How to Invest Wisely by Going With the Market's Flow
By Douglas R. Sease, 01/30/2001, The Wall Street Journal

The following is an excerpt from the book "Winning with the Market: Beat the Traders and Brokers in Good Times and Bad" by veteran Wall Street Journal editor Douglas R. Sease. Copyright 2001 by Dow Jones & Co. A Wall Street Journal Book published by Simon & Schuster Inc.

Beware when dealing with the investing industry.

Don't get me wrong: Aside from finding a way to save money and avoid debt -- the most important skills in personal finance -- I believe that stock investing is vital. Stocks should be your preference in an investment portfolio for the same reason that Willie Sutton robbed banks: That's where the money is.

But I see no reason that investors, encouraged by Wall Street, should waste hours of time and thousands of dollars in a futile effort to "beat" the market.

That is exactly what thousands of investors do, of course. Sure, if I could find someone to whom I could pay huge sums of money to pick the perfect stocks for me day in and day out for the next 40 years, I would gladly pay him or her 80% or 90% of my gains (I'd still be left with millions). But, as you'll discover, the financial-services industry, by and large, doesn't want to work for a cut of your profits. Brokers, money managers, and mutual-fund managers want to be paid regardless of whether you make money or lose it.

There's a simple reason for that: None of them -- absolutely none -- can guarantee to make you richer every day for 40 years.

What I'm leading up to, of course, is what I think you should do to build and maintain your stock portfolio over the rest of your life: Invest in "index" mutual funds. You will never see an index fund that tracks, say, the Standard & Poor's 500-stock index, leading the best-performance charts in The Wall Street Journal. But your fund's returns will most certainly beat the majority of actively managed funds over a period of five years or more. And you will never see an S&P index fund at the bottom of The Wall Street Journal performance charts, either.

Most -- not all -- of these funds have the exact characteristics that a serious long-term investor needs: diversity, low cost, tax efficiency and good service. It just doesn't get any better than that. I'm speaking of such mutual funds as Vanguard Group's Vanguard Total Stock Market Index Fund (this is from the firm whose founder, John Bogle, pioneered index investing) or Fidelity Investments' Fidelity Spartan Total Market Index Fund. Both of these funds give you low-cost, extremely broad exposure to the overall U.S. stock market.

Now, this is advice you won't always get from Wall Street. Thus, let me introduce you to the Wall Street people who will soon try to become your best friend and financial confidant, and the ways in which they will try to sell you on their methods for beating the market.

Some stockbrokers make a living by charging you for something that you don't always get: good advice.

If you don't believe me, ask your broker for a list of five mutual funds you should buy. Chances are the list won't include any no-load mutual funds, the kind that don't charge any sales fee (from which a broker's commission is paid). Instead, you'll get an explanation (I've heard this several times) about how no-load funds aren't really that good, that as in everything else, you get what you pay for.

The fact is, any broker who tells you that you get better performance from load funds than you get from no-load funds is telling a bald-faced lie. It's just that if everyone bought no-load funds, half the brokers in business today would have to find another line of work.

The sales pitches of Wall Street brokers and other professional investment managers can be persuasive. Take "value investing." If markets are efficient -- meaning that most of the information about a given stock is already encapsulated in its price -- value investing doesn't work; it works only if they are not efficient.

At the heart of value investing is the determination of a company's intrinsic value: what the company is worth when its assets, earnings, dividends, outlook and management are all taken into account. To make money, a value investor buys a stock when its price is below the intrinsic value of the company and sells it when it is at or above intrinsic value.

Sounds pretty simple. All you have to do to get rich is start calculating the intrinsic values of bunches of companies, then buy the stocks of companies whose share prices are below their intrinsic value.

But, of course, you know that if it were that easy, everybody would be doing it. And if everybody did it, they would already have bought up all the stocks trading at less than the intrinsic value of the companies that issued the stock.

That isn't to say that value stocks are impossible to find; there are times, for example, in which investors in large numbers become fearful of owning stocks and seem to sell somewhat irrationally. The stock-market crash of 1987, in hindsight, was one such period. An alert investor would have done very well by buying a broad range of big, well-known stocks in the immediate aftermath of that stunning fall.

Yet for all their rational discipline, value investors have had a very tough time over the past decade or so. They argue that value stocks haven't been "in style" amid the frenzy over fast-growing technology and Internet stocks. Efficient-market advocates, of course, argue that market pricing is cyclical and that sick company stocks are exactly where they should be priced given what is known about them. Certainly some of those companies and their stocks will do very well. But others won't, and the trouble is, nobody knows in advance which ones will and which ones won't. No matter what your broker or financial adviser says.

Don't ask a growth-stock investor to calculate the intrinsic value of a company. She doesn't care. Ask her how fast earnings are growing, though, and she can tell you the percentage gains in each of the past eight or so quarters and give you projections on the eight quarters yet to come.

Earnings -- specifically earnings growth -- are the heart of growth-stock investing. Earnings are growing fast? The stock will rise fast. Earnings in a slump? The stock is going down. A stock with a price/earnings ratio of 60, a level that would give a value investor a heart attack, doesn't even faze your average growth investor if he or she figures it can go to 80.

At its best, growth investing will take you into the most exciting parts of the economy -- technology, the Internet, health care or retailing, for example. At its worst, it will lead you into the realm of the greater fool, a place where you buy a stock at a ridiculously high price on the presumption that someone even dumber than you will buy it from you at an even more ridiculous price.

You've doubtless read about the huge gains that new issues of stock in Internet companies tended to post on their first days of trading during last year's IPO boom. Wouldn't you like to be part of that game?

Well, when I first began covering the financial markets more than a few years ago, I rapidly concluded that individual investors had no business dealing with initial public offerings (IPOs). It was obvious to me that the only IPOs that came the way of individuals were those that the big -- and smart -- institutional investors wouldn't touch.

Times have changed. Increasingly, brokerage firms are making shares of respectable IPOs available to individual investors.

But while times have changed, my opinion of IPOs hasn't. My conclusion is that most individuals should just stay away from IPOs. The reasons for that conclusion, however, are different. The fact remains that some schlocky IPOs still get palmed off on innocent and unwary individual investors. But as the IPO frenzy has grown and more individuals clamor for shares, it makes sense for the investment bankers to let them in on the initial offerings, simply because in their emotional hysteria (often fueled by Internet chat rooms touting the IPO) these individuals bid the prices up to incredible levels, allowing the underwriters to make huge sums as they sell the shares they held in the fledgling company.

Even when the IPO is a well-known company underwritten by a reputable investment bank, there remain two problems for individuals. First is the outright long-term performance of IPOs. In the 10 years from 1988 to 1998, of the 4,900 companies that became publicly traded, nearly 30%, as of 1998, were no longer listed on any market. And of the 70% or so still trading, a study done by US Bancorp Piper Jaffray showed that the median annual return was a paltry 2.4%, less than what an investor could have earned in a simple and relatively safe money-market account.

Now that we've addressed some issues that bother me, here are a couple of positive suggestions that, I hope, will help you on the road to becoming a better investor.

So far our stock discussion has centered on stocks of companies headquartered in the U.S. But the U.S. stock markets represent less than 40% of the total stock-market capitalization in the world. Why on earth would you want to ignore that other 60%-plus?

Fear is usually the reason investors cite for not venturing abroad. Only a hermit living in a cave doesn't know that disaster struck many of the Asian economies in 1997, sending their stock markets into a devastating plunge, and that Russia's economy and markets imploded in 1998. Yet in retrospect, crises in foreign markets can be spectacular buying opportunities. I'm convinced there are great opportunities for investment outside the U.S.

And it isn't just opportunities that draw me abroad. As you probably already know, diversification is the hallmark of a good investor, and foreign stocks add diversification. I won't argue that you should have 60% of your portfolio abroad, but I do suggest that you have up to 20% of it outside the U.S. as long as you are cognizant of and willing to take the risks.

The best thing about it: You don't need a broker to bombard you with recommendations about which foreign stock to buy. You can indulge your foreign tastes through -- you guessed it -- index funds. A couple of my suggestions: Vanguard Global International Stock Index fund, or Fidelity Spartan International Index Fund.

I've been writing about investments and personal-finance issues for years, and I hear frequently from people who, despite excellent incomes, are having immense difficulties with their finances. The problem is they're overreaching, trying to hit too many financial targets with too few dollars.

You can't have an income of $100,000, spend $102,000, and have much left over for a disciplined and fruitful investment program. One common but dangerous solution that many use is to try for outsize returns to make up for the lack of a steady flow of new money into their investment portfolios.

Saving isn't easy. It requires discipline, knowledge, and forethought. An effective saver is able to forgo the instant, but often short-lived gratification of spending money now.

Yet the ability to save is nothing less than freedom.