Chris Farrell’s
SOUND MONEY
  GUIDE TO
INVESTING in the
 STOCK MARKET
“We’ve had 10 years
                                                                        of a huge bull market where
  ...
This booklet is designed as a brief introduction to equi-         THE EQUITY FUNDAMENTALS
ties. The suggestions for furthe...
versus 8 percent for bonds and 1 percent for cash.) The                        Hold on to your wallet. Trying to beat the ...
replicates the performance of a market index, such as            the fund from selling securities, and capital gains again...
PICKING INDIVIDUAL STOCKS

                                                                “The business is about making m...
performance of stocks and the market to divine the mood                           RISK MATTERS
of investors. Technical ana...
The key question is: How much investment risk can you                      DIVERSIFY, DIVERSIFY,
tolerate? To find out, you...
that you’ll earn a decent return over time. By mixing                             RESOURCES
some of each asset class into ...
WEB SITES

Valuing Wall Street: Protecting Wealth in Turbulent             www.berkshirehathaway.com. Warren Buffett is he...
Sound Money ® is produced by
      Minnesota Public Radio and distributed by
  Public Radio International. It is carried o...
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SM StockMarket Bk Rev

  1. 1. Chris Farrell’s SOUND MONEY GUIDE TO INVESTING in the STOCK MARKET
  2. 2. “We’ve had 10 years of a huge bull market where we’ve brought more and more people into the game because they thought it was simple. Now, we’re coming to a period where people are going to be very suspicious of the stock market. This is where you really see the value opportunities created.” Steve Leuthold W ALL STREET VETERANS are fond of saying the CHRIS FARRELL is host of Sound Money, heard on public most dangerous phrase in the markets is, radio stations nationwide, and of public television’s “This time is different.” Yet, in a vital sense, Right on the Money. Farrell is also a contributing eco- “This time is different.” For the first time, more nomics editor at Business Week magazine and chief economics correspondent at Minnesota Public Radio. than half of all American households earn a paycheck He holds degrees from the London School of Economics and own stock either directly or indirectly though a mutual and Stanford University. fund. Workers are investing in the stock market to fund their retirements, their children’s college educations and other long-term savings goals. Little wonder investing in the stock market is a hot topic at work and at neighborhood gatherings. And, as of this writing, many investors are reeling. The stock market put on a once-in-a-lifetime performance in the 1990s, espe- cially the tech-laden Nasdaq composite index. But the Nasdaq collapsed in 2000, and the rest of the stock market faltered. The stock market has recovered somewhat since the beginning of 2001. Still, many workers are worried STEVE LEUTHOLD is chairman of The Leuthold Group, about their stock investments, especially their retire- a Minneapolis investment research organization, and ment nest egg. What should they do? Stay the course? president of Leuthold & Anderson, a money manage- Trim back their holdings? Or get out until the good times ment firm. He is a nationally known expert on the stock and bond markets and is frequently quoted in noted return? business and financial publications. You can’t get rid of the uncertainty. But you can improve You can read and hear all of Chris Farrell’s interview the odds of doing well by concentrating on a few core finance with Steve Leuthold online at www.soundmoney.org. principles, focusing on the long haul, keeping your costs low and your moneymaking expectations realistic. Investing in the Stock Market 1
  3. 3. This booklet is designed as a brief introduction to equi- THE EQUITY FUNDAMENTALS ties. The suggestions for further research and study at “People talk about contrarians, the end offer a much deeper look into the risks and and I guess, in a lot of ways, I am. returns associated with saving money in the capital The less people like the stock market . . . the markets. more I do. People’s dislike for the stock market is built into the depressed prices that exist in the market. Really, investing in stocks is about buying companies that are cheap that produce earnings over a long period of time.” Wall Street slices the stock universe into Steve Leuthold many categories. Here are four especially sig- nificant distinctions. E QUITIES ARE OWNERSHIP SHARES in a company. GROWTH STOCKS are glamour stocks. You are an owner of General Electric even if you These are fast-growing companies with a good story, such as computer, software, tele- only buy one of its nearly 100 million shares out- com and biotech. Investors are looking for standing. Equities represent the uncertain returns capital appreciation, since these companies to entrepreneurship, and it is corporate profits that typically don’t pay a dividend. Growth stock companies invest all their cash in expanding largely determine stock prices over time. the business. Think Apple Computer or Microsoft when they were fledgling firms. The price of a stock will change depending on how VALUE STOCKS are out-of-favor companies, investors assess a company’s earnings prospects. A old-line firms with dividends and companies software company with growing sales and cash flow will with a low stock price relative to earnings sport a higher stock price as investors anticipate addi- and assets. Value investors are contrarians. tional gains ahead. But investors will drive down the LARGE CAPITALIZATION STOCKS are stock price of a software company with dwindling sales companies with a market value of $5 billion and an incoherent management strategy. or more. (You calculate market value by tak- ing a company’s share price and multiplying it by the number of shares outstanding.) Many companies also pay a dividend, or regular cash Coca Cola, Nike, Wal-Mart and IBM are all payment, to their investors. Historically, dividends large cap stocks. account for about half the long-run return earned by SMALL CAPITALIZATION STOCKS are investors. The total return of a stock, the best measure companies with a market cap of under $1 of its performance, comes from the sum of dividend pay- billion. These are usually less seasoned enterprises with fewer financial resources— ments and any price appreciation or loss. but more potential. Stocks are volatile, more than twice as volatile as bonds. (The annualized volatility of stocks is about 20 percent 2 Sound Money Guide to Investing in the Stock Market 3
  4. 4. versus 8 percent for bonds and 1 percent for cash.) The Hold on to your wallet. Trying to beat the market is a volatility reflects the greater risk of stocks relative to loser’s game. Investing may be the world’s most compet- bonds or cash. When a company encounters financial itive business as millions and millions of investors trouble, bondholders have first dibs on corporate cash struggle to uncover good stocks and steer clear of com- flows while equity holders carry the brunt of any losses. panies with poor prospects. Terrance Odean and Brad Still, the only way to create an opportunity to earn a high Barber, two finance economists at the University of return is to take greater risks. And stocks leave bonds California, Davis, looked at the trading accounts of more and cash far behind in the performance sweepstakes than 66,000 households at a large discount brokerage when held for the long term. Over the past two centuries firm from 1991 to 1996. The stock market recorded an the return on U.S. stocks has averaged 7 percent, after annual return of 17.9 percent during those years, yet adjusting for inflation, according to finance professor active traders only earned an 11.4 percent return. Jeremy Siegel of The Wharton School. The respective return on bonds and cash is 3.5 percent and 2.9 percent, There is no evidence that trading in and out of the mar- after adjusting for inflation. ket will line your pockets. But there is abundant evidence that a disciplined, long-term approach with minimal trading and low costs will increase the odds that you will TRADING IS HAZARDOUS reach your long-run financial goals. TO YOUR WEALTH “The biggest problem of all that people have is psychological in that EQUITY MUTUAL FUNDS when fear hits the front pages, they tend to . . . sell at the wrong time and not buy back until “The mutual fund industry, the market makes new highs.” unfortunately, promotes what sells. And what sells is past performance.” Steve Leuthold Steve Leuthold E V E R Y B O D Y WA N T S T O P O C K E T H U G E R E T U R N S T H E M O S T C O N V E N I E N T A N D S E N S I B L E WAY to in the stock market. Wall Street brokers linked to invest in equities is through mutual funds. The an army of research analysts and computer ter- big divide in equity mutual fund investing is minals promise to find you stocks that will between passive and active strategies. “beat the market.” Mutual fund managers trumpet their market-beating performance. Television shows proclaim I favor building a core portfolio around the passive the ten hottest stocks of the New Year. Internet sites investment approach, better known as indexing. It’s offer the hour’s hot stock. called passive investing because there is no professional money manager pulling down a multi-million dollar salary trying to beat the market. Instead, the mutual fund 4 Sound Money Guide to Investing in the Stock Market 5
  5. 5. replicates the performance of a market index, such as the fund from selling securities, and capital gains again Standard & Poor’s 500, the Wilshire 5000, and the when you sell the fund shares (assuming you make a Russell 2000. Although there are all kinds of equity index profit). Every year, mutual fund companies mail their funds, I prefer the broad-based indexes for participating investors IRS form 1099 detailing their tax liability on in domestic and overseas stock markets. income and capital gains distributions. A majority of professional money managers fail to do Check out the fund’s trading activity or turnover rate. better than index funds. A major reason is the low cost For example, the average equity mutual fund has a of passive investing. The annual fee for investing in the turnover rate of 90 percent, meaning a $1 billion fund Standard & Poor’s 500 index is some 0.2 percent versus does some $900 million in trades every year. The fre- an average of 1.5 percent for actively managed mutual quent trading will boost your tax bill. Indeed, some funds. Index funds are also relatively tax-efficient mutual funds that rank high on the return sweepstakes because trades are made only when a stock is dropped fall toward the bottom of the list once the tax conse- or added to the index. quences of their frequent trading are taken into account. A few mutual fund companies are marketing tax effi- Still, many people prefer an actively managed fund. cient funds where the money manager takes into Although there are thousands of actively managed equity account the tax consequences of buying and selling mutual funds, you can cut through the list fairly quickly stocks. by checking them against your goals. For instance, if you’re just starting out, you’ll want an equity mutual fund that invests in many different industries. I would steer clear of most sector funds, aggressive growth funds, option funds and other fringe investments, which tend to be very volatile and carry high fees. Avoid the temptation to join the performance sweepstakes derby. Some funds do really well one year—only to collapse the next. It’s best to find a fund with a long- term track record. You don’t need to worry about taxes if your mutual fund investments are in a tax-deferred account, such as a retirement savings plan. Outside of those accounts, however, if you are a mutual fund owner, you can get hit with taxes in three ways. You’ll pay income tax on divi- dend income, capital gains tax on any profit earned by 6 Sound Money Guide to Investing in the Stock Market 7
  6. 6. PICKING INDIVIDUAL STOCKS “The business is about making money, Here are some common measures and when you buy companies that have no for unearthing the value of the stock prospects for making any money, and they’re market or a stock. giving away their product and yet investors are going bananas over them, this is really T H E P R I C E / E A R N I N G S R AT I O is the height of speculation.” the share price of a stock divided by its Steve Leuthold per-share earnings over the past year. If P ICKING STOCKS IS FUN, especially online. But a stock sells for $100, and the company here you should invest only your “mad” money. earned $5 a share over the past 12 For most individuals, it should come out of your months, its P/E is 20. The P/E ratio is entertainment budget—the money you can a time-honored indicator of investor afford to lose. I wouldn’t put my standard of living in expectations for a company. The higher retirement, my children’s college education, my emer- the P/E, the more investors anticipate gency savings, or the down payment on a first home at strong future earnings growth, and risk to my stock-picking prowess. vice versa. If you want to buy individual stocks, it pays to develop THE PRICE-TO-BOOK RATIO is the an investment philosophy, spend time researching a per share price of a stock divided by its company, and buy stocks you want to own for the long haul. There are quite a few strategies from which to book value. The book value of a company choose. Among the best-known is fundamental analy- is the value of its assets, such as its real sis. It’s the technique of valuing a stock based on a estate and machines, minus any debt. company’s cash flow and earnings prospects. This kind of analysis includes studying industry trends, capital THE PRICE-TO-SALES RATIO is investment and management strategy. calculated by taking a company’s stock price and dividing by its revenues per Another popular technique is technical analysis, which share. The idea is that a company’s is based on the belief that studying a company’s bal- share price should keep up with the ance sheet and income statement isn’t important. All growth in sales. that information is already reflected in the stock price. Instead, what counts is market psychology. Are investors optimistic about a company’s prospects or not? Technicians create all kinds of charts plotting the 8 Sound Money Guide to Investing in the Stock Market 9
  7. 7. performance of stocks and the market to divine the mood RISK MATTERS of investors. Technical analysis is an expensive strategy since the technique encourages frequent trading. “Long term, it’s very true that stocks have outperformed other investment classes. But there have Peter Lynch, the famed money manager, popularized been periods for as long as 20 years where another method. Lynch champions the idea of individu- the stock market has lagged. ” als buying stocks in companies they encounter in their Steve Leuthold everyday life—it’s the personal experience method. Your family discovers a new restaurant, and you think R ISK IS A RICH WORD with many shades of it’s terrific. Well, is it a publicly traded company? If so, meaning. It hints at dangers to be avoided, such check it out. Or you find out that you and your neighbors as health risks from smoking cigarettes. But are all shopping at a particular store for much of your risk also suggests daring images of entrepre- household needs. Start researching it. neurs starting their own company. Risk means different things to different people. Investment clubs are a good way to learn about investing. An investment club is much like a book club, except a group Similarly, there is no one definition of risk in the capital of individuals gets together to put money into stocks, and markets. To finance professionals, risk is synonymous with the investment club is a legal partnership. Investment volatility. High volatility increases the odds that you’ll clubs stress research, education and investing for the suffer a loss if you need to sell an asset to raise money, long haul. You won’t beat the market, however. and the returns to very volatile assets are uncertain. But most people carry a different definition of risk. It’s not having the money you need to live as well in your seventies as you did in your fifties. Risk is the possibil- ity of not reaching your financial goals. Time is a critical factor when thinking about risk. If you want to buy a home three years from now, putting your $25,000 down-payment into the stock market in the hope of making more money is a mistake. Equities are too volatile for such a short-term time horizon, and the risk is too great that your $25,000 could shrink in value. But the odds of losing money in the stock market lessens—although it does not disappear—with time. 10 Sound Money Guide to Investing in the Stock Market 11
  8. 8. The key question is: How much investment risk can you DIVERSIFY, DIVERSIFY, tolerate? To find out, you could take one of the risk toler- DIVERSIFY ance tests offered by financial services companies on “So many people the Web. It’s a start. But you’ll get a better handle on are used to a defined benefit program. your appetite for financial risk by studying your reaction They know exactly what they’re going to get to a falling market and declining stock price. And think in terms of a pension benefit. But now, with the about your attitude toward risk elsewhere in your life. For defined contribution plans, it’s entirely different. instance, did you seize the opportunity to leave a good It’s your responsibility to act prudently and make sure that a nest egg is job at a stable company for a smaller, more entrepre- going to be there.” neurial outfit, or did you decide the switch was too risky? Steve Leuthold E CONOMIC RESEARCH SUGGESTS that for all the time people spend trying to pick the right mutual fund or stock, how you divide your portfolio among stocks, bonds, cash, real estate, and international equities (the main portfolio options for most people) is the main determinant of your portfo- A MARKET SNAPSHOT lio’s long-term performance. Fortunately, the task of creating an optimal asset allocation for you has been Long-term total returns made easier with the creation of a new generation of 10 years annualized, January 2001 sophisticated computer software and Web sites. return Russell 3000 17.18% The essence of asset allocation is the balance between Russell 2000 15.12% risk and expected return. Stocks offer the highest poten- S&P 500 17.37% tial return but at greater risk than, say, short-term Nasdaq Composite 20.94% Treasury securities. That’s why it pays to heed the age-old Dow Jones Industrial 17.51% Treasury bills* 6.49% mantra of spreading your investments among equities, Treasury bonds** 0.34% bonds and other assets to diversify your risks. *1-3 year maturity Diversification, the notion of “not putting all your eggs **15 years DATA: Aronson + Partners in one basket,” is among the most celebrated concepts in modern finance. (Economist Harry Markowitz even got a Nobel Prize for turning your parents’ oft-repeated advice into mathematical equations.) Diversification both reduces investment risk and increases the odds 12 Sound Money Guide to Investing in the Stock Market 13
  9. 9. that you’ll earn a decent return over time. By mixing RESOURCES some of each asset class into a portfolio, you give up John Bogle on Investing: The First 50 Years, by Bogle some performance, but you will lessen the risk of having (McGraw-Hill). A collection of speeches, this book your savings all go down the drain at once. But diversi- distills the investing wisdom of a giant in the business. fication is a much more subtle idea than simply creating A Random Walk Down Wall Street (7th Edition), a margin of safety. Since no one really knows which by Burton Malkiel (Norton). Malkiel translates into markets will soar or sink in the future, investing in all layman’s language an enormous body of academic and the major asset classes creates an opportunity to catch historic research into investing. the next big market upturn. Stocks for the Long Run, by Jeremy Siegal (McGraw-Hill). A finance professor at Wharton, his book illuminates Investing in the stock market is fun. Yes, most of us the superior long-term returns investors have earned on stocks. would choose to read a mystery novel rather than a prospectus. Yet the stock market, with its price changes, Global Bargain Hunting: The Investor’s Guide to is a dazzling economic and social institution for com- Profits in Emerging Markets, by Burton G. Malkiel and J.P. Mei (Touchstone Books). A sound guide for municating all kinds of information and knowledge in a any investor eager to put some money at risk in the global economy. And investing in stocks is sound world’s frontier economies. finance. Good luck. The Warren Buffett Way, by Robert Hagstrom (John Wiley & Sons). A systematic overview of the invest- ment techniques of Warren Buffett, the greatest stock-picker of the post-World War II era. Investing for Dummies, by Eric Tyson (IDG Books Worldwide). You can’t go wrong tapping into Eric’s expertise. The Intelligent Investor, by Benjamin Graham (HarperCollins). A classic on investing with discipline and your head, rather than haphazardly and with emotion. Everything You’ve Heard About Investing Is Wrong, by William H. Gross (Times Business). Gross is a legend among bond investors, and he offers up astute comments about investing in this short book. 14 Sound Money Guide to Investing in the Stock Market 15
  10. 10. WEB SITES Valuing Wall Street: Protecting Wealth in Turbulent www.berkshirehathaway.com. Warren Buffett is head Markets, by Andrew Smithers and Stephen Wright of Berkshire Hathaway, a holding company for a wide (McGraw-Hill). The authors largely focus on why they range of business. His witty annual letter to sharehold- thought the market of the 1990s was overvalued, but ers is a terrific read—and a genuine education in they also provide a lot of good information for investing. investors. www.better-investing.org. The National Association It Was a Very Good Year, by Martin Fridson (John of Investment Clubs offers plenty of good stock- Wiley & Sons). A readable history of extraordinary picking information. moments in the stock market, starting in 1908. www.fool.com. The Motley Fool’s “Fool School” is an Reminiscences of a Stock Operator, by Edwin Lefevre educational resource. (John Wiley & Sons). Published in 1923, this is a fictionalized biography of Jesse Livermore, a great www.aaii.com. The American Association of Individual 19th-century speculator. Investors offers some of the best guidance available on buying and selling individual stocks. Short History of Financial Euphoria, by John Kenneth Galbraith (Viking Penguin). A gifted writer and wry www.bigcharts.com. How has a stock done over the observer, Galbraith is a delight with his short excursion past year? What is its price/earnings ratio? You can find through the madness of financial crowds. out here. Devil Take The Hindmost: A History of Financial www.marketguide.com. A Web site that offers Speculation, by Edward Chancellor (Farrer-Strauss- investors price charts, key financial ratios, research and Giroux). Chancellor does a terrific job describing some so forth. of the most famous—or infamous—speculative binges in history. www.moneycentral.msn.com. Microsoft’s Web site is a huge cyber portal for investors. Against the Gods: The Remarkable Story of Risk, by Peter Bernstein (John Wiley & Sons). Peter Bernstein, an www.quicken.com. Quicken is another giant Web site economic historian and investment advisor, has written with all kinds of stock screens. an engrossing history of risk, gambling, probability and the financial markets. www.vanguard.com. The library and education sec- tion of this Web site is well worth exploring. Asset Pricing, by John H. Cochrane (Princeton University Press). This book is only for the academi- www.morningstar.com. The company is best known cally inclined, but Cochrane is at the leading edge of for its mutual fund rating system. But it offers much finance economics today. more, such as stock research. www.efficientfrontier.com. Bill Bernstein is a financial advisor and author of The Intelligent Asset Allocator. He does some of the best research and commentary on investing available on the Web today. 16 Sound Money Guide to Investing in the Stock Market 17
  11. 11. Sound Money ® is produced by Minnesota Public Radio and distributed by Public Radio International. It is carried on public radio stations across the country. Contact your local public radio station for broadcast times. For more information on Sound Money go to www.soundmoney.org Chris Farrell’s Sound Money Guide to Investing in the Stock Market is published by Minnesota Public Radio, 45 E. Seventh St., St. Paul, MN 55101. © February 2001 Minnesota Public Radio. All rights reserved. Chris Farrell’s Sound Money Guide to Investing in the Stock Market was produced with assistance from Primevest Financial Services, and their PrimeVest Investment Executives, dedicated to providing investment and insurance solutions and strategies. The information in this booklet is of a general nature and not intended for application to specific cases. You should discuss specific circumstances with your lawyer, accountant or financial advisor.

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