I think it’s equally as important to guard against losses as it is to look for gains with the stock market.
How little losses can damage your wealth
Losses on the stock market can be ruinous over an investing career. Due to the principle of compounding, a pound you own and invest today can become many more pounds down the line. However, a pound you lose is gone, along with the many pounds it could have become.
The following three steps can help you guard against downside risk as well as target gains.
1. Dividends first
I reckon it’s a good idea to stick to investing in firms that pay a dividend. The dividend tells us much about the underlying health of a business. The ability of a firm to pay a dividend proves profits are real and backed by cash flowing into the business.
Sticking to dividend payers keeps us out of speculative firms with no profits or troubled firms that require a business recovery before paying dividends. Recovery plays and speculative investments can deliver spectacular rewards but can also lead to spectacular losses for investors.
Remember, losses are multiplied over an investing career because of the lost opportunity to compound. I would argue that big upside potential isn’t worth large downside risk.
Famous investors Lord John Lee and Neil Woodford both follow a dividends-first strategy.
Rather than chasing growth, Lord Lee looks for a firm able to deliver sustainable and rising dividends. When he first invests in a firm he says he looks for no more than a steady income, believing that if he gets his analysis right, capital appreciation will take care of itself over time. Woodford’s comments chime with this approach. He recently said: “In very simple terms, our total return expectation for a stock equals its dividend yield plus the anticipated rate of dividend growth.”
2. Quality at a reasonable price
Firms with high quality, growing businesses can help us defend the downside and drive the upside in our portfolios. If you find a record of consistent and growing cash inflows, a stable profit margin and a growing dividend, there’s a good chance you’re looking at a quality operation with a strong, well-defended trading niche.
I reckon a quality business is likely to be resilient during periods of macroeconomic weakness. If temporary problems arise, a quality outfit has the potential to recover more quickly than weaker operations.
Consider this formula: Quality + Price = Value.
Quality is an essential component of value when it comes to buying shares. A lower quality operation or a higher price, as measured by indicators such as the price-to-earnings ratio, will weaken the value we think we’ve found in a stock.
To provide the best chance of protecting the downside, while capturing upside potential, we need to buy quality at a reasonable price, I reckon.
3. Moderate borrowings
High borrowings can increase downside risk.
It’s best to invest in firms with debts that are under control if we don’t want a weak balance sheet to threaten our investment in a company. If cash inflows are strong and reliable, a firm with a defensive business may be able to afford more debt than a business with more cyclical operations.
Moderate debt can increase investor returns, but each situation should be judged on its own merits.