Sunday, June 23, 2013

How to build a Portfolio and eliminate Trading Emotions with PEG for Dummies

For Dummies including me where time is a luxury, finding a way to construct a Portfolio that does not need much time to maintain is God sent. Why we need to spend hours a day to eyeball our stock prices and thus get emotionally involved? Studies have shown that most investors lost money in the stock market due to their emotions than anything else. When you start screen staring then you are in trouble. Is there a method where we can build a Portfolio minus all those complex financial modelling tools used by Wall Street experts?

Fortunately, there is a simple method to select stocks that will minus all the complex fundamental and technical analysis. It is ideal for folks like me who are about to retire and needed to build a retirement nest egg. The method is called PEG or P/E to Growth which was developed by Mario Farina and popularize by Peter Lynch. The formula for the PEG is as below.

How to calculate PEG?

PEG = (P/E ratio) / Annual EPS Growth

Say ABC widget is selling at $20 and it earns $1 per share this year. Its earnings have been growing at 40% a year. Then the PE ratio for the stock is 20 ($20/$1). Thus to calculate the PEG all we have to do is to divide the PE ratio by 40 or $20/ 40 or 0.5.

What happen if Price goes up to $80?
If the price of ABC Widget rises to $80 then we will have to recalculate the PEG ratio. Again the new PE ratio is $80/$1 = 80 and the PEG ratio is 80/40 which is equal to 2. Always remember that the annual EPS growth must be denominated by percentage not as decimal as in 0.4.

Rule of Thumb to determine whether stock is expensive

Basically, the higher the PEG the more over valued the stock. When the PEG ratio is <= 1 then the stock is considered reasonably valued to its growth rate. A stock is considered expensive when it’s PEG ratio approaches 2 and will likely be the next candidate for sale. If you are evaluating a few stocks from the same industry say palm oil PEG is a good tool for you to evaluate which stock is the most expensive. Another advantage is that PEG is available in many financial information sources and thus eliminate your time to calculate.

The bottom line is that we try not to pay more than twice the company growth rate as measured by the PEG ratio. Anyway this rule is not cast in stone and to determine whether you should only sell when the PEG ratio approaches 2 is a personal preference. Some people have a lower risk tolerance and hence will sell when it approaches 1.5. Hence with such a simple tool it not only helps you to get rid of your trading emotions but also help frees up your unproductive time spent on the stock market. You only need to re-calibrate your portfolio maybe once or twice a month - selling expensive and buying cheap ones.

# A word of caution though. This is an entry-level Portfolio building and requires time for fruition. More sophisticated Portfolio building requires the current approach to move up a few level. Studies shows that the performance of this current Portfolio approach is in the indicative range of 10-12% return per annum. To raise the performance of your Portfoliio beyond the 20% threshold you will have to incorporate additional tools other than PEG. This is beyond the scope of this article and will require a few more articles to detail the strategies.

Happy Trading !!!

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