STOCK INVESTMENT THE OPTIMUM APPROACH - OVERVIEW

In a series of articles, I will lay out in detail what I believe to be the lowest-risk approach to investing today. This overview outlines the approach, which will give the reader enough information (hopefully) to determine if the subsequent articles are worthy of review.

First, I want to look at the topic from a historical perspective. Prior to the 1950ís, largely based upon the experiences of the 1929 stock market crash, many investors considered stocks to be "risky", and automatically considered any purchase of stocks to be speculation rather than investment. Upon receiving a stock recommendation, the first question an investor/speculator would ask was "whatís it pay"? That is, what is the dividend? Stocks were expected to pay a significant dividend, with a yield higher than bonds or other fixed-interest instruments, to account for the higher risk. The principles laid out by Benjamin Graham (1894-1976) in his ground-breaking works "Security Analysis" and "The Intelligent Investor" for evaluating stocks as investments led to at least some acceptance of the idea that properly selected stocks, purchased at attractive prices, could be considered investments. Foremost among the attributes required for a stock to be selected were meaningful dividends paid consistently over a long time period, with regular increases, that were well-supported by consistent earnings.

Moving into the second half of the 20th century, a profound change in the public attitude towards stocks began to occur, culminating in the 2000 stock market peak, and even continuing on into the new millennium, to at least the most recent peak of 2007. Over this time period dividends became less and less important to most investors, dividend yields on average were considerably less than bonds and CDís, and many large, successful corporations paid either inconsequential dividends or none at all. Yet, strangely, over this same time period stocks came to be seen as respectable investments.

The goal of most investors in stocks in recent years has been capital gains, not dividends. However, that may be changing. With the world-wide economic slowdown that has occurred since the 2008 financial crisis, the environment for investors today resembles the 1930ís more than any time since then. Stocks are now considered by many to be "risky", far from a safe bet. Yet with interest rates on all fixed-income investments at lows not seen since the 1930ís, and with the retirement age population swelling, dividend-paying stocks are increasingly being viewed as the only viable alternative for the investor seeking income. This is the view I hold. Yet, I concur that stocks are fraught with risk. For one thing, the companies themselves face many risks, from adverse geopolitical developments, technological changes, catastrophic accidents, disastrous decisions by management, and many more. Then, in addition to the business risks, there is market risk, in that the stock prices can suffer huge drops when the market swoons, even if the companies themselves are doing fine. For instance, during the financial crisis, good companies suffered extreme drops because fund managers sold them to meet margin calls or redemptions, not because they believed they should be sold on the merits, but because they had to sell because these were the holdings that had value that could be extracted. Some may argue that risk can be addressed by hedging strategies, considering the many investment vehicles available today. Yet with returns meager and difficult to obtain, the costs of hedging would balance out much of the returns. I believe risk can be faced and mitigated in other ways without sacrificing returns.

The point is, market prices for stocks will go up and down, often (but not always) regardless of the outlook for the company. The approach I follow recognizes this as a fact of life, and seeks to benefit from it instead of shying away from stocks because of it.

The approach that I believe makes the most sense today accepts the lessons of history and the need for Grahamís "margin of safety" in stock selection, yet is more modern in that market fluctuations are expected in todayís volatile markets, and occasional adjustments (both buys and sells) should be considered when extreme market movements occur, thus deviating from a strict "buy and hold" approach. Again, todayís low commissions make small trades worthwhile that would not have been feasible until recent years. In fact, they are so low that the investor can get into and out of positions almost too easily. The investor must strike a balance to avoid trading too frequently for inconsequential gains, while still taking gains when worthwhile. My investment approach can thus be summarized as follows:

Dividend-paying stocks are the only viable choice for investors today. Stocks are inherently risky. This risk is to be mitigated by several methods. First, practice careful stock selection by developing a potential list of stocks (50 to 100 or even more) using screens and various valuation methods, ideally aided by subscription-based advisory services. For each stock, define the maximum price to pay, which will give a margin of safety. This is to guard against paying too much, one of the largest risks an investor faces. Also determine the full-value price, which can be a reference point for selling. Risk is to be further reduced by instituting a cap or limit on the amount to be invested in any one stock to no more than 5% of the total portfolio. Over-concentration risk is to be further mitigated by limiting the portfolio to no more than 20% in any one sector. Risk of over-paying is to be additionally countered by never paying more than the maximum price as determined for all purchases, but also by accumulating the approved total number of shares in no fewer than three separate purchases over a period of time. Each purchase subsequent to the one prior is only to be made at a lower price, ideally meaningfully lower, not just lower by a few cents. Further purchases will thus only be made if the average cost per share of the position can be lowered. (I will expound further on this "averaging down" approach later on in the essay on accumulation strategies. I realize most investment and especially trading authorities argue against this approach.) Recognize that it may take many months to get to the desired full position. If the first purchase (or two) was (or were) at an extremely attractive level(s), accept that the full position desired may not be able to be achieved. Acquiring stocks at reasonable prices is probably the most difficult aspect of the approach. The stocks of most high-quality companies are over-valued most of the time. Much patience is required to wait for a market decline to provide attractive acquisition opportunities. An upside to this is you will be more reluctant to sell out of a good position for a small profit after it was acquired so painstakingly.

In addition to tracking specifics of all trades, track dividends in detail. For each month, lay out the dividends expected, verifying as they are received. Also, track the accumulated dividends in total for each position. Over time, this can be an eye-opener, as it is seen how these payments add up.

To take advantage of market sell-offs and rallies, use the sell-offs to buy, either starting new positions or adding to positions already started. In extreme cases, allow additional purchases of full positions already held, to be considered as "inventory" to be sold when the next rally occurs. Thus a core position can be undisturbed with the "extra" shares acquired during a huge drop later sold when a rally occurs to take advantage of the price move up without sacrificing any of the core position. If the rally is extreme enough, a partial sale of a position with no extra "inventory" can be considered. There are definite guidelines to follow with this strategy to avoid over-trading. The challenge is to make the collection of dividends as the primary purpose of the portfolio, yet take advantage of extreme moves to selectively buy and sell advantageously.

A final method to increase returns is to sell options against stock holdings (covered calls) or against cash (cash-covered puts). The use of options is not required to follow the basic strategy. It is rather a supplementary tool to be used sparingly to increase returns. Attractive option opportunities under the criteria I use only appear occasionally. (My comments following assume a basic understanding of stock options. Skip this section if you do not have this knowledge.) If a stock held has had a significant run up, perhaps beyond the determined fair-value price, selling an option can be a viable alternative to selling the stock, in the sense that you are taking advantage of the price gain. Thus my number one covered call rule is to only sell the option if the strike price is such that you would (or should) sell the stock if it ever gets to the level represented by the option strike price. Usually it should be $2.00 or more than the current (already high) price. The option must be able to be sold for enough to make the trade worthwhile, say $1.00 or more, and must not be more then 3 to 6 months from expiration.

The selling of cash-covered puts should be used even more sparingly than calls. A put should only be considered when the market has declined quite a lot, yet few purchase opportunities are presenting themselves. A desired stock that is not owned may be down somewhat, but still not where you want to buy. If a put can be sold with a strike several dollars lower, where you would buy if you could, and the put price is $2.00 or better, a put sale could be considered. Keep in mind if exercise occurs, you may be buying a full position at once, not over a minimum of 3 purchases, assuming 100 shares represents a full position for your portfolio. This risk can be considered to be mitigated somewhat by the effective low price considering the strike price and the put premium. Note that the cash that would be needed upon assignment is locked up for the duration of the put (in IRAís at least). This strategy is to be used very sparingly, with no more than 1 or 2 put positions outstanding at any one time.

The approach as defined will be further explained in the following essays:

STOCK INVESTMENT THE OPTIMUM APPROACH Ė STOCK IDENTIFICATION

Goes into more detail in how to develop the list of stock candidates with maximum buy and full-value prices.

STOCK INVESTMENT THE OPTIMUM APPROACH Ė ACQUISITION & SALES

Explains further my acquisition and selling strategies, my rationale for an average-down acquisition strategy, and the parameters I consider to determine if I am facing a worst-case scenario in which averaging down has been a mistake, and a grudging stop-loss sale will be required.

STOCK INVESTMENT THE OPTIMUM APPROACH Ė RESOURCES AND ACCOUNT MANAGEMENT

Covers reference resources, market review and tracking, including economic releases, brokerage selection and trading platforms, and record keeping.

STOCK INVESTMENT THE OPTIMUM APPROACH Ė USE OF OPTIONS TO ADD TO RETURNS

Covers use of covered calls and cash-covered puts to enhance returns.

The entire collection of essays will thus present a comprehensive approach to stock investment with risk identified and minimized as much as possible, consistent with maintaining returns, but never eliminated.

CONCLUSION

A final comment about the time-commitment required. It is not "15 minutes a day", as ads for investment services commonly state. I am reminded of a quote supposedly from Einstein, that a complex topic should be "presented as simply as possible, but no simpler". Stock investing is not a simple topic. Once under way, my approach requires about 2 hours each market day, more on days with actionable opportunities appearing. At least 2 to 3 hours should be spent each weekend on reading, researching, and record-keeping. While starting up, the amount of time required can be extreme, depending upon a personís prior knowledge. There are at least 5 books that must be read, another 25 or more that would be helpful, and numerous other background materials to be absorbed. Computer skills are essential. Consider the recurring line in the "Bourne" movies, "are you ready to commit to this program"? If the answer is "no", but you still want exposure to stocks, you should invest in mutual funds or ETFs with the aid of a fund advisory service or advisor you trust. On the other hand, if you really have an interest and want to significantly upgrade your stock investing knowledge and skill set, the resources to help you do that are available, either free or at minimal cost.