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Investing vs. Speculation

May 26, 2011 12:36 PM ETMO, ED, XOM, VZ, JNJ, LMT
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Today I wanted to spend some time on the difference between investing vs. speculation.
To begin I must tell you the golden rule of investing. "The most powerful tool an investor has is dividend reinvesting over time."
 I characterize investments as stocks that have been around for a long time. The stocks should have a yield of 4-5%, they should have a relatively low P/E, an earnings per share that reflects stable income year over year and a market capitalization of at least 25 million dollars.
It is amazing that by taking the dividends that these stocks kick off and reinvesting them back into the stock, the stock will compound quickly making your portfolio grow. There are many companies that allow you to dividend reinvest so choose a company you feel comfortable with. You don’t have to do anything except set up your portfolio to dividend reinvest. If from time to time you find that you have some extra money send it to them and they will buy even more shares. Even better, if you can afford it, have $100 a month automatically deducted from your checking account to buy more shares. Just make sure you are not stretching yourself to thin. This will only lead to frustration and in time you will give up. Setting up a dividend reinvestment portfolio is like getting married. You have to be fully committed.
So what does a diversified portfolio mean? It means that your stocks are in different sectors. I will use this proxy account to demonstrate what I mean. I have holdings in Altria (MO) which yields 5.4%, is considered a consumer discretionary stock, Con Ed (ED) which yields 4.60% is considered a utility stock, Exxon Mobile (XOM) which yields 2.30% is considered an oil stock, Verizon (VZ) which yields 5.40% is considered a communications stock, Johnson and Johnson (JNJ) which yields 3.40% is considered a  pharmaceutical stock, and Lockheed Martin (LMT) which yields 3.70% is considered a defense stock. To review you can see that my diversification is in consumer staples, oil, utilities, communications, pharmaceuticals and defense. This is a well balance portfolio.
Under any circumstances, however, what you never want to do is “have all your eggs in one basket.” You would never want to hold 5 financial stocks because they have high yields. Financials is a perfectly fine sector but it is one sector. Never own more than one stock in a sector. Diversification is the only "free lunch" we have as investors.
I would suggest that you do not hold more than five or six stocks. It becomes overwhelming and while you never want to trade these companies it is important that you watch them and stay on top of any “Black Swans” that might affect how they perform. I suggest you review these companies every six months to make sure that there has been no fundamental change in them. If you feel that nothing is broken don’t fix it! Leave them alone and continue to let them dividend reinvest. I know I'm repeating myself but I believe it's worth saying twice. The golden rule in investing is “dividend reinvestment over time is the most powerful tool an investor has.”
Now I’d like to speak about speculation. Rule number 1, 2 and 3 is never; ever turn a speculative trade into an investment. Speculation is the “art” of finding a stock that you think will perform in a certain way and dollar cost average into it as the price rises. Before you buy the stock you must know how low the stock will go, how high the stock will go and what the time frame is. The great financier Bernard Baruch taught us that to be successful speculating in the market you only have to be right 4 out of 10 times. In this hypothetical if you are wrong 6 times you have a net loss of $.50 per share but if you are right 4 times you have a net gain of $15.00 per share.
So you buy a small stake of XYZ at $10.00 and you think it might go as low as $9.50 and the upside is $25.00 within six months.
     When you buy the stock at $10.00 you put a stop under the stock at $9.50 because you have determined that you will not sustain a loss greater than 5% for this stock. What you and you alone must determine is an acceptable loss you are willing to sustain. I know people that use stops of 3% and some that use 10% stops. That is something that you must determine by understanding the fundamentals and the charts before you even buy a share.
     If the stock acts as you thought it would you buy a little more and you raise you stop to 5% below the new price. It is a very hard concept to understand but the successful speculators buy a stock high and sell it higher. Denis Gartman uses the analogy of grabbing onto a rocket that has taken off and holding on as it moves higher. If however the stock drops past your stop get out and don’t ever look back.
    The tricky part is knowing when to get out. A study of the charts will often give me a clue as the stock becomes over bought but I have found that by consistently raising my stops as the stock moves up I am able to lock in my hard earned gains. As an editorial note I would like to add that I, personally, do not use triggered stops but rather mental stops because along the way institutional buyers will short the stock to shake out the “faint of heart investors” so by using mental stops I can sell when I see that this is really the time to get out or if it is simply a “shakeout”. This comes with time and experience so in the beginning use triggered stops because nobody ever got hurt taking a profit. 
So to quickly review, we have determined that there is investing and there is speculation. I believe as we grow older, investing should be a greater part of our portfolio but when we are young we have time on our side so to be a little more risky is not such a bad thing.
        Again if you have any questions about what I have written please leave me a message and I will be happy to reply.

Disclosure: I am long MO, ED, XOM, JNJ, VZ, LMT.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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