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A Native Guide to Investing: Eat Bite-Size Chunks of Stock

There is practically no end to the ways you, the investor, can slice and dice the stock market, the key for how you carve it up is diversification.

There is practically no end to the ways you, the investor, can slice and dice the stock market, as I mentioned briefly when discussing ETFs in a previous column.

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The key for how you carve it up is diversification. Especially in the size of portfolios you and I can afford, we don’t want stocks that trade together. When I say, “trade together,” I mean something in addition to the tendency of the entire market to move up and down in concert. The state of the market moves all stocks but they all do not move equally. The state of the particular market sector moves stocks within that sector. Diversification cushions both. The former because non-cyclical or “defensive’ stocks are somewhat resistant to general downturns and the latter because, if you are properly diversified, you never have most of your money in one sector.

Toward the goal of accomplishing a diversified portfolio when it’s limited in size, I want to talk about some ways to divide up stocks.

Keep in mind that there are two ways you can make money investing long (betting that the price will go up). The obvious one is “capital gains,” which is the difference between the price you paid and the higher price you get when you sell, less commissions. If the sale price is not higher than what you paid, you have a capital loss that can be offset against your capital gains for tax purposes on Schedule D, with which you will become familiar if, like me, you do your own taxes.

The other way to make money is dividends. Stocks likely to produce large capital gains – “growth stocks” or “momentum stocks”—seldom pay dividends. A dividend declared by a corporate board returns capital directly to shareholders. Growth stocks seldom offer dividends because those companies need capital to expand the business.

Generally speaking, dividend stocks are a bit safer, because the dividend, when it’s safe—meaning the company will be able to continue paying it—tends to establish a floor for share prices. A dividend amount is normally expressed in the percent return you will get on your investment over a year. That sum puts the stock in competition with money kept in savings accounts or certificates of deposit on the low end, and corporate bonds on the high end.

Since the Federal Reserve has hammered interest rates down in an attempt to stimulate the economy, savings accounts pay next to nothing. The low interest on Treasury notes also bleeds over to corporate bonds. That’s how low interest rates stimulate the economy. It becomes a good time to borrow (issue bonds) and expand, which means jobs. But lower interest rates also drive money into the stock market in search of yield, when what the bond investors are used to is safety.

The corporations that can pay dividends over long periods of time and have a cash flow to support dividends are among the safest stocks to own, which is why they are called “granny stocks.” Should the share price begin to fall, the dividends, which are expressed as a yearly return on investment based on the current share price, go up. As the return goes up, more buyers are attracted, and the shares quit falling.

Back before the dot-com crash, very few tech stocks paid dividends, because expansion was the name of the game. When the bubble burst on March 10, 2000, what followed was a lot of bankruptcies and mergers and acquisitions. After it all shook out, some tech companies had become parts of the establishment and, after the scare was over, they began to return some of their robust cash flows to shareholders in the form of dividends.

The tech bubble is why you won’t find as many tech stocks as you might expect on the lists of reliable dividend paying granny stocks. Apple only started paying a regular dividend in 2012. Google does not pay a dividend. Amazon not only does not pay a dividend, it has not yet consistently turned a profit.

The dividend paying lists dominated by granny stocks are:

*Dividend Achievers, U.S. companies that trade on the NASDAQ or the New York Stock Exchange and have increased their dividend for 10 or more consecutive years.

*Dividend Champions have increased their dividend for 25 or more consecutive years.

*Dividend Aristocrats have increased their dividend yield for 25 or more consecutive years and are members of the S & P 500.

If you want to enter individual stock positions, how do you decide when and how? Any stock purchase assumes some time-frame. I explained in a previous column why I don’t do day trading, which involves getting in and out of a position on the same day.

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I prefer swing trading, which means that I look for a stock that is about to get more valuable because of something I anticipate happening. That something is called a “catalyst,” and obviously you might expect a catalyst over shorter or longer time-frames.

One of my earliest catalysts was when I expected a strike to settle and I could predict the terms of the settlement. That was a short-term trade, and it worked for me.

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When all Eurozone stocks were plummeting because of the PIIGS economies (Portugal, Italy, Ireland, Greece and Spain), I focused on a Spanish bank that I knew was not exposed to Spanish sovereign debt and was heavily invested in parts of Latin America that were chugging along nicely. I loaded up on that stock even though I make it a practice not to invest in banks or insurance. I’ll trade anything. My theory was that Mr. Market would shortly notice what I had already noticed and the stock would spike. It did and I sold. If it had not spiked, I would still have sold, because it was a trade, not an investment.

The “Oracle of Omaha,” Warren Buffett, famously remarked, “Our favorite holding period is forever.” That’s a classic statement of “buy and hold” investing coming from an investor who made his fortune discovering value that others had overlooked or undervalued. As a value investor, you open a position in a company with strong financials and a market advantage or “moat,” and you hold it until something changes.

The dividend lists will steer you to high yield stocks that are fairly safe. Your time horizon will depend on whether you intend trading or investing. Neither will get you diversified.

The first major division to straddle is cyclical and non-cyclical stocks, which represent the difference between luxuries and necessities. Non-cyclical stocks make money without regard to the general ups and downs of the economy, and they represent food, energy, soap, medicine—the kinds of things people have to buy. Sectors that are non-cyclical include consumer staples, health care, utilities.

Cyclical stocks depend on general prosperity. Things like automobiles, major appliances, sporting goods. These stocks live in sectors like consumer discretionary, materials, and industrials. When you have some of each, the value gyrations of your entire portfolio should be limited to the gyrations of the market generally.

Another way to describe stocks that depend somewhat on the business cycle is “secular.”

Secular trends are long-term catalysts. Some secular trends I am currently investing include my opinion that climate change will cause famine, which will spike agriculture stocks. Within tech, I believe that grid level energy storage is the major problem that needs solving to make renewable energy economically sound, so I am invested in energy storage and smart grid technology.

When the economy slows down, the “smart money” piles into non-cyclical stocks, which are also known as “defensive,” because people have to buy necessities even in a downturn. That is the time to load up on secular stocks.

When the economy starts picking up, defensive stocks trend down, and so that is the time to buy them, if you are a long-term investor. If you are a trader, then the general business cycle is just a backdrop for your decisions, not a driver.

In addition to the big divide between cyclical and secular, the market is divided into “sectors” that analysts believe are meaningful because they represent categories that will not rise and fall together. Different analysts divide the sectors differently, but here are the divisions used by Standard & Poor’s, in alphabetical order with examples of ticker symbols for ETFs that track each sector: consumer discretionary (FDIS, FXD, PEZ, VCR), consumer staples (XLP, FSTA, FXG, VDC), energy (UBN, JJE, ONG, DBE, RICI) , financials (FNCL, XLF, RYF, RKH), health care (FHLC, FXH, XLV, VHT), industrials (FIDU, RGI, IYJ, VIB), information technology (FTEC, FXL, IYW, MTK, VGT), materials (FMAT, FXZ, RTM, IYM, XLB, VAW), telecommunications services (FCOM, IYZ, XTL, VOX), utilities (UTLT, FUTY, FXU, RYU, IDU, XLU, VPU).

If you want examples of individual stocks from each sector, use the tools available at any online brokerage to open the portfolio of a sector ETF. If your portfolio contains five stocks, no two should be in the same sector, and if your portfolio contains more than five individual stocks while you are working full time, you are probably not paying enough attention to where your money is.

Note that “information technology” and “telecommunications services” have not existed all that long in the great scheme of things, but now they are considered major sectors of the modern economy. Investors who tagged the rise of those sectors as secular growth trends really made a killing, but if they got greedy, the tech bubble explosion wiped them out to the degree they were not diversified.

NASDAQ, historically where new tech companies went to list their stocks, was born in 1972 as the National Association of Securities Dealers Automated Quotations. Now NASDAQ is as much a part of the establishment as the New York Stock Exchange (NYSE) and is included in the general descriptive term for the stock market, “Wall Street.” The rise of NASDAQ roughly coincided with the move of investments away from stockbrokers acting by telephone to individuals placing trades by personal computer.

Changes of this magnitude are always happening. Information about social changes in progress is often, I have discovered, “investible.” The education that helps you predict change is found in history, sociology, and political science as much as anything in the business school. I set out to prove this in my personal market adventures.

If you are outside Wall Street wanting to get in, and you have decided against my advice to use ETFs, this would be a good time to visit the list of stocks that can be bought without broker commissions at Loyal3 and place them in sectors.

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Then (because this is what stock picking is about) research the stocks you “like” until you truly understand why you like them more than you like the rest of the sector. Failing to do this is like going to the track and betting on “that pretty gray horse.”

You can test yourself by “paper trading.” Write down how many shares you (would have) bought for how much on what date. Decide when to check in on your paper portfolio in the future. Paper trading becomes more exciting as your time horizon shrinks because you have more catalysts coming at you and, honestly, paper trading will do little on the investment side of things but quiet your anxiety, because in granny stocks, you won’t see a lot of movement.

Stick to investing over trading unless you come to enjoy researching individual stocks and you have the time to invest as well as the money. Next week, if there are still enough readers, I’ll write about diversification in terms of geography.