Barron's Guide to Making Investment Decisions: Revised & Expanded

Introduction

Reprinted with permission of Leo Cullum.

The first edition of this book, published in 1994, began with our two-word summation of investment advice:

Caveat emptor!

Buyer, beware!

Fortunately for us, people brushed that warning aside and purchased copies in sufficient number that our publisher encouraged this new edition. We are flattered, to be sure, but the truth is that conditions in the economy and the markets have changed considerably in the past several years. As we write, the longest bull market in history is long in the tooth, but still going strong. Stock prices have climbed rapidly to levels that few dreamed were possible. Mutual funds have become far and away the preferred vehicle for most individual investors. Indeed, there are now more mutual funds than there are stocks listed on the New York Stock Exchange. The American economy is the strongest and most productive of any on earth. Our technology and finance sectors are the envy of the world. While growth is unusually strong, so far there has been no evidence of inflation. And Washington-in a tardy but nonetheless welcome recognition of the fact that most voters are also investors, directly or indirectly - sharply cut capital gains taxes. In short, it’s a different world from the one that existed when the first edition of the Barron’s Guide was published, and it is time we freshened these pages with more recent examples and expanded discussion of certain topics.

Most of our advice remains sound, however, and we retained the overall approach and tone. We’re grateful for the feedback we received from readers of the first edition. We’d like to share some excerpts to help explain what we are about with this book.

Your book shies not from the many complexities in investment areas, and doles out advice and counsel succinctly and without hyperbole, a formidable task in itself, writes a retired gentleman from Florida. Above all, as an editorial product, it has balance.

We indeed aim to make investing understandable, but without oversimplifying. Furthermore, while we certainly have opinions that we don’t hesitate to convey as forcefully as we can, in most instances we devote some space to alternate views. Our ultimate goal isn’t to convert you into disciples of the way we handle our money but to get you thinking about making your own investment decisions - and to raise your confidence in your ability to make them yourself.

In his syllabus for beginning MBA students at a university out on the Great Plains, a professor observed: Unfortunately, when it comes to the published investments literature, that which is ‘short and snappy’ often tends to be wrong. At the same time, much of the correct and useful literature tends to be long and boring. Then he proceeds to assign readings from our first edition. This is an excellent investment guide for both beginning and advanced investors. Students with no experience or a limited background in investments will find this guide to be especially well organized and readable.

We’re flushed from the praise, but the good professor (how could he be otherwise with such excellent taste?) makes an important point: Our book is not just for beginners. Experienced investors can get sidetracked, hustled by salespeople and so focused on trees that they stray from the forest. This book can help them regain their bearings.

One such reader of our first edition, a millionaire several times over, penciled his thanks on a sheet from a yellow pad: As a result of your book, I’ve changed my whole (and my company’s) investment program. In his case, he dropped his broker, who was making so much money off this guy that he treated our reader to lunch at a fancy New York restaurant every once in a while. Our reader signed up with a consultant who finds - and monitors - professional money managers for his personal and company accounts. I don’t perform my own dentistry, he told us during a visit, so why would I think I could invest this much money very well?

Some people simply aren’t interested in investing. But in this day and age they can’t afford not to be investors, or they will find themselves more than a dollar short when retirement rolls around. What to do? We address such conflicts in this book in the course of showing how laying out an investment program depends very much on the kind of person you are. For those of you without millions to dangle in front of a money manager, we repeat the good news of the first edition: You can reach your financial goals with an uncomplicated program that you are capable of managing yourself.

As with the first edition, you should know what this book will not do. It will not tell you which stocks or other investments to buy. That is your responsibility. You know yourself, your financial circumstances, and your investment objectives far better than anyone else.

This book won’t steer you to this broker or that financial adviser. To the extent that you choose to delegate to someone else part or all of the responsibility of picking specific investments, it is up to you to find qualified financial advisers who understand your goals, are aware of what resources you have, and who will act in your- not their- best interest.

This book certainly won’t reveal a system for beating the market, for earning 20% annually with no risk, or even for avoiding losses. Someone may have such systems and be using them, but we don’t know about them. And if we did, would we tell you for less than $20?

But don’t despair. Though we won’t give you specific how-to-invest advice, you will get your money’s worth out of this book by learning how to think about investing. We will help you devise your own approach to investing, taking into account your goals and your willingness to take risks to achieve them. We’ll show you how to assess the risks and the rewards of various investment vehicles and strategies; and we will share with you some of the insights we have picked up in years of interviewing money managers, corporate executives, and investment strategists.

We will help you acquire an attitude about investing, which should bolster your resistance to the get-rich-quick siren songs they are forever playing on Wall Street. We certainly have an attitude, and it will become apparent to you as you read along. It’s there not for you to adopt as your very own - although if you want to, be our guest - but to show you how helpful it can be in sorting through the confusing investment possibilities. If we were to propose a subtitle for this book, it would be Investing with an Attitude.

We’ll also direct you to sources of more detailed information about specific securities and other investments. One of these - no surprise here - is Barron’s. The statistical data in Barron’s are invaluable for tracking the performance of investments. The interviews with financial pros and articles about companies provide another type of capital that no investor can afford to ignore: ideas. And if there is any publication that has an attitude about investing, it’s Barron’s.

In preparing this guide to making investment decisions, we made a few assumptions about our readers. The main one is that you already have your financial house in order. We assume you know whether you can afford a house and how to shop for a mortgage if you need one. We assume you aren’t so foolish as to be planning an investment program while paying 19.8% interest on credit card balances. Frankly, we assume you have enough money to invest- which means life’s necessities and, yes, a modest number of luxuries are provided for.

We also assume you have a working knowledge of the economy. You don’t need to be able to recite how much durable goods orders grew last month or where the consumer price index stood in January. But we do assume you know whether the economy is growing or shrinking, and whether interest rates are rising or falling. For economics and beyond, we expect you to be reading a daily newspaper or two to keep abreast of the world.

We do not assume that you have a Master’s of Business Administration degree. It certainly isn’t necessary, and as a good investor you probably know that an MBA isn’t worth nearly as much as everyone used to think it was. We also don’t assume that you know how to read a balance sheet and an income statement. If you’re interested enough in investing in stocks, that skill is picked up easily along the way.

As you embark on an investment program - or salvage the remains of a previous, unsuccessful one - there are certain things we think you must keep in mind. Collectively, they add up to:

Colloca sapienter.

Invest wisely.

• You alone are responsible for your investment decisions. Don’t blame this book, your broker, Congress, or your spouse and children for the mistakes you will invariably make. On the other hand, take credit for the decisions that work well, and don’t let anyone else (like your broker) take bows ex post facto.

• Your broker is not your friend. He or she may be cordial, competent, and clever, but never forget: Brokers make money whether you win or lose. There’s a simple test you can conduct to eliminate the worst brokers right away. Find two mutual funds with similar objectives and performance, one of which rewards the broker with a sales commission while the other, known as a no-load fund, doesn’t. Ask a broker which is best for you. Be prepared for a long search.

• The markets are not your friends, either. A common misconception among investors is that they are owed something by the financial markets. You give the market some money, and it gives you more back. But markets have no emotions and no commitments. The stock market isn’t some friendly pet that roams Wall Street. It’s an arena in which lots of very smart people want to take your money and put it in their pockets.

• Never buy an investment you don’t understand. Some brokers and financial advisers work hard at leaving their clients slightly mystified about whatever it is they peddle. This creates a dependency that the broker then continues to exploit for years at his clients’ expense. Even worse are the brokers who themselves don’t really understand what it is they are selling.

• Don’t buy anything over the phone if you didn’t originate the call. We can’t begin to count the number of otherwise perfectly sane people who, beguiled by an unsolicited sales pitch, have sent huge checks off to total strangers. These folks spend the rest of their lives trying to get even a portion of their money back and hating themselves for being duped. Life is far too short for that.

• Simplicity is better than complexity. By this we don’t mean be unsophisticated. We don’t recommend putting all your money into a single stock, for example, though that’s a lot simpler than buying 50 of them. But be a good engineer, constructing a portfolio no more complicated than it has to be to accomplish your goals.

• Leverage is dangerous. Investing with borrowed money can produce immense returns and also immense losses. Unless you thoroughly understand a leveraged investment and are financially and psychologically prepared to accept the worst that might happen, confine your use of leverage to buying a house in which to live. Even that can be highly risky, but at least you can come in out of the rain to contemplate life’s cruelties.

• As your coach might have told you in school, play heads-up ball. You have to know when to hold ’em and when to fold ’em, when to make your move and when to sit back. No amount of advice can supplant paying attention to what you’re doing and knowing exactly why you’re doing it. If you don’t know, don’t do it. Remember, a lost opportunity is better than lost money.

• Base your investment decisions on investment criteria, not something related perhaps but in reality quite different. For example, don’t go into an investment solely for its supposed tax benefits or because your son got a job with the company. Above all, superstition has no place in an investment program. If you think the alignment of planets has something to do with total return, please put this book back on the shelf without bending the corners.

• Enjoy the investment process. There are bound to be frustrations in any investment program, and you must live with them. But if you’re constantly fretting about whether you have made the right decision regarding a particular investment, it is almost a sure bet that you haven’t. Not that it’s a bad investment from a financial point of view but because it’s one you can’t be comfortable with. Unwind it at the first opportunity and put the money somewhere that allows you to relax and enjoy life.

We know you want to get right down to the business of picking some stocks that will make you wealthy. Chapter Three of this book is aimed at helping you decide how to pick stocks. But don’t be in such a hurry. Investing in haste has been the undoing of many a portfolio. Instead, spend a little time in Chapters One and Two. We wrote them to help you devise a systematic approach to investing that will stay with you for the rest of your life, subject only to your changing financial circumstances.

Chapter One. You will be asked to assess your own tolerance for risk, taking into account such variables as age and investment objectives. It is to your advantage to be brutally honest with yourself. There’s no room for reluctant heroes in the financial markets. If you don’t like risk, no one is going to think less of you for choosing a conservative approach to investing. On the other hand, we hope you’ll see that, given sufficient time, seemingly risky investments might not be so risky after all and some safe ones could end up costing you plenty.

We’ll also discuss some of the costs of investing, not the least of which can be the time you spend monitoring and managing your investment portfolio. Again, we want you to be honest with yourself. If you really enjoy following the ups and downs of a portfolio of stocks, deciding what to buy and, perhaps more difficult, when to sell, that’s wonderful. You’re exactly the kind of person for whom Barron’s is published. But if you’d really rather be out playing golf Saturday mornings instead of poring over the stock tables, that’s fine, too. You can still have a sophisticated investment program that will produce substantial gains over time; you’ll just need some help in running it. And we can assist you there as well. The financial services business has more than its share of shysters, fakes, and plain old crooks. But it’s also full of many very smart, creative, and interesting people from whom you can learn and profit. The key is knowing what you are getting for your money. That’s where Chapter One comes in.

Chapter Two. The next step in establishing your lifetime investment program is deciding how to distribute your investment capital among the various markets and instruments available to the individual investor. Professional money managers often try to make the asset allocation process some kind of mysterious ritual, the secrets of which are known only to those in the investment advisory business. Bah, humbug! There’s nothing the least bit mysterious about the process once you recognize your own tolerance for risk and identify your investment objectives. We have devised a few simple asset allocation programs to illustrate how the process works. But they’re only illustrations. Part of the challenge and the fun of investing is to devise your own program, one that is uniquely suited to your personality, your financial resources and your investment goals.

Chapter Three. NOW you can start looking for those hot stocks. But be careful. Hot stocks can burn you as assuredly as hot pots. In Chapter Three you will get an overview of the risks and rewards of the stock market. You’ll probably notice that this is the longest chapter in the book, and that’s no accident. The U.S. stock market is probably the single most fascinating playground in the world for true investors. The rich menu from which to choose - from staid old blue chips to tiny companies that exist only to bring to fruition an idea lurking in some scientist’s mind - has something for everybody. The dynamics of the U.S. economy, the world’s largest and most influential, keeps the market churning with activity. And the securities laws and enforcement agencies make this the world’s most open market as well. Nobody guarantees profits in the U.S. stock market, but there is no place better to give it your best shot.

Chapter Four. Bonds are often thought of as the safe investment, which they certainly can be. Indeed, probably nothing is safer than a U.S. Treasury bond held to maturity. But the bond market is seething with products that can take a big bite out of your portfolio and never give it back. Perhaps you weren’t aware that municipal bonds, those havens for the heavily taxed, can be highly risky. And junk bonds didn’t get their name by accident. Chapter Four takes you on a walk through this deceptively quiet forest, pointing out the dangers lurking behind bonds of every stripe.

Chapter Five. Mutual funds aren’t just for investment wimps. You will see in Chapter Five that mutual funds can get you into places you can’t go by yourself, such as to many foreign markets. They offer instant diversification and, as long as you stick to no-load funds, relatively inexpensive access to some top-notch money managers. You can even set up an entire portfolio based on mutual funds. But they can be deceiving, too. If you’re one of the millions of Americans who hate to pay taxes, beware of municipal bond funds: Part of their gains come from trading bonds, and you’ll owe taxes on those gains. Another caution: Sector funds, which concentrate on investments in only one industry, force you to make asset allocation decisions that you might not be prepared to make. We’ll look at fee structures as well as the perils and pitfalls of old standbys, especially index funds. And we’ll tell you about a new kind of fund that is traded on a stock exchange.

Chapter Six. If you need or want more personal attention than mutual funds can provide, a competent money management firm may be the answer. Just be aware that you will pay for the service. What’s more, you’ll already have to be something of a successful investor yourself because many firms require minimum investments. Those minimums are coming down a bit, however, because of competition. Banks compete with insurance companies, which compete with stock brokers, who compete with fee-based advisers - all to get their hands on fees and commissions for helping investors run their finances. We survey this fast-growing money-management scene.

Chapter Seven. Americans are only beginning to feel comfortable sending some of their investment money abroad. Yet as you will see in Chapter Seven, foreign markets, which make up half of the investment universe, have produced superior long-term results. The wise investor will put at least a portion of his portfolio in international stocks and bonds. But you probably can’t do it alone. International investing is expensive, cumbersome, and risky for the individual, but mutual funds and closed-end funds can help smooth the process.

Chapter Eight. As we said, leverage is dangerous. But futures and options have their uses, not least of which are the potential of enhancing returns on your portfolio and reducing your exposure to market risk. Trouble is, you will have to study long and hard to master this part of the investment world. If you leave it all up to brokers and advisers and don’t make the effort to understand what they are doing and why, you deserve the losses you are certain to sustain.

Chapter Nine. If you own your home, you already are a certified real estate investor. Indeed, this real estate could well constitute the largest single asset in your portfolio. If you don’t own a home, think twice before buying one. We’ll show you in Chapter Nine that there are powerful demographic trends working against real estate prices, and you might be better off investing some of that money elsewhere. You can still get exposure to real estate in much smaller quantities through real estate investment trusts, or REITs, which trade on the stock exchanges. But steer clear of limited partnerships; they are usually much too limited.

Chapter Ten. Each season you read in the newspapers about the fabulous prices paid for works of art. What you don’t read about are all the paintings hanging on walls or sitting in attics and basements that were bought not for their beauty or interest but for investment. In Chapter Ten we explore the fascinating but treacherous world of collectibles. You might one day make money by selling your baseball card collection, your toy soldier collection, or the decorated egg collection, but don’t bet on it. Collect for enjoyment, yes, but don’t collect as an investment.

Chapter Eleven. Uncle Sam is such a pain in the neck. He does damn little to help you make good investment decisions, but he sure wants his cut when the score is settled. He has been nice to investors lately by reducing the tax rate on capital gains. Still, there are ways to lighten your tax burden even further, which we elaborate on in Chapter Eleven. But never, ever invest just to avoid taxes.

1

Setting Investment Objectives

Someone keeps moving the finish line.

Reprinted with permission of Leo Cullum.

Investing is only half about money. The other half is time. Any successful investment program is based on the identification of objectives that can be placed somewhere on a time line. You can decide if each objective is a reasonable goal, given how much time you have to achieve it. To undertake an investment program at age 40 with the aim of retiring to a Caribbean island in five years is probably ludicrous (unless you’re starting with an awfully big grubstake or are willing to accept a humbling decline in your standard of living). It isn’t nearly so unreasonable if you have 20 years to get there.

It’s always later than you think when it comes to starting an investment program. But while it’s always better to start early rather than late in life, it’s also better to start late rather than never. You just have to remember to set objectives that are reachable within the time frame you have. And don’t make those objectives too specific. If buying that house or boat requires you to earn 20% per year for five years, you’re going to be disappointed and frustrated. Trying to force the market to march to your drumbeat is a losing proposition.

In fact, this is the time and place for an important reality check. Although it is always possible that the future holds tremendous surprises for us, you probably shouldn’t count on earning much more than about 12% annually from a long-term investment program - and that’s assuming you’re willing to take more risk than the average investor. Although the past doesn’t necessarily predict the future, that’s roughly the average return from a diversified stock portfolio since World War II; it’s a little on the rich side if you go back to World War I. You might be really smart (lucky is more likely) and do better than that. Or you might make more than your share of dumb mistakes and do worse. In any case, that’s before taxes and before inflation. If you’re in the top tax brackets, kiss more than a third of that return good-bye and make sure your investment objectives reflect an anticipated 8% annual return after taxes. Taxes are what make 401k plans and IRAs so attractive to smart investors. Taxes also make tax-free municipal bonds attractive to many investors, but they aren’t always a bright buy.

Now subtract inflation from the equation. If it’s running at a relatively modest 4% annually, subtract that 4% from your return for a net return of 4%. That’s right, 4%. Horrible, isn’t it? But what if you’re a very conservative investor and have all your money tied up in a money market account yielding 7% before taxes and inflation? You’ll end the year with a net loss. More horrible, isn’t it? Avoiding that trap is the entire reason behind having a long-term investment plan.

Figure 1.1 Stock Market Performance, 1950-1997

Annual Percentage Change

There is no need to limit your entire portfolio to a single time frame. Just because your child is going to Outrageous U. in five years doesn’t mean you should neglect the care and feeding of your retirement nest egg. (Remember what we said about getting started early.) Instead, have a separate time frame for each objective: the kid to college; new car or furniture (please don’t finance these purchases unless you use them in your business and can gain some tax advantages); the boat of your dreams; and a comfortable retirement. Bear in mind, though, that these objectives vary not only in when they are to be reached but also in the amount of money they require. An Ivy League college education costs more than a degree from a state university. And a comfortable retirement, although perhaps further away, will require far more money than a degree from any college. As you set these objectives down on your time line, you will understand why it is never too early to start that investment program. The less time you have, the more likely it is you will find yourself having to make some hard choices: a kid with a degree or that boat.

TIME AND RISK

Time also plays an important role in the relative risk of investment vehicles or strategies. A bank certificate of deposit or money market account are usually considered safe in that there is little risk of losing some of your invested capital. But it also isn’t likely to grow very much. Over a long period - and the definition of what constitutes a long period seems to be growing shorter all the time - the money parked so safely faces much larger risks than most people realize. Inflation can eat into it much more quickly than you suspect. If it doesn’t, then you may face reinvestment risk- having to roll over that maturing CD into some similar instrument with even lower returns or higher risks. Millions of retirees came face-to-face with that unpleasant picture in the 1990s as interest rates plunged. And don’t forget the fact that money tied up in a five-year CD can’t be put to work more profitably elsewhere.

Conversely, investments that seem risky on their face - small growth stocks, for instance - are indeed risky in the short run. It’s quite easy to conceive of putting $20,000 into a portfolio of small stocks and watching it plunge in price for a year or two. That $20,000 can become $10,000 awfully fast. But over a period of 10 years - better yet, 20 years - a portfolio of small stocks is likely to provide among the best returns of any investment you probably are going to be comfortable making.

To get an idea about the relative long-term risks of investments, consider that since 1926 there have been 20 calendar years in which Standard & Poor’s 500-stock index declined. Some of those drops were breathtaking, especially the 43% plunge in 1931, the worst of them all. Since 1926, however, stocks have produced an annual return of 10.4%, including reinvested dividends. In that same period, long-term government bonds, considered relatively safe investments, produced a total return (price changes plus interest payments) of 4.8% annually. And Treasury bills, regarded as about the safest investment one can make, returned 3.7% annually, barely above the average 3.1% annual rate of inflation. So, which is really the safest investment for the long-term investor?

On