This week, The Simple Dollar takes a look at the new investing book from Jim Cramer, Mad Money. This book is surprisingly different from its predecessor, Real Money, in a number of ways. I quite enjoyed the first one; will I enjoy this one, too? Let’s find out!
A large portion of the early part of the book centers around Cramer’s plan for how an individual small-scale investor should buy a stock. He breaks this down into three parts:
1. Know Yourself And Your Goals
What are you like, and what are your goals with investing? Are you temperamental? Are you young? Do you have a lot of discretionary money? These are vital questions you should know the answer to before you jump into individual stock investment.
Cramer says that there are four key factors in determining how and where you should invest: your age, your discretionary income, your timeframe, and your temperament. If you don’t have a firm grasp on each of these elements, what they mean, and how they relate to your investment, you need to kick back and do some serious self-evaluation before diving into individual stock investing.
Why? For starters, Jim breaks stocks down into four stock types, of which different ones are attractive to different people based on those factors: speculative stocks, value stocks, growth stocks, and steady earners. For example, steady earners are best for people with a shorter timeframe and who are risk-averse, meaning people who are looking at these stocks to earn steady money for them, while speculative stocks are for people with high risk tolerance and a lot of discretionary income that can take the potential hit from a big loss.
2. Do Your Homework
Cramer’s mantra is buy and homework, not buy and hold, and he means it. He gives a five step process for how to evaluate a stock, and he basically says you should never buy a recommended stock for at least 24 hours so you have plenty of time to do this homework. Here are the five steps:
1. How does a company make money? What is their business model? What keeps the cash rolling in the door?
2. What sector is it in, and how does it compare to the rest of the sector? Take a look at the recent performance of other stocks in the sector and see how yours holds up.
3. What does the recent performance of the stock and the company look like? Is the company in the trash can, or is it doing well?
4. What does the stock look like compared to the competition? You should use the forward P/E ratio and also the PEG for such comparisons, according to Cramer.
5. What does the company’s balance sheet, income statement, and cash flow statement look like? Are there any big red flags? There’s a wonderful ten page tutorial in here on how to read a company’s balance sheet that was one of the most useful things I took from the book.
3. Use Limit Orders And Buy Incrementally
Before anything else, Cramer basically commands people to have a reasonably diverse portfolio: no two large holdings in a single sector and also no more than 20% of your portfolio in any one stock, so that means a minimum of five stocks. He also advocates buying incrementally, meaning not buying your entire position at once. This is effectively dollar cost averaging. One more major point of advice: never use market orders, use limit orders, as they allow you to specify the price you want to buy at, not the price that the market gives you.
He also advocates doing one hour of homework a week per holding, which involves ensuring that your company’s earnings are okay, that your reason for owning the stock is still true (if you can’t flat out state in one sentence why you own a stock, you shouldn’t be in it), and that your company’s sector isn’t undergoing major change.
Tomorrow, we’ll review more stock picking advice from Cramer’s book.
Jim Cramer’s Mad Money is the fifteenth of fifty-two books in The Simple Dollar’s series 52 Personal Finance Books in 52 Weeks.