How To Diversify Your Portfolio - Cramer's Mad Money (4/20/15)
- Have at least two high yield dividend stocks in your portfolio.
- Gold is an insurance policy.
- Own a speculative stock for giant returns.
Stocks discussed on the in-depth session of Jim Cramer's Mad Money TV Program, Monday, April 20.
Cramer continued his investor education series. Until interest rates become normal and investors can survive on fixed income from bonds or certificate of deposits, stocks are the only game in town. While it is alright to go for an index fund if an investor is not willing to do their homework, very few of them have beaten the stock market. For those who like to play the stocks game, Cramer talked about the importance of diversification in a portfolio. This it not the usual diversification where different sectors are chosen. "I am offering a new kind of diversification that can help you, guide you toward what kinds of stocks I want you to have if you are going to manage your money yourself," said Cramer.
Cramer recommended a portfolio with a minimum of 10 stocks and maximum of 15. That way investors can keep track of all the stocks and do their homework. Next, it is important to be humble. "Repeat after me, 'Sometimes I am going to be wrong.' Come on, say it. 'Sometimes I am going to be surprised.' And one more: 'Sometimes my stock picks won't work out despite my disciplines'," said Cramer.
Stocks across the world trade together in many ways. Also ETFs are linking sectors in a way that did not exist some time ago. To protect a portfolio, an investor should follow these Cramer tips:
- Dividend paying stock with high yield
- Growth stocks
- Speculative stocks
- Stocks from a healthy geography
With not more than 20% of the holdings in one sector, and following Cramer's five areas of diversification, an investor can ride the wave of prosperity and keep themselves protected.
Dividend paying stocks
We are in a world where interest rates will go higher eventually. In such a scenario, income from bonds and deposits is not enough. Hence, to hold a dividend paying stock with high yield is very important.
Many investors would not consider dividend stocks, but eventually they are making investors money and compound in time if dividends are re-invested. "You need to own a stock; at least one, possibly more with a high-yielding dividend, but unlike when we diversify by sector, owning two or even three high-yielders, but no more than that, can actually be a good thing," said Cramer.
Dividend stocks not only provide safety and protect capital, dividends reinvested allow for compounding, which in the long run is good money. Also, dividends protect in turbulent times.
Cramer advised looking at stocks with a yield of 4%, because the stock price has fallen to a level that yield skyrockets and the stock looks attractive. While high yields are attractive, it must be taken with caution that an exceptionally high yield might not be sustainable. Therefore, it is important to check the safety of stocks and invest in dividend aristocrats; those that pay dividends and increase over time. Stocks with a payout ratio of 50% and consistent cash flows are usually considered safe dividend stocks.
Cramer said that dividends protect stocks and are a great way to add profits into your pocket. It's a win-win.
What are growth stocks? These are stocks that keep growing in all market scenarios due to strength of their business. We pay to buy a stock based on the company's expected future earnings. Using algebra, "The share price, P, equals the earnings per share, E, times what's known as the multiple, M. E times M equals P." said Cramer.
"The PE multiple is the key; it tells us what investors are willing to fork over for a company's future earnings. And the most important factor influencing multiple is the company's growth rate," said Cramer. Investors will accept and pay a bigger multiple for a business with fast growth as it means that the earnings will get larger in the coming years.
The PE ratio determines if it's cheap when compared to the average PE of the S&P 500. Lower interest rates make growth stocks more attractive, while higher rates make them less attractive as investors can then generate income with cash or bonds. Higher interest rates might also mean lower growth, as higher borrowing costs can affect a company's bottom-line.
When invested in a high growth stock, it is important to be cautious regarding the direction of earnings estimates. If estimates are being cut at a faster pace, it means that the growth is slowing down and vice-versa. Growth stocks can rocket and double quickly, as long as analysts keep raising estimates. Once a
momentum stock slows down, its PE multiple can shrink for ages. That means it is time to sell.
Another important aspect of diversification is owning a speculative stock. Cramer said that speculation is often perceived as a dirty word. But in reality, it might be more good than one thinks. What are speculative stocks? According to Cramer, speculative stocks are those that offer higher return and present high risk.
"Not only is it OK for you to own those tempting, risky, broken-seeming stocks that trade in the single digits, it's a necessity, as long as you follow my rules and speculate wisely," said Cramer. Investors need something against the boredom. High-risk high-reward spec stocks have a reputation of mystery, but Cramer advised that if they are owned with the right rules and discipline, they could also have huge upside potential for your portfolio as well.
Stocks like Home Depot (NYSE:HD ) and Comcast (NASDAQ:CMCSA ) were considered speculative in the 1980s. In fact, some of Cramer's biggest gains have come from speculative stocks.
How to identify these speculative stocks? Cramer recommends that the overall goal for spec is to invest in tiny, largely unknown companies in sectors that could catch a turnaround. When these companies become popular, one can benefit from gains. One way to identify these stocks is to look for companies that trade in the single digits. Cramer added that money managers usually stay away from single digit stocks because they think they are too risky. Thus, investors benefit from mispricing created by pessimistic money managers.
Another key to profit from a speculative stock is a shorter lifespan. The profits should be locked in quickly. Cramer also cautioned that the losses should be cut before they become too large.
Old is gold. Having gold in the portfolio is the old school method of investing. It brings a special element to the portfolio that other metals cannot give. "I think that 10% is the upper limit because I consider gold as an insurance policy and no worthwhile insurance policy should be 20% of the money you have invested," said Cramer.
Gold tends to go up when everything goes down. It is the investor's insurance against geopolitical events, uncertainty and inflation. While gold has not done anything great in previous years, it is important to note that a person does not cringe when his insurance value does not go up. Insurance is to protect and not grow. Likewise, gold is the insurance of the portfolio.
"You could also potentially call your broker and buy bullion, the actual physical bars of gold, as opposed to the bouillon cubes I like in my soup, but that only makes sense for investors who have lots of money and can afford to buy gold in bulk and pay to store it in a depository bank," said Cramer. Otherwise, buying gold via ETFs is an easy and low cost alternative.
Stocks from a healthy geography
U.S. stocks surged on Monday due to stimulus announced by China. This is a clear indication that advantages of different geography affect domestic stocks. So what does a healthy geography mean?
"What you really need is a stock that is in a safe geography. At times, when the United States is growing more slowly than the rest of the world, you need something international and not just something that does a lot of business overseas," said Cramer. He means owning a stock, the headquarters of which are in a foreign country. A safe geography will protect your portfolio from the craziness of a changing world.
However, foreign stocks might not always be a good idea. Look at Europe. In times of international turmoil, the domestic security of the U.S. will shield a portfolio. Cramer is recommending being domestic for the near future.
Viewer calls taken by Cramer
What should investment strategies be in one's 20s. Cramer recommended taking more risks in the 20s. This means owning speculative stocks, high growth stocks and moderate growth stocks.
Should profits be taken off stocks after gains. Your financial goal should be to play with the house's money. At the same time, it is important to take gains off big moves.
At age 35, is it wise to sell and take cash of a Roth IRA that invests in the S&P 500. Cramer said at this age, one should stay in to take advantage of the high growth phase.
What should the investment allocation be in one's 20s. No bonds. Pay your loans. Buy growth stocks.
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