As of today’s date, the stock market has fallen over 20% in the past 7 days and 40% since its peak in 2007. Article in today’s Wall Street Journal by Jason Zweig suggests Dow could go as low as 6000 based on the past psychology of crashes which typically overshoot the correct market valuation. Jason reviews some history and quotes a financial consultant to evidence that most individual investors are in a state of denial and inaction, not calling their brokers and avoiding reviewing their financial statements. This suggests we still have not reached the capitulation phase of a crash when we realize how much we’ve lost, and those who’s interior commitment is to buy and hold freak out and sell. Jason concludes that for the long time investor that it might be a good time to buy even though capitulation hasn’t occurred yet;if you wait you probably will risk missing the bottom. (For myself I”m probably not there yet – I’d rather catch it on the upswing). Personally, most of my stock investments have a long horizon (more than 20 years) and while I wished I had cashed out more of my shorter horizon (less than 10) I’ve learned from the past that’s a bad idea and it’s better to hold.
Anyway, all this has spurred me to review some basic stock market fundamentals and to offer some tips:
A. Every investor (and that should mean EVERYONE) needs to read (must read!) the following:
1) The Intelligent Investor by Benjamin Graham, (ISBN-13 978-0-06-055566-5, ISBN-10 0-06-055566-1 2006 edition, preface by Warren Buffet, update and commentary by Jason Zweig (can’t vouch for other editions)
This is the stock investor’s classic written by Warren Buffet’s mentor and teacher, Benjamin Graham. The primary value of this book in my opinion is the wisdom of Graham’s years of experience in analyzing multiple market cycles (and in this edition, Zweig’s commentary which applies Graham’s analysis and advice to the dot com crash, contrasting it with the silliness of many modern analysts). Particularly relevant on the day of this writing where the stock market has fallen over 20% in the past 7 days and 40% since its peak in 2007 is the chapter “The Investor and Market Fluctuations.”
2) A Random Walk Down Wall Street by Burton G. Malkiel (2003 edition, ISBN# 0-393-05782-8)
While the Intelligent Investor is fundamental in understanding the historical background of the stock market and for providing the core analysis for value investing, a more practical guide for investing, and for me, the far more persuasive argument for the common investor, is A Random Walk Down Wall Street which advocates index investing and . If you’re looking for a bit more simplified down to earth guide, try “The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns” by John Bogle (ISBN-13: 978-0470102107) (or practically anything by Bogle for that matter).
The basic approach (well, my version of it, and a summary of the Random Walk strategy more or less) comes down to:
A. Figure out your risk tolerance. The closer you are to the time you need to spend the money, the less risky your investment should be. If you want your money back within 10 years invest in non-stock, preferably in my opinion either GNMA or money market. Contrary to popular opinion bear market cycles can last as long as 20 years.
B. Choose your investments as follows:
1. For Stocks: Avoid individual stocks and actively managed mutual funds and invest in Vanguard’s Total Stock Market Index (or equivalent index fund or ETF, if not available, such as S&P 500 index, SPDR, etc.). It gives you complete diversification across 5000 stocks so no danger of losing everything if one stock blows up, has very low expenses, no sales commissions, and is tax efficient – you generally won’t be getting taxed if the fund loses money which can happen lots of times with actively managed funds) . And it’s simple – you do what the market does, no more, no less.
2. For Bonds: GNMA’s which are guaranteed by the US Gov’t (pronounced Ginnie May, not to be confused with Fannie May, which of course is a scandal!). If you don’t buy individual bonds, buy Vanguard GNMA fund.
3. Cash: Vanguard Money Market (take your pick of Prime, Treasury (safest), or Tax-Exempt, with various degrees of return/safety. You can put it into a bank and get the FDIC insurance if the account is below the FDIC minimum (now 250,000 I believe) but your return will be lower. The recent bailout package allows money markets to be insured but the insurance is temporary and I don’t believe applies to new money after 9/19/08.
C. Invest through tax deferred accounts to the extent possible: For retirement max out your 401k first (assuming it’s a good one and it’s not filled with annuities or junk mutual funds – read the prospectus), then IRAs. If you’re self-employed checkout Vanguard’s SEP or similar plans. For education, 529 accounts (would suggest Vanguard’s or the Utah 529 (favored because of low cost and availability of index funds), unless your state has a good one (low cost, availability of index funds, gives a break on state taxes; but most states plans are fairly lousy, you’ll need to do some research here)
D. Avoid individual stocks (unless you want to gamble and risk losing it all). If you want to experiment with a small portion of your stock allocation, invest NO MORE than 4% of your portfolio in any one stock (yes I said 4%!!) and research each stock by reading the Value Line Investment Survey (available at public libraries at the reference desk, no need to spend the big bucks on the subscription). For a broker, I (personally) avoid full-service firms like a plague (they may be okay for some, but I don’t need the financial advice which they will charge you out the nose for and my experience is that they will push stocks and mutual funds for their own benefit, overly complicate your portfolio by putting you in complicated investments, and not answer the phone when you need to sell). I prefer to stay in charge of my stocks and invest online through an online broker like E-Trade or Ameritrade or Vanguard’s brokerage).
E. Debt Problems? Read Total Money Make Over by Dave Ramsey and follow his advice!!
F. Keep yourself in touch with the financial markets – Get a subscription to the Wall Street Journal (they’ve been running specials for $99 a year which includes both an online and print subscription – if it goes beyond that, just do an online subscription which typically runs $79 a year). Read the money section. For regular commentators, I like Jason Zweig, Jonathon Clement and Bob Brinker (a blow hard but 90% good advice). Avoid those stupid infomercial radio shows by your local broker, CNBC, Kramer, etc.
G. For those who want to check out an interesting stock market strategy based on index investing and timing (a model that usually don’t work) check out www.mojena.com (a retired Finance professor’s timing model – I’ve been watching his timing for over 10 years and he’s been fairly accurate – this past time he got out of the market June 8. Bottom line is he’s close to buy and hold returns on the long term but with much less volatility.