Investors are always trying to time the market. They want to get in at the lows and get out at the highs. While this simplistic goal sounds easy, it is almost impossible to achieve.
Regardless of their timing abilities, one area where investors have seen good results is low-priced stocks. Single digit stocks are attractive to investors for many reasons, but when is it best to build them into your portfolio? Let's take a look at why now is a good time to buy low-priced stocks.
Works at the Highs
Low-priced stocks work when the market is at the highs because these are the stocks that have been overlooked. The market is too concerned with which stocks are soaring towards triple digits (or even quadruple digits in some cases) to look down the scale.
This allows investors the chance to get in on something that is still fairly close to the ground floor. With the overall market raising all prices, the lower you go on your entry, the better chance you have of outperforming down the road.
Wise investors know that you cannot have all your eggs in one basket. Apply this same idea to the high flyers with big price tags. Adding low-priced stocks to your portfolio works as a defensive measure. If things turn sour, the high priced stocks will be among the first that are sold.
Works at the Lows
When markets are at the lows, single digit stocks are among the best plays out there. They are the ones that stand to see significant returns when the market turns around. The small price tag alone will get many investors to "buy low."
Another reason single digit stocks will work at the lows is because investors begin to scour the entire universe of stocks looking for what is working. Low-priced stocks tend to be among the first to recover from panic selling.
Often times we see investors getting burned on those high flyers. We don't hear many stories about investors losing everything on the stocks that are already beaten down. On the contrary, the time to be buying stocks like that is after everyone else has already abandoned ship.
Have a Game Plan
I know it sounds like I am talking out of both sides of my mouth here. I supported the idea of buying low-priced stocks at the highs and also at the lows, so which is it? The truth is, it always makes sense to have single digit stocks in your portfolio.
More . . .
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You still have to know your target investment structure. By that I mean you should not have a portfolio of low-priced stocks built to reflect the Dow Jones Industrial Average. That stalwart mix of mega cap stocks behaves much differently than most low-priced stocks. Instead, look to a smaller index for guidance.
The Russell 2000 is a much better benchmark to use when structuring a lower priced stock portfolio. Use the weighting in that index as a guideline and be overweight sectors that look likely to outperform. The Zacks Industry Rank can help you figure out which areas are seeing more strength.
From $5 to $50
The headline for this section isn't just an attention grabber, it really happens. In fact, it happens more than you think. Stocks that start out in the single digits hold the promise of being 5, 7, even 10 baggers over time. The key is to be patient and let the winners run.
This is not to say that investing in this space comes without risk. Only a fool would believe all single digit stocks are destined to be double digits. Along with patience, investors need to be able to accept the risk that comes along with under-followed low-priced stocks.
Balancing risk is key to a well-rounded portfolio. Maybe even more so in a portfolio of low-priced stocks. Let's look at some ideas on how to balance that risk for your low-priced stock portfolio.
Limiting the Risk
The first step in a single digit stock portfolio is diversification. I talked about benchmarking the portfolio to the Russell 2000, so be sure to use that as a guideline of what sectors should be overweighted or underweighted. Financials tend to be overweight in that index, so be sure to check that against the Zacks Industry Rank to see if you should follow suit.
One should not only diversify among industry, but size as well. It is imperative to have some large cap stocks in your portfolio of low-priced stocks. It fits with the idea of not having all your eggs in one basket, so be sure to have a few big cap names in there as well.
The big cap names will also serve to soften the blow if the small caps see a sector rotation. Leadership among stock classes changes frequently and often without warning. Having a few big cap names sprinkled in can only help if things take an unexpected turn.
Stay on Top of the Market
In a low-priced stock portfolio it is important to keep your winners and sell your losers quickly. The Zacks Rank will help you get that early advantage you need to succeed. The Rank will tell you which stocks are seeing positive earnings estimate revisions, which often leads to higher stock prices.
Remember you are an investor, not a trader. Use time to your advantage. Patience is one of the best weapons you have in your arsenal, so use it wisely. Make sure you have the fortitude to weather the storms of mild market pullbacks, as churning and selling at the lows are surefire ways to have an underperforming year.
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Brian Bolan is our aggressive growth expert and the editor of Zacks' Stocks Under $10 portfolio.
¹ The results for the trades listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research's newsletter editors.