Make Safer Investments With These Four Rules of Thumb

When it comes to science, medicine, and investing... few things work better than good rules of thumb.

"Eat your vegetables" and "an apple a day keeps the doctor away" may be simplistic. But they are two of the best health guidelines ever uttered. These simple and easy-to-remember rules bring proven benefits.

The same is true for investing. Simple rules of thumb can take much of the human error out of your decision-making...

For example, one dangerous phenomenon that rules of thumb can help you avoid is called "recency bias." People tend to place too much importance on the most recent events. That forces them out at the bottom of markets and in at the top.

To see recency bias at work, just think about 2012...

People were afraid of another collapse like we saw in 2008 and 2009. Record numbers of mutual-fund investors were piling into bond funds and, worse, buying U.S. Treasury securities.

Interest rates were near all-time lows, but investors followed the crowd into bonds. They were overly concerned about the past, and they were dumping stocks. But in my flagship investment letter, Retirement Millionaire, we stuck with the simple rules for evaluating opportunities... And we made a lot of money in stocks.

So, as you can see, learning a few rules of thumb can help you continue to build your wealth. Today, we'll cover some of my basic tenets for finding safe income opportunities in the markets...

These simple rules will help you know when an individual stock represents a great opportunity to collect income and grow your wealth safely... or when an investment may have run its course.

Even if some of these ideas seem familiar or simplistic, I urge you to incorporate them into your investing as you build a long-term portfolio. It's a time-tested formula for success.

Rule No. 1: Look for price-to-earnings ("P/E") ratios below the long-term average of the S&P 500 Index, generally below 17. A low P/E ratio suggests the company is trading below its value, making it cheap.

Rule No. 2: Look for stocks trading for a price-to-book ("P/B") ratio of less than 1. A low P/B value suggests the company is undervalued, and you could be getting into a great company at a discount.

Rule No. 3: Try to avoid paying more than a price-to-sales ("P/S") ratio of 3 for the stock of a solid, reliable business.

In the private markets, businesses usually get bought and sold at prices that are between 1 and 2 times sales. Of course, some well-established businesses with reliable sales can command a higher ratio.

Rule No. 4: Look for stocks that pay a dividend representing at least 2% of the share price. I also like to see a history of growing dividend payments. And I like the dividend yield to exceed the five-year Treasury note.

I prefer companies with a payout ratio of less than 50%... The payout ratio is the percent of earnings needed to support the dividend. In theory, at a 50% payout, a company's earnings could fall by half and still cover the dividend. This is an extreme. But by limiting ourselves to payout ratios of 50% or lower, we feel safer at night knowing our income is reliable.

A strong, consistent dividend almost always indicates a healthy business. The company is generating cash and wants to say "thank you" to shareholders.

Rising dividends also shore up stock prices in bear markets. Thus, dividend stocks are defensive stocks by nature. A rising dividend acts like a pontoon float and prevents the stock price from falling much.

These four simple rules for valuing a company will make investing easier. Following them is a great way to invest in safe and solid opportunities... without letting emotion and biases get in the way.

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig

Editor's note: For more actionable advice from Doc, check out his Health & Wealth Bulletin – a free e-letter for folks who want to live well in retirement. Recently, he has covered the illness that should scare you more than coronavirus... the simple steps to protecting your credit... which three industry titans are still "buys" today... and more.

If you're interested in health and wealth stories like these, click here to learn more.

Further Reading

Buying a stock mispriced for bankruptcy is every investor's dream. But how do you tell the difference between a company headed for oblivion and one that can turn around and provide huge gains? Read more here: How to Tell Whether a Stock Is a Turnaround or Is Headed for the Trash Heap.

When emotions get in the way, rules of thumb can guide you to better investing decisions. Recently, Doc shared why investors fail to beat the market... and a few simple concepts that can help you outperform. Learn more here.

Market Notes
THIS 'FAD STOCK' WIPED OUT SPECULATORS

Today, we’re looking at a “fad stock” that failed to deliver…

As longtime readers know, when speculators crowd into a stock, eventually there’s no one left to buy. Even a good company can see shares plummet if the market has inflated its true value… And bad companies can fall even more dramatically. Today, we’re looking at a loser in the growing legal-marijuana sector…

Aurora Cannabis (ACB) operates in Canada, where the substance is legal for medical and recreational purposes. It’s an exciting new industry. But eager investors missed that Aurora regularly dilutes its shareholders to pay for acquisitions… What’s more, it lost about $90 million in the most recent quarter on just $42 million in sales.

After speculators pushed ACB shares as high as $11.68 in October 2018, the stock fell even faster… and it now trades just over $1, for a loss of around 90%. When everyone is rushing to profit from the same fad, just remember, the crowd doesn’t always pick the best company…