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Becoming a Better Investor

by James K. Glassman, Kiplingers Personal Finance, January 2007

Warren Buffett noted in 1999 that "success in investing doesn't correlate with IQ, once you're above the level of 25." What you need, he went on to say, "is the temperament to control the urges that get other people into trouble in investing." He's right too. Investing isn't nearly as hard as most people think. And, yes, proper temperament is important. But to really succeed at investing, you also need good strategy and good tactics. So as another year begins, here's my simple guide to both.

Your Strategic Checklist.

First, decide why you're investing. You can't achieve a goal unless you know what it is. For many investors, the prize is a comfortable retirement, perhaps 20 or 30 years away. Or you may have multiple goals - to purchase a second home in the next five years and to retire in ten years. The more distant the goal, the higher the proportion of stocks you should own in your portfolio. Also, you have no business owning an individual stock (as opposed to a stock within a mutual fund) if you do not intend to hold it for five years or longer.

Second, know your pain threshold. Stocks are volatile. Standard & Poor's 500- stock index has declined in 23 of the past 80 years. The dips can be sharp, unexpected and disturbingly enduring. In one day in 1987, the Dow lost nearly one-fourth of its value. The S&P 500 fell every year from 2000 to 2002, skidding from 1469 to 880. These things happen. If you can't tolerate that kind of pain, then choose bonds over stocks, but realize that your returns will inevitably be about half as much, if history is any guide.

Third, develop a view about the economy and stick to it. My own (which I highly recommend) is that the future will be pretty much like the past. Since the end of World War II, the U. S. economy has grown at a little more than 3% annually, with intermittent but not prolonged recessions. If you are continually shifting your opinion about the economy, you will also be continually shifting your portfolio, and you can't be a good investor. Don't pay attention to the Fed or to the unemployment rate. If you buy for the long term, think long term.

Fourth, be a partaker, not an outsmarter. Markets are generally efficient, so do not expect to beat the historic averages by very much over time. The annualized return for the S&P 500 since 1926 is a little over 10% - figure 9% with expenses. If you can beat that mark by one or two points a year, you are doing spectacularly well.

Your Tactical Checklist

Construct a portfolio and know what's in it. Most investors have stocks and bonds in several accounts. Consolidate the information on your holdings and establish clear, comprehensive allocations (for example, 70% in stocks and 30% in bonds) and sub-allocations (such as for stocks, 50% in large US companies, 20% in large international companies, 20% in small US companies and 10% in real estate investment trusts).

Stick with stocks and bonds. Don't buy commodities. In a recent report, Alliance Bernstein noted that "over the last 50 years, commodity prices have grown at an average of 2.5% a year, well below the rate of inflation." Commodities are also extremely risky. Low return and high risk don't make an attractive package.

Approach the investing process systematically. The exact proportions of stocks and bonds are determined by your goals, age and risk tolerance, all of which may change over time. But if, for example, you decide in your forties that your allocation will be 80% stocks and 20% bonds, don't change course over the decade. Having more bonds in a portfolio means lower returns but a smoother ride. For example, Ibbotson Associates found that a portfolio allocated 90% to stocks (S&P 500) and 10% to bonds (long-term US Treasuries) returned an annualized 10.3% between 1926 and 2004. A 50 - 50 portfolio returned an annualized 9.5% but was one-fifth less risky.

Balancing Act.

Keep your allocations consistent by rebalancing. Over time, it's likely that the value of stocks will rise faster than the value of bonds, so a 60 - 40 stock-bond portfolio will eventually become 80 - 20. To avoid this "allocation drift," you'll need to sell stocks and buy bonds. How often? A study earlier this year by the Vanguard group concluded that "annual or semiannual monitoring, with rebalancing at 5% thresholds, produces an acceptable balance between risk control and cost minimization." Another approach Vanguard recommends is to use dividend income from stocks to buy bonds. That way, the study found, you might not have to reallocate at all.

And don't forget to reallocate within broad asset categories. Many investors suffered devastating losses in 2000 and 2001 because they had let their portfolios become too heavily weighted in tech stocks - or in one particular tech stock. Priceline.com, for instance, fell from $974 a share in 1999 to a mere $6.60 barely three years later.

It pained me, late in 2005, to trim my holdings of Whole Foods after its price nearly doubled, to almost $80. But my rule is that no stock may represent more than 5% of my stock holdings, and the grocery chain exceeded the limit. I felt a little better about the sale when Whole Foods dived more than 20 points in one day, to $46. I bought more, of course.

Be a Partner.

Don't trade stocks. Think of your purchases as making you a long-term partner in great businesses. When you buy, jot down the reason you bought and save the note to retrieve should your resolve weaken. Of course, if the business stumbles badly, new competition develops, key products fail or changes in management produce poor results, then consider selling. Otherwise, hang on to what you buy and prosper with the company.

Owning stocks and bonds inside of mutual funds or exchange-traded funds is a perfectly acceptable alternative to owning individual securities. But understand that, as Donald Mulvihill, of Goldman Sachs, wrote in a recent white paper, large-company stock funds consistently fail to earn a return equal to their benchmark. Research found that through 2005, in only three of the preceding twenty quarters did the average large-company fund beat the Russell 1000 index of large companies - even before expenses. In addition, says the paper, in recent years, "the returns of mutual funds are more similar to one another."

Here are my quick-and-dirty rules for picking mutual funds. Look for a manager who has at least five years' tenure, below-average expenses (1.2% or less), above-average performance for the past three- and five- year periods, low turnover and a willingness to buck the crowd. Find data on these subjects at Web sites such as www.morningstar.com. In particular watch expenses. Using the Securities and Exchange Commission's fund-cost calculator (www.sec.gov/investor/tools/mfcc/get-started.htm), I assumed that each of two no-load funds would produce gross annual returns of 11% over ten years. An investment of $10,000 would grow to $27,006 in a fund with an expense ratio of 0.5%, but to just $24,411 in a fund with expenses of 1.5%. And there's no evidence that high-fee funds will beat low-fee funds.

Your stock portfolio should look like the economy. Don't make bets on individual sectors. For example, the S&P 500, a good reflection of the broad market and thus of the economy, currently allocates about 10% of its value to energy stocks. If you believe that energy companies are especially attractive, then overweight energy in your portfolio, but not by much.

Lean toward stocks that pay dividends. Their advantages: The payouts provide cash, dampen risk and provide discipline for management.

For your bond portfolio, stick with US Treasuries. There's no sense taking risks with the less-risky part of your portfolio. But remember that even bonds issued by the government aren't completely risk-free. Their value can decline sharply if inflation rises - unless you own TIPS, or Treasury inflation - protected securities, bonds that I recommend.

Play the Tax Angle.

Finally, remember that everything you do in investing has tax consequences. Tax rates on dividends and capital gains dropped to 15% in 2003 but are scheduled to rise again in 2011 unless Congress acts. Meanwhile, opportunities for tax-deferred investing through 401(k) plans and IRAs are expanding. What counts is what you ultimately put in your pocket.

Now how hard is that?

Strategies - Four Keys to Investing Success

Decide why you're investing. Pick a financial goal that is important to you. You don't have to limit yourself to one.

Know your risk tolerance. Even your best investment will be tested. Can you withstand the pain of a falling price.

Craft your economic expectations. If you expect decent economic growth over time, then invest for the long term.

Be a partaker, not an outsmarter. Don't try to guess which way the market will turn next. Invest in the best companies and share in their success.


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