Aristotle once wrote that there are only seven stories to be told, and all drama is a variation on one of these seven stories.

While not as profound, there's a personal finance equivalent to this truism. There are seven stories to write on matters for individual investors, and all personal finance stories are variations on the same seven stories. No matter how we dress up different stories, every personal finance column can be reduced to one of these basic seven tenets. Today's Financial Education column will explain the essence of each of these seven stories.

Story No. 1: Diversify, Diversify, Diversify, or Mark Twain Was Wrong

We 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 Portfolio X-Ray .

We'll leave this section with the three fundamental long-term truths of diversification:

  • 1. Stocks beat bonds, bonds beat cash.

  • 2. Small stocks beat large stocks.

  • 3. Value beats growth.

    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.

    Story No. 2, one that should've been discussed more frequently in the 1990s, is a fairly straightforward one: Know how much risk you can live with, and make sure your portfolio matches your comfort level. As Sacramento, Calif., financial planner Cynthia Meyers said, "If you can't sleep at night over your portfolio, chances are you have too much risk."

    Story No. 2 comes down to the three R's: risk, returns and rebalancing.

    Risk: A big determinant of an investor's risk profile is age: How close are you to retirement? Other factors include life changes -- junior's getting close to college age. But behavioral factors come into play as well: If a 30-year-old is going gray after watching the markets collapse over the past three years, perhaps that individual should adopt a less risky portfolio.

    Returns: The headline listed at the beginning of this section shows just how delusional we had become in the 1990s. The 15.6% average annual return from 1982-2000 gave everyone a false sense of expected returns. In Stocks for the Long Run , Wharton professor Jeremy Siegel shows that roughly 7% annual returns have been the standard for the past two centuries, and he cautions that "future real returns on stocks could be 1 to 2 percentage points lower." If there are any investors out there who anticipate getting double-digit returns every year, they are in for disappointment.

    Rebalancing: Investors don't benefit from active trading, but they do need to rebalance from time to time -- once a year is a fair time frame -- to keep their proper asset allocation. As we noted recently, a 1988 TIAA-CREF study found that the average investor never rebalances after their initial retirement-plan investment. This is silly but true. Rebalancing enables investors to pare back on the asset classes that have run up, while adding to the underperformers -- an easy-peasy version of buying low and selling high. The following chart demonstrates how not rebalancing can distend your portfolio into something you didn't think it was.

    A Portfolio Out of Balance
    If you don't rebalance, your portfolio allocations will get disrupted.
    Date Stock Weighting Fixed-Income Cash
    Jan. 1, 1994 60% 30% 10%
    Dec. 31, 1999 78% 17% 5%
    Source: Ibbotson

    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.

    Here's a great antidote to active investing: dollar cost averaging. This technique involves buying a fixed dollar amount of an investment on a set schedule, regardless of the share price. Most shares are purchased when prices are low, which is another simple way to buy low and sell high. It also removes the behavioral issues from investing: Human beings in general aren't wired to be savvy investors.

    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 One Up on Wall Street , "Stop listening to professionals. ... Ignore the hot tips, the recommendations of brokerage houses and the latest 'can't miss' suggestion from your favorite newsletter -- in favor of your own research."

    Story No. 5: To Be or Not to Be the Market: Indexing vs. Active Management

    Wall 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 A Random Walk Down Wall Street , an investor who put $10,000 in an S&P 500 index fund in 1969 would have a portfolio worth $327,000 by the end of 2002, assuming dividends were reinvested. A second investor who put $10,000 in the average actively managed mutual fund would have a portfolio worth $213,000. The index fund investor had a 50% greater return than the average.

    Over the past 10 years, the Vanguard 500 index fund topped 81% of all actively managed large-cap funds. The following chart shows how the index has fared against the competition over the past 32 years.

    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
    Surviving 158 44.5%
    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
    Source: Vanguard

    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 carries some risks . Indexing is using a low-cost, benchmark-pegged approach to investing in a variety of asset classes. There are index funds for just about every asset class under the sun, and they provide a low-cost alternative to actively managed funds.

    Story No. 6: The Other Side of the Coin: Expenses and Taxes

    Most investors don't may much attention to expenses, taxes and fees when they invest -- in part because the financial media doesn't drive home the importance of it enough. But consider: A recent Lipper study found that investors lose as much as 25 cents of every dollar of their annual returns to Uncle Sam. Given that we are also losing a lot of it to the bear market, investors would be wise to pay closer attention to costs.

    Here's a simple example of how much costs eat into your returns, courtesy of Thomas D.D. Graff and James M. Dugan of Cavanaugh Capital Management. Investor No. 1 invests $100,000 in a portfolio of index funds with an expense ratio of 0.22%. The portfolio returns 10% a year over 10 years. Investor No. 2 investors the same money in actively managed funds with an expense ratio of 1.53%. The portfolio also returns 10% a year over 10 years. After 10 years, Investor No. 1 has $253,724, Investor No. 2 has $222,314. The difference: $31,410, or 14%. And that's assuming Investor No. 2 finds actively managed funds that keep up with the markets.

    Story No. 7: Do You Need Help?

    There are lots of fine personal finance stories on choosing the right broker or financial planner or accountant.

    Plenty of investors decide they want professional help -- maybe they have special needs, maybe they don't trust themselves to stay on top of their portfolio, etc.

    I am a firm believer in do-it-yourself investing -- no professional has as much incentive to safely steward your portfolio as you do. The Internet, the local bookstore and a few hours of research a month is all most investors need to build a balanced, diversified portfolio.

    For individuals considering going it alone, I strongly suggest the following books to get you started. If you don't have the time or interest in reading them -- which is understandable, not everyone finds asset allocation and personal finance alluring -- maybe you are better suited with a little outside assistance. There are dozens of great investing books; here are four to get you started:

  • The Intelligent Investor by Benjamin Graham.

  • A Random Walk Down Wall Street by Burton Malkiel.

  • Stocks for the Long Run by Jeremy Siegel.

  • The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William Bernstein. has a revenue-sharing relationship with under which it receives a portion of the revenue from Amazon purchases by customers directed there from

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