Fear-mongers are always with us, along with stock touts and charlatans of all varieties. What investors need is a context in which to judge their proclamations, which are always made with the extreme confidence that the rest of us mortals lack. And context requires investor education.
My view is that investor education doesn’t need to be complicated. It should be simple — and brief. If I were designing a curriculum, the course would last for five days, with each session running three hours. It would look like this:
* Day One: Your goals determine your investments.
To decide what to include in your portfolio (a process known as asset allocation), you need to decide why you are investing. A strategy for retirement is different from a strategy to accumulate enough to buy a house in two years. Far-off goals (five years or more) require stocks. Medium-term goals (one to five years) are more appropriate for bonds, which are loans you make to businesses and government agencies. And for short-term needs, stick to cash, meaning money-market funds, savings accounts or certificates of deposit.
History shows that stocks return far more than bonds: an annual average of about 10 percent, compared with a little over 5 percent for long-term Treasury bonds. But stocks are more volatile. They lose money in one out of every three or four years. Over the long term, however, that volatility evens out.
* Day Two: Markets are (mostly) efficient.
The price of a stock reflects the considered judgment of millions of investors who have their own hard-earned money at stake. These investors use all available knowledge about a company, the economy, the political situation, the weather — you name it — to reach their conclusions about the “right” price for a stock today.
Of course, as Warren Buffett points out, to say that markets are efficient most of the time is not to say that markets are efficient all the time. Sometimes, stocks become expensive or cheap, and, occasionally, small investors can capitalize on such anomalies. But it is a gigantic error of hubris to believe that you are smarter than the market as a whole.
A Harris Poll taken on Feb. 6, well before the March 11 bombings in Madrid, found that 62 percent of respondents believe that “a major terrorist attack” is “likely” in the next 12 months. When many people expect a calamity, for example, their expectations tend to be reflected in the price of stocks — just as, for example, the price of Johnson & Johnson stock reflects the expectation that the company’s dividend will rise in 2004, as it has for the previous 42 years in a row.
In fact, you might argue that the belief that terrorists will strike again has depressed stock prices severely since Sept. 11, 2001. In other words, an attack may come, but that doesn’t mean that a stock-market crash — or, more important to investors, a prolonged downturn — will result.
There are other conclusions to draw from the lesson of efficient markets. One is that, as a long-term investor, you shouldn’t worry too much about whether the stocks you pick are cheap or expensive. The market has determined that their prices are “right” at any given moment. The market may be wrong, but the default position is that it is correct.
* Day Three: Diversify for protection.
Own one stock, and you are vulnerable to disaster. Own 40 stocks in different sectors, and your portfolio is more likely to perform about the same way as the market as a whole.
It’s the same with bonds. Own a single corporate or municipal bond, and you could lose everything you have in a default. Government bonds won’t default, but owning just one, with a single maturity date, is also risky. A sharp rise in interest rates could leave you having to sell at a loss.
The easiest way to get diversification in stocks is through mutual funds or exchange-traded funds. Because stocks are efficient, smart investors are not outsmarters, but partakers; instead of trying to beat the market, they join it. How? By owning index funds like Vanguard Index 500, which reflects the Standard & Poor’s 500-stock index.
But managed (or human-run) mutual funds can also be a good choice. On Thursday, I used a screening tool on the Morningstar Web site (www.morningstar.com) and specified that I wanted to find all U.S. domestic-stock large-cap growth funds that had a manager with at least a five-year tenure, required a minimum investment of no more than $2,000, had turnover of 100 percent or less (that is, the average stock was held for one year or more), had a rating of five stars (tops) and had beaten the S&P over the past one-, three- and 10-year periods.
The computer spit out just two funds, and they are both terrific: Smith Barney Aggressive Growth, managed by Richie Freeman since its inception in 1983, and American Funds Growth Fund, run by a six-person team with an average of 28 years of experience.
* Day Four: The little things count.
Thanks to the power of compounding over long periods, taxes, inflation and expenses all add up. Gross returns mean nothing. The question is how much you can put in your pocket at the end of the day. So pay attention to the tax ramifications of what you are investing in. Watch the cost of living index, and keep fees to a minimum.
* Day Five: Know what you don’t know.
It’s your money, so it’s understandable that you worry about the many things that can affect it. The lesson here is: Don’t.
The economy, for example, has its ups and downs, but over long periods — and, if you are a stock investor, you should only be investing for long periods — the trajectory has been up. After each bear market, for instance, stocks move to a new, higher level.
In the end, the best qualities for investors are the same ones Aristotle admired: moderation, common sense, restraint, modesty and integrity. Maybe, instead of five days of investor education, we should all sit down and read five days’ worth of the ancient Greeks.
[Source: James K. Glassman, New York Times, April 3, 2004]