008, or 2009, and if you had too much money invested in the afflicted sectors because you scorned diversification, you could have lost a fortune. These days we don’t have fortunes to lose anymore, so you have to be especially careful.
ABOUT THE AUTHOR
James J. Cramer, author of Jim Cramer’s Getting Back to Even (Copyright © 2009 by J. J. Cramer & Co.), is host of CNBC’s Mad Money; cofounder of TheStreet.com, where he is also an online columnist; and “Bottom Line” columnist for New York magazine.
MORE ARTICLES BY THE AUTHOR
- Spotting Bottoms in the Stock Market
- The Importance of Stock Price in Building a Diversified Portfolio
- Why You Should Ignore the Three Golden Rules of Investing
- How Stocks Are Meant to Be Traded
- Read Chapter 1 of Jim Cramer’s Getting Back to Even
- Browse more books by bestselling author Jim Cramer