Back to Basics

Education Is Expensive But Try Ignorance

Back to Basics

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Education Is Expensive But Try Ignorance

Derek Bok, former president of Harvard University, said, “If you think education is expensive, try ignorance,” but whether he is the originator of the sentiment is debatable. In any event, since this button was created decades ago, the cost of a college education has skyrocketed ... and it’s still cheaper than ignorance.

At Cabot, there’s a big emphasis placed on education. We receive three daily newspapers (The New York Times, The Wall Street Journal and Investor’s Business Daily) that are placed on a communal table for us to peruse as time permits. Our walls are lined with investing books that we often reference. And our boss, Cabot’s President Tim Lutts, encourages us to go to conferences and other educational seminars if we feel they would be beneficial. I’ve been at a conference in Las Vegas all week learning and brainstorming new ideas so that I can be a better Cabot Wealth Advisory editor.

So today, I’m going to get back to basics and share some of the fundamental educational information you need to be a successful investor. Many of our readers are experienced investors, but a lot of you are completely new to the game. This tutorial should help get new folks up to speed in the hopes that having more basic knowledge will give you the tools you need to better understand what we write about. (Note: These lessons primarily apply to growth investors, but they can be beneficial to everyone’s investing strategy.)

Why should you own stocks?

Over the long term, stocks have outperformed all other investments. From 1926 through 2010, S&P 500 stocks brought investors an average annual return rate of 9.9%. Stock ownership entitles you to benefit from price increases and to receive dividends the company distributes.

How many stocks should you own?

We generally recommend that growth investors own at least five but no more than 12 stocks. That allows winners to truly have a big positive effect on your portfolio, while at the same time preventing losers from sinking it completely. We advise investing equal dollar amounts in each stock to balance risk.

How does Cabot pick growth stocks?

Cabot’s growth stock selection system starts by focusing on stocks that are strong and going up faster than the general market. These stocks are said to have positive momentum. But we need to see more than that. Behind each stock, we want to see a great growth company. In most cases, we require a company to be demonstrating strong growth of both sales and earnings. And we want to find a story that convinces us this great earnings growth is likely to continue in the years ahead. This system is followed in Cabot Market Letter, Cabot Top Ten Trader, Cabot Global Energy Investor and Cabot China & Emerging Markets Report.

What is relative performance?

Relative performance (RP) is a measurement of how a stock is acting relative to the market as a whole. It is one of the tools used by Cabot growth stock analysts to gauge a stock’s momentum. When a stock’s RP line is moving upward, the stock is performing better than the general market; when the RP line is moving downward, the stock is performing worse than the market; and when the line is level, the stock is performing the same as the market.

What is market timing?

We are strong believers in long-term market timing, mainly so we can sell stocks and raise cash to avoid losing money when the broad market enters into a major decline. Market timing is not an exact science, but we’ve had great success timing the market over the years so we feel confident in recommending that all growth investors practice it. Our three primary market-timing indicators are Cabot Trend Lines, Cabot Tides and the Cabot Two-Second Indicator.

The Cabot Market Letter averages one major market-timing signal per year. If it’s a sell signal, we work to reduce risk by selling our poorest performing stocks and putting close limits on the others. The object is to reduce the risk of loss and to raise cash for the next buy signal, when bargains abound. When that buy signal comes, we invest aggressively in the best-performing stocks we can find. Interestingly, that’s the time investors are most fearful!

How do I know when to sell a growth stock?

The most important rule in growth investing--and the hardest to learn is, “Cut your losses short.” That means if your loss in a growth stock exceeds 15% (in a bear market) or 20% (in a bull market) at the end of any trading day, you sell. Period. In general, we also believe it is wise to sell a stock when it has underperformed the market for eight weeks. The stock’s RP (relative performance) line is a good indicator of this.

Selling winners, however, is more difficult. Generally, the goal is to hold a stock as long as its momentum is positive, which means your profit has a chance to multiply. If you can do this, you’ll benefit mightily from the magic of compounding.

Is it risky to buy stocks hitting new highs?

In the long run, no, because a trend, once established, tends to persist. So if a stock’s trend is up and you’re convinced the company is capable of great earnings growth in the years ahead, you should buy it. You can reduce risk, however, by waiting for a normal correction, and buying a stock when it touches its 25-day moving average.

Which Cabot newsletter is right for me?

In addition to Cabot Wealth Advisory, which is free, Cabot publishes 10 other newsletters covering a variety of investing strategies. We understand that it can be difficult to decide which one best suits your investing needs, so we created a quick quiz. You can take it here.

That’s all for today. I hope you learned something that will help you become a more successful investor. Again, thanks to everyone who filled out the survey ... expect to see more topics pulled from the results in the future!

In this week’s Stock Market Video, Cabot China & Emerging Markets Report Editor Paul Goodwin tells us the market is still showing upward momentum despite the volatile week, and Cabot’s buy signals are still positive. Stocks discussed: Oil transport company Kirby (KEX), cosmetics company Estee Lauder (EL) and electric car maker Tesla Motors (TSLA). Click here to watch the video!

In case you didn’t get a chance to read all the issues of Cabot Wealth Advisory this week and want to catch up on any investing and stock tips you might have missed, there are links below to each issue.

Cabot Wealth Advisory 11/7/11 - Recipe for a Bull Market

On Monday, Cabot Publisher and Cabot Stock of the Month Editor Tim Lutts discussed the Panic of 1907 and why the measures put in place after each crash have not stopped the next one. He wrote about why you should not invest by looking back, but by listening to what the market is telling you right now. Tim also recommended a semiconductor stock for aggressive investors. Featured stock: Silicon Laboratories (SLAB).

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Cabot Wealth Advisory 11/10/11 - A Powerful Buying Spree

On Thursday, Cabot Market Letter Editor Mike Cintolo did some “precedent analysis” and found some surprising similarities between late-1990 and the current market. Featured stock: Hexcel (HXL), an aerospace parts maker that’s benefiting from a multi-year wave of orders thanks to expansion in emerging markets and Boeing’s new 787 Dreamliner.

Until next time,