7 Questions for Growth Investors

11/18/2011 8:30 am EST

Focus: STOCKS

Whether you’re a grizzled market veteran or a new investor learning the ropes, it always helps to establish the fundamentals before you’re forced to learn the hard way, says Elyse Andrews of Cabot Wealth Advisory.

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 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 Do You Pick Growth Stocks?
Our 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.

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 our 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.

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.

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