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Tuesday, January 4, 2011 - 12:30
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Tuesday, January 4, 2011 - 12:30

5 Pitfalls for Investors in 2011

Tuesday, January 4, 2011 - 12:30pm

What worked for investors in 2010 won't necessarily work in 2011. And in light of StreetAuthority's recent look at "8 Valuable Lessons We Learned About Investing" in 2010, I decided to take a look at how I would apply some of the lessons I've learned over the years to 2011.

Here are five things you should look out for this year...

1. Look out for portfolio creep
One of the challenges of a rising market is to know when to take profits. Instead, many of us hold on to our winners and bring in fresh ammo to buy yet more stocks. Before you know it, you're holding 15 or 20 stocks. (I once counseled an investor that asked me to look at his statement -- and I told him right away that the 40 stocks he owned were far too many.)

With the ever-rising market of the last two years, some investors likely have been buying a lot more than they have been selling. Yet you really need to own just six to 10 stocks that have a truly diversified portfolio. So if you're above that figure, you should spend as much time researching which stocks to sell as you spend on which stocks to buy.

2. Beware of the IPO market
After a moderate rebound in 2010, the IPO market looks to be even healthier in 2011. Your broker may push you to get in on the action, offering up shares in seemingly hot deals. But you should be wary.

Part of the charm of a weak IPO market in 2009 and a so-so IPO market in 2010 is that only the best companies were able to get to the starting gate. A stronger IPO market invites more dubious companies to line up. You should be especially wary of firms that are backed by Private Equity (PE) groups, as they often carry far too much debt in this still-risky economic environment.

For example, when PE backers brought Hertz (NYSE: HTZ) public again in late 2006 at around $15 a share, the rental car giant still had too much debt to withstand any economic downturn. Shares eventually fell below $4 in late 2008 on concerns that bankruptcy would be the endgame. Those concerns proved false and Hertz is now healthier, but this is precisely the kind of stock that investors shun when economic concerns are renewed.

3. Don't extrapolate
Many stocks are hitting new highs these days on the heels of impressive revenue growth rates. But that revenue growth often stems from the fact that business was bad a year earlier. In 2011, these easy year-over-year comparisons will be gone, and you need to tread very lightly with any stock that is expected to grow sharply -- absent of acquisitions. Simply extrapolating 2010 trends into 2011 will get you into trouble.

In just a few weeks, we'll greet the start of earnings season, and for many companies, we'll get the only full-year revenue projection that we'll get all year. (Many companies are shunning the practice of quarterly guidance and instead weigh in about the future much less frequently than in the past.)

4. Wait for bottoms
The herd was never more pronounced than in 2011. Buyers followed buyers and sellers followed sellers. That set up for extended market moves in each direction that took a while to play out. Buyers ran with the ball in the first four months of the year, sellers ruled the day for the next four months, and buyers took the reins again for the year's final trimester.

It will be awfully tempting to load up on stocks any time the market pulls back in the weeks and months ahead, but wait for the selling to play out. The sentiment ship turns slowly and you have to let it run its course. The best time to buy again: when a sell-off is pronounced enough to have many pundits speaking in fearful terms. As a reminder, you only make money in stocks when they are hated, like they were around Labor Day this past year.

5. Fight the Fed
There is an old investing maxim that says "don't fight the Fed," which means don't buy stocks when the Federal Reserve is raising interest rates. That maxim no longer applies. The Fed hiked interest rates by 0.25% on five separate occasions in 2004 , another nine times in 2006, and four times again in 2006. Yet in that three year span, the S&P 500 rose 28%. The key difference is that the rate hikes were coming off of a very low base, and even when the Fed finished the rate hikes, rates weren't high enough to choke off economic activity.

These days, many investors plan on holding stocks until the Fed starts raising rates again, which may happen later in 2011. But based on recent history, that's really no reason to sell. Stocks would still be attractively priced even if rates were 200 or 300 basis points higher. It's at levels far higher than that, when inflation and interest rates move closer to 10%, that stocks have suffered. But the likelihood of a return to 1970s-style levels of high inflation is very remote.

Action to Take --> With stocks already off to impressive gains in the New Year, the market shows no signs of cooling off. But when this current rally maxes out, many are likely to realize that stocks have come a very long way in a very short time. That suggests limited further upside in 2011 or possibly even a pullback. So forget about what worked in 2010. It's a new year, and keeping these five items in mind should help you develop a new playbook.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.