When it comes to science, medicine, and investing... few things work better than good rules of thumb.
"Eat your vegetables" and "an apple a day keeps the doctor away" may be simplistic. But they are two of the best health guidelines ever uttered. And more recent advice to "walk 15 minutes a day" has now been shown to decrease risks of cancer and diabetes...
These simple and easy-to-remember rules bring proven benefits.
The same is true for investing. Simple rules of thumb can take much of the human error out of your decision-making...
For example, one dangerous phenomenon rules of thumb can help you avoid while investing is called "recency bias." People place too much importance on the most recent events. That forces them out at the bottom of markets and in at the top.
To see recency bias at work, just think about 2012...
People were afraid of another 2008-2009-type collapse. Record numbers of mutual-fund investors were piling into bond funds and, worse, buying U.S. Treasury securities.
Interest rates were near all-time lows, but investors followed the crowd into bonds. They were overly concerned about the past, and were dumping stocks. But in my flagship investment letter, Retirement Millionaire, we stuck with the simple rules for evaluating opportunities... And we made a lot of money in stocks.
I've been getting more and more questions recently about the latest round of volatility in the market... And once again, folks are getting nervous – piling into bonds and Treasury securities or holding tons of cash at the local bank or credit union.
So if you're wondering what to do... learning a few rules of thumb for investing will help you immediately.
These simple rules will help you know when an individual stock represents a great opportunity to collect income and grow your wealth safely... or when an investment may have run its course.
Even if some of these ideas seem familiar or simplistic, I urge you to incorporate them into your investing as you build a long-term portfolio... It's a time-tested formula for success.
Rule No. 1: Look for price-to-earnings (P/E) ratios below the long-term average of the S&P 500, generally below 17. A low P/E ratio suggests the company is trading below its value, making it cheap.
Rule No. 2: Look for stocks trading for a price-to-book (P/B) ratio less than one. A low P/B value suggests the company is undervalued, and you could be getting into a great company at a discount.
Rule No. 3: Try to avoid paying more than a price-to-sales (P/S) ratio of three for the stock of a solid, reliable business.
In the private markets, businesses usually get bought and sold at prices that are between one and two times sales. Of course, some well-established businesses with reliable sales can command a higher ratio.
Rule No. 4: Look for stocks that pay a dividend representing at least 2% of the share price. I also like to see a history of growing dividend payments. And I like the dividend yield to exceed the five-year Treasury note.
I prefer companies with a payout ratio of less than 50%... The payout ratio is the percent of earnings needed to support the dividend. In theory, at a 50% payout, a company's earnings could fall in half and still cover the dividend. This is an extreme. But by limiting ourselves to payout ratios of 50% or lower, we feel safer at night knowing our income is reliable.
A strong, consistent dividend almost always indicates a healthy business. The company is generating cash and wants to say "thank you" to shareholders.
Rising dividends also shore up stock prices in bear markets. Thus, dividend stocks are defensive stocks by nature. A rising dividend acts like a pontoon float and prevents the stock price from falling much.
These four simple rules for valuing a company make investing easier. Following them is a great way to invest in safe and solid opportunities. In fact, most of the times I've lost money, it was because I violated these rules.
What We're Reading...
- I'm not the only one who uses times of volatility like we're experiencing today to buy stocks...Stansberry Research founder Porter Stansberry just detailed how to collect your share of a legendary investor's $1 billion "bonus fee." My colleague Steve Sjuggerud recently shared why a massive discount in the "Rolls Royce" of precious metals creates a big opportunity in his True Wealth letter. And my colleague Dave Lashmet just sent an update to his subscribers about why a company he recommends is in line for big government money as it researches a Zika virus cure.
If you're interested in accessing these three opportunities... plus every single issue, update, alert, and report that Stansberry Research has published... click here to learn why the Flex Alliance program is only available one last time before it closes for good on March 9.
- Something different: A recipe for making a better McDonald's Egg McMuffin at home.