October 7, 2007
Q. I am 24 and have been saving in my 401(k) for about a year, but I find mutual funds boring. So I started paying attention to stocks. I discovered that I was good at spotting those that would do well. For a while, I just made a mental note of stocks I liked, but when I saw them go up I decided to buy my first stock. It was Garmin, which makes navigation devices for cars. I bought it for $70 and I made money immediately. Now I'm wondering how to decide when it's time to sell. Are there some rules of thumb?
A. When it comes to investing money for your future, boring can be beautiful.
In fact, you might be asking your question now because Garmin Ltd. stock has suddenly plunged. That might mean your initial excitement has turned to fear, dread or confusion.
After soaring to more than $122 a share in late September, shares fell below $100 in just a couple of days. That's a tremendous drop in a short time. And you are probably wondering what it means: Whether you should bail now and lock in your $30 gain on the stock or hope for the magic to return.
Boredom might feel better at this point.
Morningstar Inc. analyst Pat Dorsey suggests taking your gains and getting out now unless you know more about the future of the company than your question suggests.
The stock plunged because of competition, the bane of a hot stock. Nokia, which makes telephones, is acquiring digital map-maker Navteq Corp. And that means Garmin could have another significant competitor in the navigation device business as Nokia blends navigation with cell phones.
Investors don't like it when they see competition shaping up. A stock might have been a high-flier, and its products might be good, but when competition shows up, it means it is tougher for a company to make a profit, no matter how good the company is.
This is critical for investors to realize, especially those who buy hot stocks without understanding what will drive the stock price higher. Stocks do not go up over time unless a company is as profitable, or more profitable, than investors think it will be.
And if an investor simply buys based on the obvious, a good product in a growing market, they are likely to be disappointed, Dorsey said. Every other investor sees the obvious, and that is usually built into the stock price people are paying.
The disappointment may not come at first. Momentum and investor excitement can drive a stock higher for a while. But when a high-flying stock drops 20 percent, that can be a sign that "people have changed their opinion about a stock," Dorsey said.
And that can mean that holding on and wishing for an old stock price to return can be folly.
Too often individual investors don't sell when they should.
They see a $50 stock go to $40, and say they will wait for $50 again. Then the stock goes to $35, and they wait for $40 to return.
Dorsey, who wrote "The Five Rules for Successful Stock Investing," suggests studying a stock before buying it. When you do that, you decide upfront what you think will drive profit and by how much.
On that basis, you decide if the price of the stock is too high. If you pay too much, you could have a solid stock but still encounter a plunge in price.
If profit is lower than expected, that could be a reason to sell. If sales growth slows because a competitor is taking business, that could be a reason.
To learn how to analyze a stock, try the "research wizard" tool found under "stock research" athttp://www.moneycen tral.com. It walks you through the type of analysis professionals use.
If you do not want to do this analysis, stick to mutual funds. Even if you build up $1 million by retirement, that may not be enough. With the impact of inflation, such savings would only buy what $300,000 would today.
As a rule of thumb, you should be investing at least 10 percent of your income in your 401(k) so you have enough for retirement.
Then, if you want to use a little play money to invest in stocks on the side, go for it. But do it thoughtfully.
Picking stocks is tough. Even professionals get it wrong. But because mutual funds often hold 100 stocks or more, you have insulation if one stock suddenly takes a turn for the worse. The stronger stocks in a mutual fund buffer the effects of losers.
There is safety in numbers, and you have a better chance of winning with 100 stocks than one or two.
Professional stock pickers who work for mutual fund companies generally set what are called price targets when they pick a stock. They analyze all the factors that they think will drive profit, and then estimate where the stock price should go. They promise themselves to sell the stock when it reaches that point.
When that time arrives, they will re-examine their analysis of the stock and see if there is new information that suggests profit will be greater than they thought. If so, they will raise their price target and hold on.
Sometimes even they succumb to wishful thinking when stocks perform badly. They set up disciplines, like noting profit assumptions, to fight the urge to trick themselves.
If you are serious about picking stocks, learn to do this analysis. Although you often hear about stocks that are so strong you can buy and hold them for life, you must continually revisit your analysis and see if the reason for holding the stock remains sound.
Even solid stocks often lose their luster.
The Leuthold Group recently researched how stocks hold up over time.
They reviewed the 100 largest stocks of 1966, or the equivalent of such stocks as Exxon Mobil, General Electric and Microsoft today. Only 23 of those companies from 1966 remain on the list of the largest 100 stocks.
The next time you want to buy a hot stock and figure it will be as good as gold for life, consider Polaroid. It was a hot stock in the early '70s. A few years ago, it filed for bankruptcy, leaving shareholders high and dry.
Gail MarksJarvis is a Your Money columnist. Contact her firstname.lastname@example.org.
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