Simple advice for the beginning investor

By Don Kuehn

In the December 2003/January 2004 issue I wrote about three simple steps to follow to get "rich." At least one reader felt I was too simplistic in suggesting that by living below your means, saving regularly and using time to your advantage, you and everyone else could reach your financial goals.

Granted, the advice was simple, but that’s the beauty of it. Investing to reach long-term goals doesn’t have to be hard. Hey, kids are doing it on their allowances and part-time jobs.

Start by finding a Web site or checking out books from the library that explain how financial markets work and how companies distribute profits to shareholders. Try the Motley Fool (www.motleyfool.com), CBS Marketwatch (www.cbs.marketwatch.com/) or Morningstar (www.morningstar.com) for starters. Look for tabs like "fool school" or "personal finance" or "retirement" or "forum." You’ll learn a lot just by immersing yourself in the jargon and opinions of the marketplace.

Next, practice a little. Nobody says you have to put your money at risk right away. Pick a few investments you like. Read their prospectuses. Check their performance. Investigate the management of the fund. Look at the administrative fees and narrow your focus to one or two funds. Then watch them for a time to see what would have happened if you had really invested. On many Web sites, you can set up "watch lists" to track your phantom investments.

While you are on the sidelines practicing, remember that one of the biggest risks in investing is "opportunity risk." That’s the lost chance of turning a profit while your money remains in your pocket.

When you are ready to invest for real, find a discount broker. Although it is possible to make almost all transactions directly through the fund company, you might find that discount brokers offer additional services you can use to keep all of your transactions in one place.

So what do you look for? If you have followed this column over the past six years, you know my preference, especially for new investors: Go with no-load mutual funds. They require little attention, don’t leave you on the wrong side of the information gap and provide you with professional management of your money.
 

Diversify

The advice your mom gave you as a kid is still valid as an investor: Don’t put all your eggs in one basket.

I got crossways with members of an investment club I belonged to when I asked my fellow members if they were "collecting stocks" or trying to build a portfolio. When the smoke cleared, it was apparent that they didn’t perceive a difference. They were just trying to cherry-pick good stocks without a larger investment plan.

Don't make that mistake. Spread your risk by allocating money into several "baskets" in the following priority order: one for short-term goals and emergencies (cash and cash equivalents like money market accounts), one for stocks or no-load stock mutual funds (equities), one for fixed income investments (bonds and bond funds), and a basket for other miscellaneous funds (like international funds and real estate).

Within these categories, as your wealth grows and you are able to branch out, you should determine a formula for the percentage of your assets you want in each basket. That's called asset allocation.

A young investor might want a cash reserve equal to three to six months' take-home pay, 70 percent of the portfolio in stocks, 20 percent in bonds and a small amount in international and other funds.

Later, you will want to make decisions about the kind of funds you buy in each category. For example, you can choose among small, mid-size and large capitalization funds, a measure of the size of the companies whose stocks the fund buys. You also can favor growth, balanced or value approaches, or market niches such as healthcare, technology or banking.

It’s not a bad idea to start with an index stock fund that tracks the S&P 500 stock index. That gives you a piece of the 500 largest companies in America--a decent start. By investing in an index fund, you are basically buying the stock market. The success of your investment depends more on the health of the market as a whole than on the stock-picking expertise of the fund manager.

Make no mistake, there is risk in investing in the stock markets. Sometimes stock values go down, and some companies don’t perform well or get caught with their technology down. They slip in market share and their prices fall. Some even go out of business. That’s what Mom meant when she warned you about those eggs.

You control risk by adjusting the ratio of various stock and bond categories within your portfolio. The more risk you are willing to accept, the greater your potential return.

On average , the stock markets return about 10 percent annually. That's far from guaranteed, of course. Conservative bonds generally produce returns of only 3 percent to 6 percent a year. Low bond returns can be wiped out if inflation heats up. Higher-interest bonds (what used to be called junk bonds) do produce greater returns, but with higher risk.

So why would anyone settle for returns that barely beat inflation when there are alternatives that can average more than 15 percent per year? The simple answer is diversity. Typically, when stocks are down, bond returns are up.

There still will be educated investors who say that I have been too simplistic, leaving out caveats about personal tolerance for risk, geopolitical concerns, hidden costs of fund trading, fees, loads and more. They're right. But readers who have not participated in the stock markets’ rebound in the past year, or those who are just getting their heads above water so that they can dedicate some savings to regular investing, need to start somewhere.

Over time, you should see your investments grow as the economy continues to improve, corporate profits rebound and companies grow their business base. By keeping it simple--living below your means enough to invest regularly and being patient enough to let your investments grow through the up and down cycles of the market--you can assure your financial goals and prepare for a secure retirement.