INVESTING in the
“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.”
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
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-
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
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.”
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
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
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
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
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.
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
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
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
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?
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.
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
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
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
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
The Intelligent Investor, by Benjamin Graham
(HarperCollins). A classic on investing with discipline
and your head, rather than haphazardly and with
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
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.
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