Beginner's Bravado Can Cost You

Risking it all for big gains means risking having nothing left when the market turns.
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One day in late October, we got a question in our Start Investing Community with the title "Aggressive or Stupid?" It came from a college student by the handle, "Blond." I want to take a look at it because Blond expresses some feelings common to many new investors.

Blond told us he'd first come to the message board in early September hoping to learn something before he started investing. He'd put together a little money, he said, "which is pretty much meaningless to me at this point."

Blond wanted aggressive-growth investments, presumably so he could make his money meaningful. But he didn't think he'd get much help on the Start Investing message board because, he said, aggressive growth "usually meets a cold response here."

That's a claim I've heard before. We get a fair number of newbies on the Start Investing message board, and many of them say that Tim Middleton,

MSN MoneyCentral's

mutual fund columnist, and I -- not to mention the other regulars in the group -- are wimps when it comes to mixing it up with high-powered investments.

Risk for Beginners

They're partially right. I'm not a wuss when it comes to putting my own money on the line. But I'm pretty concerned about beginners because I believe it takes a fair amount of experience to be able to ride through the downdrafts.

What do you suppose a newbie -- someone who has never invested before -- means when he says he wants aggressive growth? I think he means he wants to make a lot of money. Fast. He wants aggressive growth as opposed to puny growth. Or no growth.

Rarely, though, does a newbie say, "I'm willing to lose a lot of money if the markets go against me." Yet that's precisely what can happen with an aggressive-growth investment. Indeed, that's what many newbies learned in the roiling markets of September and October. I think it's time for a lesson about the beta coefficient.

Beta, one of the tools of modern portfolio theory, measures the volatility of a stock or fund compared with the overall market. The market as a whole, as measured by the

S&P 500 index, is assigned a beta of 1.0. An investment with a beta of 1.5 is 50% more volatile than the market. That means you can expect it to rise 50% more than the overall market in an uptrend and sink 50% more in a downdraft.

I own a number of high-beta stocks. For instance,

JDS Uniphase

(JDSU)

has a beta of 1.8 and

TranSwitch

(TXCC)

, a beta of 1.3.

Applied Micro Circuits

(AMCC)

, which I do not own, has a beta of 1.7.

We expect mutual fund betas to be lower because of the diversification. Still, the

(MNNAX) - Get Report

Munder NetNet fund has a beta of 1.84 and the

(TVFQX)

Firsthand Technology Value fund, a beta of 1.4.

(VWEGX)

Van Wagoner Emerging Growth, another volatile fund, has a beta of 1.35.

Sycamore Networks

(SCMR)

has a beta of 1.6. It traded not too long ago at $170. I bought it in October at $85 and $76, and it was recently trading around $60. That's a high-beta stock! It's that second part of the aggressive growth -- the aggressive loss -- that most beginners don't think about until it's too late.

A 10% Gain -- Per Week?

But back to Blond.

"What I've been trying to do," he told us, "is gain 10% a week, which equals 520% a year." I won't go into the shortcomings of both his logic and his arithmetic, but no matter how you calculate it, his is not exactly a modest goal -- particularly for someone with six weeks' experience. His plan was to invest $1,000, earn 10% in the first week, tuck away that gain, reinvest the $1,000 to earn another hundred bucks the second week and so on. In one year, Blond figured, he'd turn his $1,000 into $6,200. "I know all you long-time investors are shaking in your shoes," he said. But Blond compared his investing strategy to "riding a wave, kind of like surfing."

What was really over the top, though, was when Blond said, "I've found this to be pretty easy. So why don't all of you do it?" And he also wondered why we weren't giving this moneymaking advice to other newbies.

(While obviously not the primary flaw in his strategy, I'll credit Blond for mentioning taxes as a possible negative. Indeed, investors must pay short-term capital-gains tax on any investment that is held less than 366 days. Short-term gains are taxed at the same rate as regular income, which means up to a maximum of 39.6%. Add state taxes, and an investor can lose half his gains to taxes. But long-term capital gains are taxed at a maximum rate of 20%. And beginning in January, new, lower rates go into effect for assets held more than five years. The top rate will be 18%, with taxpayers in the 15% tax bracket paying as little as 8% on investments held five years or more. So, the holding period is important.)

I really wasn't too concerned about whether Blond would lose his $1,000 -- I figured that's a given -- but thought he might at least learn an important lesson. What bothered me more was that other newbies might be drawn to his approach. It might have looked valid, for instance, in February and again in August when the market was going up and up and up. But Blond would have been a big loser in April and October.

There's Always a Scheme

That's the problem with all get-rich schemes. They're one-dimensional. When the market goes up, we have someone like Blond suggesting that we trade and trade and trade to increase our returns. When the market goes down as it did in October, we always have someone new in the newsgroup asking why the rest of us don't short stocks. (Shorting is a strategy that involves selling borrowed stock with the hope that the price will go down, so you can buy the stock, repay the loan and still pocket a profit.)

These are not sound approaches for beginners, or even for many more-experienced investors. I would never use them. Neither would Tim nor most of the other regulars in the community.

The buy-and-hold strategies we offer in Start Investing can look pretty boring alongside Blond and the shorts. But they work. For beginners, we recommend funds like

(PRSGX) - Get Report

T. Rowe Price Spectrum Growth, a diversified fund that can anchor a portfolio. We also like specialty funds like

(VGHCX) - Get Report

Vanguard Health Care and

(WOGSX) - Get Report

White Oak Growth Stock for those who can handle more volatility -- higher betas -- as well as international funds like

(PRITX) - Get Report

T. Rowe Price International Stock or

(FEURX)

Invesco European.

Here's one thing I think beginners should think about. If you lose 50% of your money, you must then get a 100% gain to get back to even. That's the dark underside of aggressive investing.

I don't think we've seen the last of Blond, though. I have him pegged for a guy who is trying to learn something, who is testing us with his aggressive strategies to learn why they won't work. I think he'll learn a lesson about beta and become a student of investing like lots of other newbies before him. We'll be happy to have him.

At the time of publication, Mary Rowland owned or controlled shares of the following equities mentioned in this column: JDS Uniphase, TranSwitch, Sycamore Networks, Invesco European fund and Vanguard Health Care fund. She welcomes your feedback at

mctsc@microsoft.com.

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