Masters Series: Four Rules of Thumb to Collect Income and Grow Your Wealth Safely
Editor's note: Certain investment decisions can mean the difference between having a comfortable retirement and just scraping by.
Today's Masters Series essay comes from Dr. David Eifrig's Big Book of Retirement Secrets. In it, he discusses different ways to take the human error out of investing... and shares the four basic rules he uses for valuing a company...
Four Rules of Thumb to Collect Income and Grow Your Wealth Safely
By Dr. David Eifrig, author, Big Book of Retirement Secrets
When it comes to science, medicine, and investing... nothing works better than good rules of thumb.
"Eat your vegetables" and "an apple a day keeps the doctor away" may seem like hackneyed or simplistic advice. But they are two of the best health guidelines ever uttered. Advice to "walk 15 minutes a day" has now been shown to decrease risks of cancer and diabetes...
These rules of thumb will bring easily gained 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 it helps you avoid is the "recency bias." People 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 the recency bias at work, just think about 2012... People were afraid of another 2008-2009-type collapse. 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 were dumping stocks. But in Retirement Millionaire, we weren't.
We stuck with the simple rules for evaluating opportunities... And we made a lot of money in stocks.
You may be among those stuck with tons of cash at the local bank or credit union, earning 0.05% on your money. If you're wondering what to do... learning a few rules of thumb for investing will immediately help you.
In this chapter, I'm going to outline a few simple rules that 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, 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 below one. 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 ratio of three for the stock of a solid, reliable business.
In the private markets, businesses usually get bought and sold at prices that are between one and two 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 in 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 make investing easier. Following them is a great way to invest in safe and solid opportunities. In fact, most of the times I've lost money, I violated these rules.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Editor's note: Doc's Big Book of Retirement Secrets is jam-packed with more than 250 ways to help you get more money from the government... get free travel and luxurious upgrades... and get prescription drugs for free. The ideas in this book could save you tens of thousands of dollars and allow you to retire like a millionaire. Get your copy by clicking here.