The last several years can truly be called the golden years for investors. We are in the midst of a historic bull run with the S&P 500 experiencing total returns of 31.49%, 18.4%, and 29.57% (estimated for 2021) in each of the past three years, respectively.
Looking at those numbers, the natural tendency is to assume that this rate of increase likely won’t continue in the years ahead. Yet history has shown us that it most certainly
can happen. For those who remember the market boom in the 1990s, the S&P advanced for nine straight years – and saw double digit returns for five years in a row from 1995-1999.
A similar stretch occurred in the 1980s, and more recently in the 2010s when the S&P advanced nine years in a row (again) when incorporating total returns. The plunge in early 2020 reset the financial clock, with a new multi-year bull market taking shape.
Remember – the crowd is usually wrong. The stock market is primarily driven through two dynamics – corporate earnings and economic activity. With earnings reaching all-time highs and GDP growth accelerating into year-end, the market is telling us that the rebound story since the pandemic-induced downturn in early 2020 may still have legs.
Individual investors have better access to more information than at any point in history. Therein lies today’s challenge – we must separate the relevant information from the myriad of uninformed opinions and personal biases that exist in the financial world. Let’s review two tried and true market lessons as we head into the new year.
The Most Important Thing to Know
The single most important thing to know in the stock market is how to protect your investment account. This means cutting losses before they reach a certain threshold. Whether you’re a novice or a seasoned investor, most people struggle with the idea that they simply won’t be right all of the time. Experienced investors embrace this idea and have little trouble cutting their losers short. If you don’t cut losers quickly, sooner or later you will likely suffer large losses.
This lesson speaks to human emotion. The problem for most investors is that hope plays a huge role in their decision-making process. When buying a stock, they always hope it will go up. When the time comes to sell and take a loss, they find it hard to admit that they were wrong. They would rather wait and hope for the price to bounce back so they can at last break even.
For newer investors, think of cutting your losers as a tiny insurance policy. If you own a home, you likely purchased home insurance to cover costs in the event of a disaster. Assuming disaster didn’t strike this year, ask yourself – are you mad that you purchased insurance even though your house was fine? Of course not. You bought insurance in the unlikely event that you suffered a major loss. That’s all we do when we cut our losing stocks early.
The more experienced you become as an investor, the better you will be at picking the best stocks and identifying proper entries. This will automatically translate into less losers in your portfolio. At Zacks, we have built a system composed of several different proprietary ranking systems and indicators to help you recognize leading stocks and appropriate entry points. Our Zacks Rank system and Earnings ESP filter help investors locate stocks that are primed to exceed earnings estimates and outperform the general market.
Investors should aim to maintain a certain profit to loss ratio. For example, if your goal is to sustain a 3:1 P/L ratio, cut losses at a maximum of 10% and
begin to take gains at 30%. Notice we highlight ‘begin’ here – ideally, your P/L ratio is greater than 3 to 1. We want to let our winners run and cut our losers early. That’s the secret to successful portfolio management.
As you become a better investor, you will realize not every loss will be taken at your threshold – some will be taken slightly less because you’ll realize earlier in the price move that your entry wasn’t ideal. But you need to be vigilant about cutting losses if they reach your threshold – this should be your maximum loss. If you get stopped out of a certain stock that hits your loss threshold, that doesn’t mean you invested in a bad company. Your timing may have simply been a bit off, and waiting for conditions to improve before reentering can pay huge dividends in the future.
There’s always a bull market somewhere. It could be in growth stocks, value names, small caps, large caps, commodities, cryptocurrencies, real estate…you get the picture. Our aim is to detect where the money is flowing and follow it.
Cut your losers early (hopefully few and far between), and let your winners run.
Pay Attention to the Company a Stock Keeps
You’ve likely read in the past that according to historical market studies, approximately half of a stock’s future price appreciation is due to its industry grouping. Focusing on the top-performing industry groups provides a constant tailwind to your investing success. Top industry groups are dynamic and change over time as sector rotation occurs. Let’s take a look at our current #1 Zacks Industry Group and illustrate why targeting leading industries is so important.
The Electronics – Parts Distribution industry group, part of the Zacks Computer and Technology sector, has outperformed the market this year by a wide margin (+42.7% vs. 29.57% at the current time). This industry group is composed of three stocks which all exceeded earnings estimates in the past quarter. The group is also exhibiting some favorable characteristics as shown below.
Image Source: Zacks Investment Research
Let’s take a closer look at the three stocks that comprise this industry group.
Arrow Electronics, a Zacks #1 Strong Buy stock, is up nearly 40% this year. (
ARW Quick Quote ARW - Free Report) trades at a forward P/E of 9.32 and is on track to exceed earnings estimates for the seventh quarter in a row. Arrow Electronics most recently reported EPS in November of $15.37, a +56.68% surprise over estimates. ARW has averaged a positive surprise of +18.57% over the past four quarters. Full-year earnings for ARW are expected to increase 88.39% relative to 2020.