Friday, December 19, 2008
(Cont'd from above)...

Jim (cont'd):   

 

Rule # 1:   You Must Stay Diversified
Jim:      Simple, most important rule of all if you are going to stay in this game. You must stay diversified. Diversification, as I said, as I say so often on this show, and people keep forgetting it, or they don’t understand how… easy it is. It is the only free lunch. And it is the first and most important rule for any investor to follow…. You want to stay out of this…. Diversification is this… Diversification in one sentence, never keep more than 20% of your portfolio in one sector. How about 5 stocks, like when we play “Am I diversified,” you own 5 stocks . There should be no overlap between any of the stocks in your portfolio. How about talking poker, I will use any analogy I can, you can’t own two of a kind. And you especially don’t want 4 of a kind. Investing is the opposite of poker. Keep that in mind. Four of a kind is a winner in one game, it’ a loser in another. Not being diversified has been the ruin of so many investors… That I have to repeat this one over and over and over, even though I think many of you probably get it.

In 2000, everybody wanted to be in the dot.coms. A lot of people owned only dot.coms, it was so hot, it was sizzling….

Well, you know how that turned out., people lost fortunes in these stocks. I made a small fortune at my hedge fund, I don’t run that kind of money anymore, I just run the charitable trust. I made a small fortune in my hedge fund in 2000, shorting these stocks. And frankly, this is a phrase that is always dangerous to use if you get a call from someone telling you to buy something. But indeed, shooting the dot.coms, was like shooting fish in a barrel… This is what knocked so many people out of the game, I had a lot of people who never got back in, they kept all their eggs in one vulnerable dot.com basket, and at the end of the day, all they were left with was egg on their faces… which you know I would put on right now, but I had a terrible outbreak of pimples the last time I did it.

In 1998 all people wanted to be was in the telcos. Well, think about it, what did you end up in WorldCom, Global Crossing, Level 3, hey, you never know. And Telegent. And a bunch of others that don’t even exist, 360 something. They all went belly up.

In 2001, it was the energy merchandisers. Holy Cow! I remember, people were saying, I own every energy merchandiser… Well, yeah, the hottest one was Enron…. Enough said.

If you were diversified, and only had 20% of your portfolio in these hot, at the time, groups, you would have lost less money, than all the people who went in and got crushed. I know, less money doesn’t sound sexy. But you know what, sometimes losing less money is the really the most important thing in the world.

Another example, how about this, in 2003, do you know what was the most hated, you know what nobody owned?... Oil. If you had an oil stock purely for the sake of diversification, which you should, because it was enough for the Standard and Poor’s 500 to merit a pit… you would have huge gains over the next 5 years. So it is not just not losing money… diversification can make you money.

Rule #2:   Buy And Sell Slowly On Wide Scales, It’s Important To Space Out Purchases
Jim:      This rule is right... well... right out of one of the canons of my investing career. The toughest one, by the way, the one that was written as a guide to working with me. It is rule #3 from “Real Money”, the book...

Buy and sell slowly on what are known as wide scales.

Never or buy your entire position in a stock all at once. This is something that seems counterintuitive to a lot of people. Hey, if you really like a stock, shouldn’t you buy it right here because it is going to go up. But if you space out your purchases, buy them at different levels, try to buy first and then wait till it comes down. You could avoid losing money, by putting down all of your money at the top. Which is something that is so many people do, and is so discouraging that I must stop it tonight.

More important is when it comes to selling. When you are up big in a stock, you want to schnitzel… some of those gains. Strange term, not if you have the glossary to this one… Schnitzel is a proprietary Mad Money term, meaning taking something off the table… Sell some of your stock to lock in the gains… Lots of people didn’t want to sell in 2000, what were they afraid of, they were afraid of paying the tax man…

By the way, “Real Money” rule #2, don’t be afraid to pay the tax man. If they had schnitzeled some of their gains, they wouldn’t have lost so much money. Tax man got cheated, didn’t he in the end, because no one had any gains.

Now you also want to do this because a lot of stocks are like an egg on a red hot grill. Now, I would say that it is the griddle at the Holland Tunnel diner, but unfortunately that closed. If you sell at the right time, you make a lot of money. But if you wait to long, you could get totally charred, inedible, burnt eggs, which is awful after you have had a night on the town, and you need a sop up...

Look… this is what happened to natural gas, as in July of 2008, look, it is the fuel, the fuel of the future. But the stocks got overheated, and we got burned... Now if you had been selling slowly in large scales as the natural gas stocks moved higher, you could have already taken some profits before those stocks overheated. I even used the burnt egg analogy at the time. Simply because taking a profit could never hurt anyone. Buying and selling in wide scales is particularly important in big dollar stocks, that fluctuate pretty wildly... Stocks that tend not to split. I am talking about the Apple (AAPL)s, the Research In Motion (RIMM)s, okay... Because there is rarely a time when you won’t get a chance to sell higher or buy lower, just because the market fluctuates.

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Rule #3:   Your First Loss Is Your Best Lesson
Jim:      For our loss prevention show… this one comes straight again from the book that was my hedge fund handbook. Your first loss is your best loss. It is important to take losses, to sell stocks you own that have gone down, and lost you money. When the reason you bought them is no longer true. Your thesis is broken. You thought that something was going to happen. Maybe you thought that oil was going to get crushed, and it didn’t. Maybe you thought the Fed was going to ease, and it didn’t. You have to limit your losses…

Just because you thought that someone was going to have a better than expected quarter, and it didn’t… don’t come up with new reasons to own it. Take your loss. Gains take care of themselves. I owned Fannie Mae for ActionAlertsPlus.com, my charitable trust, at one point. And the thesis started falling apart. I didn’t come up with a new reason to own it, I sold it in the 60’s. I didn’t care that it lost me money. It would have destroyed me. I just didn’t want to buy and hold. And I was right. I mean that stock made it’s way down to single digits. Fannie Mae was way to painful to own, given my fed rant given round the world. When it was clear that foreclosures were mounting… When it was clear that people thought that housing had stabilized… But then my thesis changed, because housing hadn’t stabilized… If the thesis changes, you go. Never feel bad about taking loses when the story has changed.

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Rule #4:   Dividends Limit Your Losses And Protect Your From Any Downsize
Jim:      Dividends… limit losses. As long as they are relatively safe. This is something I talk about in “Stay Mad for Life”, that is my personal finance book. For those who say, Jim why don’t you ever write about a 401k, why don’t you ever write about IRA. That is what Stay Mad For Life is about. You measure a dividend by its yield, versus what treasuries are selling for, 10 year federal treasuries. And you look for stocks that can grow their dividends. These stocks can protect you from the downside. Grow the dividends, mean increase it every year. Because as these stocks go lower, the dividend yield becomes higher, and that attracts new investors, particularly ones who are trying to compare it with bonds. But looking at the dividend alone isn’t enough, you need to know is it fairly safe? Can the dividend be covered? English, means can it be paid, do they have to borrow money. Does the company have the cash on hand and the cash flow to pay out the dividend it is promising?

Now in the first half of 2008, the bank stocks had these yields, it’s 10, 9, 10, 11. These banks were being ultimately, serial slashers… of dividends… especially, Wachovia and Washington Mutual… Why? They didn’t have the money to cover the dividends, so they cut it. And it was obvious, the dividends were too big. But Telco companies like, AT&T (T) and Verizon (VZ), and utilities like Consolidated Edison (ED), had no problem maintaining their dividends. Because they weren’t hemorrhaging money. Dividends will protect you from loses, as long as you protect yourself, from the dividends that can’t be paid.

I gotta another tip on how to spot a bogus dividend later in the show. Here’s the bottom line for my first 4 rules for helping you avoid losses. Stay diversified, buy and sell slowly with large scales, your first loss is your best loss, and dividends can limit your losses as long as they are safe.

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The Bottom Line!:     Stay Diversified, Buy & Sell Slowly, Remember Your First Loss & Dividends Limit Losses
 

Read Jim's next Segment - Jim Cramer's Investing Rules - Rule No. 11 here  

Then, Jim took calls from viewers:


Q: I have been able to purchase a few stocks with a little bit of money. I am curious if I need to be able to built those positions nor, or should I start diversifying and build those positions later?

Jim: Never too late to diversify, is the point blank answer. Now, what I say for a lot of people is your first $10,000 you save, should be in an S&P 500 fund. Why, because that is the ultimate diversification. Now here is the thing, when you want to get 5 stocks. You have to buy them one at a time. I don’t want you to go buy 10 shares, 10 shares, 10 shares. You pick a stock, then you add a stock, then you add a stock. Now when you are adding 2 and 3, you are still undiversified. So get in the game plan. Figure out what you like, figure out the 5 stocks ahead of time, and then buy them. Let the market take them to prices that you think they don’t deserve to be.

Q: I own a few energy trusts, and one large core position stock for dividends only. Now, when the market is really ugly, and these stocks are down a few dollars, and it is so very hard to separate facts from rumors. I need you to tell me exactly the things that you look for while doing your homework, that lets you sleep at night, knowing that your energy trust dividends will stay in tact.

Jim: Alright. The most important one is to know what you own. People don’t know what they own. So therefore they get freaked out. Secondly, understand why you bought it. You buy an oil trust because you believe that you believe that oil is going to stay higher. If you think, or if the thesis change, of if oil goes lower, you have to change your thesis. And you gotta skiddaddle. The key to all of these changes, is knowing what you own, so you can buy more if it goes down. Versus, knowing what you own, and having the thesis change.. And if the thesis change, then it goes from (buy, buy, buy)… To (sell, sell, sell)…

My defensive game plan starts with following my rules to save yourself from losses. I got a lot more rules coming up.

[verbatim recap]

Read Jim's next Segment - Jim Cramer's Investing Rules - Rule No. 5 here