Story No. 1: Diversify, Diversify, Diversify, or Mark Twain Was WrongWe have all heard the Mark Twain line from Pudd'nhead Wilson: "Put all your eggs in one basket and watch that basket." Well, Mark Twain was his era's Willie Nelson -- a celebrity who frequently had difficulty managing his assets. A better investing truism comes from Shakespeare's Merchant of Venice: "My ventures are not in one bottom trusted, nor to one place; nor is my whole estate upon the fortune of this present year; therefore, my merchandise makes me not sad." Of the seven personal finance stories, this is the simplest, the most important and the most often misconstrued. Proper asset allocation is the key to long-term investing. Ibbotson Associates, an authoritative source on asset allocation, found that about 90% of the variability of returns over time is due to asset allocation. Let's briefly explain what diversification is, and what it isn't. Diversifying is spreading your assets among several classes that don't always move in tandem -- large stocks, small stocks, bonds, international and real estate, for instance. Diversifying enables investors to reduce the risk of their portfolio without losing on the returns side of the long haul. Diversification is not spreading your money around five, six or 15 mutual funds, if they are overwhelmingly large-cap growth, large-cap value. Those two classes have a 96% correlation, which means they move in tandem almost all of the time. Anyone who owned a Janus fund, an S&P 500 index fund, Fidelity's Magellan fund and a few other large-cap funds that move up, and down, in sync doesn't need to be informed of the perils of having too much retirement money in one basket. Want to know if you're diversified? A good place to start is Morningstar's
Story No. 2: Know Thyself -- and Thy Portfolio"Invest Safely and Make 20% or More" -- a personal finance magazine headline in September 1996. A lot of people lost touch with reality when it came to how much risk they could accept in the go-go 1990s. The newspapers have been littered the past three years with terrible stories about retirees who lost their paper fortunes because they took on too much risk.
|A Portfolio Out of Balance |
If you don't rebalance, your portfolio allocations will get disrupted.
|Jan. 1, 1994||60%||30%||10%|
|Dec. 31, 1999||78%||17%||5%|
Story No. 3: It's Not About Timing the Market, It's Time in the Market"Patience is a necessary ingredient of genius." -- Benjamin Disraeli Lots of personal finance stories are variants on Story No. 3, but often times, financial journalists give investors bad advice by encouraging them to time the market. Investors love to try to time the market. Most times, they are dead wrong. Here are two simple lessons on the perils of active trading. Lesson No. 1: A 2001 study by Financial Research Corp. found that the average investor's $10,000 investment in mutual funds over 25 years would grow to $123,000 without any trading, but only $70,000 with trading. Lesson No. 2: Financial-services consultant Dalbar found that from 1984 to 2000, the S&P 500 returns 16.32% a year, but the average stock-fund investor had an average annualized return of 5.32%. The reason for the undeperformance: active trading. The greatest asset allocation strategy in the world is worthless if an investor doesn't stick to it. This doesn't mean that investors should never adjust their portfolio. If an investor believes that large stocks, growth stocks in particular, are going to underperform over the next decade (as I do), shifting some of those assets into smaller stocks or value stocks is a prudent move.
Story No. 4: Who Needs Stocks?A large number of personal-finance stories pivot around individual stocks --the "Five Stocks to Buy Now!" sort of thing. However, here's the plain truth: Most investors can retire comfortably without ever owning or short-selling an individual stock. It's a lot harder to pick an individual stock than pick a diversified blend of stellar funds. Consider eBay ( EBAY). There are lots of extremely intelligent professions getting paid a lot of money to do hundreds hours of research to assess eBay's true worth. And these professionals come up with greatly divergent views: Even the outstanding writers on our subscription-based sister publication, Street Insight, don't reach unanimity. Making a sizable bet that you will be right on an individual stock is a risky proposition. This isn't to say investing in individual stocks is bad. In fact, Princeton Prof. Burton Malkiel and other financial planners say individuals can satisfy their urge to gamble on the market by betting small sums on specific stocks. So, if you think Cisco ( CSCO) looks cheap and will prove the skeptics wrong, have at it. Just don't tie your fortunes to one company. One final piece of advice on investing in individual stocks: Do your own research. Don't just listen to one pro's sound bite on TV and call your broker. As Peter Lynch wrote in
Story No. 5: To Be or Not to Be the Market: Indexing vs. Active ManagementWall Street is not Lake Wobegon. We can't all get above-average returns. In fact, the surest way over the past 30 years to get above average returns is by investing in funds that mirror the major indexes: Index funds. Full disclosure: I am not an index fund investor. I own a group of funds run by active managers and I hope to beat the market over the long haul by doing so. That said, I try to make the case for index fund investing often because there are a lot of bad actively managed mutual funds out there. According to Burton Malkiel in his newest edition of
|The Odds of Success |
Here's how 355 actively managed large-cap funds fared against the S&P 500 between 1970-2001*.
|Odds of:||Number of Funds||All Funds|
|Beating the S&P 500||39||11.0%|
|Beating the S&P 500 by more than 1%||23||6.5%|
|Beating the S&P 500 by more than 3%||2||0.6%|
| * Through 9/30/2001 |
Caveat emptor: Indexing and the S&P 500 are not synonymous. In fact, while I might recommend index-fund investing, investing in the S&P 500