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HELP FOR NOVICE INVESTORS
by Bill Jones

The following are tips for people who are just beginning to invest in stocks for the long term. It only covers the first year-and-a-half or so; after that, the possibilities are endless.

CHAPTER 1 GET YOUR HOUSE IN ORDER

Before investing in stocks, you need to do two important things: (1) Eliminate debt that carries a high interest rate, and (2) Establish an adequate emergency cash reserve.

You should pay off any debt with an interest rate of 12% or more. Why, you may ask, do this when stocks are doing so well? In the average year, stocks return 10 to 12%, which is more like 7 to 10% after you allow for income taxes. So you are more likely than not to beat the stock market just by paying off those high-interest debts. It is even a good idea to pay off loans with rates of 10% or more.

Example: If you pay off $1,000 in credit-card charges at a 19% interest rate, you will have an extra $190 in your pocket after a year. The stock market would have to return something like 21 to 27% this year in order to match that, because taxes reduce the 21 to 27% returns to about that same $190. This is unlikely; in fact, the stock market might even lose money this year. So the credit-card payoff is a far better choice.

Second, you should build up an adequate emergency cash reserve. Financial advisors almost universally recommend at least three months worth of paychecks, depending on your particular situation. It might be six months worth or a year if you are a free-lance consultant or writer; it might be just $1,000 if you have a very secure job and a significant home-equity line of credit that you could draw on if you lost your job.

Where should you keep your emergency cash reserve? If it is money that you are pretty sure you will need within one year, it should be in a money market fund or your bank account. Otherwise, it should be in a shorter-term bonds. Also, money you save for annual insurance payments, property taxes, and the like, can earn you more interest in a money market fund rather than in a checking account.

For the first $20,000 or so that you have invested, it is convenient if it is all with one family of funds. Later on you can branch out. Any of the following five fund families are good; each has a substantial number of no-sales-load fund choices, including money markets and short-term bond funds:

1. Vanguard: www.vanguard.com, 1-800-892-3335, $3000 minimum.
2. Fidelity: www.fidelity.com, 1-800-544-8888, $2500 minimum.
3. T. Rowe Price: www.troweprice.com, 1-800-541-8803, $2500 minimum.
4. American Century: http://networth.galt.com, 1-800-345-2021, $2500 minimum.
5. Scudder: http://funds.scudder.com, 1-800-225-2470, $2500 minimum.

Choosing one of these families guarantees a large financially sound company with excellent reasons to treat you right in order to keep its reputation. Avoiding a sales load (sales commission) means that you do not have the benefit of the advice of a professional, but also you do not pay 3 to 6% of your assets for that advice. The list shows the minimum investment required to start a non-IRA account.

Since "short-term bond" means specifically maturities of 1.5 to 3 years, this discussion uses "shorter-term bonds" to mean either (a) a mutual bond fund with an average maturity of 1 to 5 years, U.S. treasuries or corporates or municipals, or (b) individual treasuries with maturities of 1 to 5 years. A bond fund is much more convenient than individual treasuries, but a bond fund is more expensive for amounts over $10,000 to $20,000. Beyond that point, individual treasuries will be a little cheaper (due to the expense fees of bond funds). Initially, most people should choose the standard short-term corporate bond fund that their fund family offers.

Short-term bond funds tend to outperform money markets by 0.5 to 1% per year in the long run. A relevant fact is this: Over a 10-year survey period, short-term bonds with average maturities of 2-3 years outperformed money markets only 83% of the time for various 1-year periods, but 100% of the time for various 3-year periods. So say you keep emergency funds in short-term bonds and you lose your job about 4 or 5 years from now and cash in those bonds. Looking back, you will surely find that you were better off for those 4 or 5 years in short-term bonds than in a money market. But there is a small chance that you would have been 2 or 3 percent better off if you had switched it to a money market six months before. That is the chance you take. It is similar to the uncertainty of stocks. Since you cannot know when you will lose your job, you will come out ahead in the long run with short-term bonds.

How do you get your money into a bond fund? You need a minimum of $2,500 or $3,000 to open an account, but only $1,000 to keep it going. So when your money market fund reaches $4,000, you can move $3,000 of it into a bond fund (or $2,500 if your fund family allows this low an amount). Of course, you need to leave more in your money market account if your within-one-year needs are more.

See if your fund family will let you start the bond fund with a smaller initial amount if you establish an automatic withdrawal plan from your checking account or paycheck of $100 or so a month. If you do not need this bond money for emergency reserves, and if you are investing for retirement, it is far better to have this put in a 401k or IRA or similar tax-sheltered plan than in a post-tax account; you will make much more, and the account minimum is only around $1,000.

You may wonder if you should buy tax-free municipal bonds instead of taxable ones. The problem is, municipals pay much less interest than taxables, so it depends on your income tax bracket: (a) if you are in the 15% bracket, taxables will leave you more even after paying taxes; (b) if you are in the 28% bracket, it is sometimes slightly better and sometimes slightly worse, but the difference is so small that it is not worth calculating unless you have at least $50,000 in bonds; (c) if you are in the 31% bracket, you will probably be better off with municipals, but then you are rich enough to afford a professional financial advisor to help you with this question and others on investing. For most people, the answer is, don't buy municipals unless you are quite sure that the after-tax situation is better.

Never use tax-deferred annuities or municipals within an IRA or 401k or 403b or Keough or the like; they are already tax-sheltered, so this is just plain silly. The tax status of bonds implies (a) MOST of your tax-sheltered bond funds should be corporates, but (b) if you live in a high-income-tax state, ALL of your after-tax bonds and your money market should be U.S. treasuries.

CHAPTER 2 GET YOUR FEET WET

This chapter discusses a person who is just beginning to accumulate assets for investing. Beginning investors who already have a lot of assets are considered specifically in the next chapter, but most of the material here applies to them in somewhat modified form. A beginner should start with mutual stock funds only; individual stocks come only after you have developed substantial experience and knowledge about investing.

From this point on, you should put as much as you can in an IRA-like tax-sheltering vehicle, assuming you are saving for your retirement. The only exception might be when your tax-sheltering plan assesses fees of at least 1% above what you would pay in a non-sheltered fund and also does not have employer matching. Of course, your emergency reserves cannot be tax-sheltered, because they have to be available. And you cannot add more than $2,000 to an IRA each year (though you can in most cases add about 20% of your pay to a 401k).

Your objective at this stage is to save $9,000 to $12,000 in three different kinds of mutual stock funds; to have equal amount in each of those stock funds (so $3,000 or more in each); and to have at least that same amount in shorter-term bonds. (The excess in bonds, if any, will be due to your need for emergency reserves.) In the early part of this stage, you may have much more in one stock fund than the other; but this imbalance will be only temporary, until this stage is done.

First, you need to increase your shorter-term bond holding by several thousand dollars over the emergency reserves, to make the minimum balance required to start a mutual stock fund account. Meanwhile, you are already experiencing the thrill of investing, as you watch your bond fund gain or lose 1 or 2% of its value in a matter of weeks. In fact, if you are finding that this is thrilling enough, maybe you should just stick with bonds. But if you are investing for purposes 10 years or more in the future, then you really should learn to live with uncertainty and get into stocks.

What kind of stock fund should you buy? (1) It should be one that has a widely diversified holding, over 100 different companies with no great concentration in any one sector. (2) It should have a good record for the past 5 years (beating the average stock fund of its class in at least 3 of the past 5 years, and no more than 2% below the average in the other 2). (3) It should have no sales load charge (front, back, or level). (4) It should have an annual expense ratio below 1% including 12b-1 fees. (5) It should have had the same manager for the past five years, unless it is an index fund. Even with these five restrictions, there are many choices.

An index fund is a safe if boring choice. An index fund tends to outperform more than half of all mutual funds of its class in the long run, and it tends to have fairly low taxable distributions (dividends and realized capital gains; this is important for after-tax investments). Of course, "safe" just means you don't have to worry about the fund manager making bad choices. An index fund can lose one-third of its value in a month, just like any other stock investment.

The first stock fund you should buy is in American large-cap companies. When you get enough in additional assets, your second purchase is a stock fund of American small-cap companies (or you could reverse the order of these two if you wish). The third purchase is an International stock fund. Finally, additional savings are distributed among the three stock funds to make them reasonably balanced. You might even have to make up a loss in one of the stock funds, if it dropped over the several months in which you are developing this position (that does happen, you know).

How you complete this stage depends on your particular pattern of savings. For instance, if you are saving in a 401k, you could put the first $1,000 you save in large-caps, the second $1,000 in small-caps, the third $1,000 in internationals, and thereafter add maybe $300 at a time to the three stock funds in rotation. If you are saving with an IRA (limited to $2,000 in one year), you might start a small-cap IRA with $1,000, add to it periodically until you have put in $2,000, then wait until you have another $3,000 in your short-term bond fund to invest in indexed large-caps post-tax. By then it might be the next calendar year, so you can put another $1,000 in the small-cap IRA and then start saving the $3,000 for the international fund post-tax. Investigate Automatic Investing Plans with your fund family to see how to have $100 or so deducted from your checking account each month for investing in your mutual funds; you may not need a minimum to start.

Actually, it is a good idea to get a small start with stock investing even before you establish your emergency reserves, if you do it for no more than $100 a month through an Automatic Investment Plan. The logic is that, the earlier you start investing in stock, the sooner you will get a feel for how stock prices can go up and down so drastically, so you become familiar with the uncertainty. But do not put more than $100/month in stock until you have your emergency reserves and have paid off all of your credit cards.

Here is a list of reasonable no-load choices for stock funds from the five fund families previously listed (*some Fidelity choices have loads for non-IRAs). Your homework assignment for this period is to call at least three of these fund families and discuss these choices with a representative, and get some literature from them for further details, to see if they meet the five qualifications listed earlier, before you actually buy into one of them.

Vanguard: Intnl: International Growth, International Value; AmLg: Equity-Income, Index 500, Index Value, Tax-Managed Growth&Income;AmSm: Explorer, Extended Market, Index Small Cap.

Fidelity: Intnl: Diversified Intnl, Intnl Growth&Income; AmLg: Growth & Income, Contrafund*, Equity-Income, Disciplined Equity; AmSm: Low Priced Stock*, Small Cap Stock*.

T.Rowe Price: Intnl: Intnl Stock, Spectrum Intnl; AmLg: Equity-Index, Equity-Income, Value, Dividend Growth; AmSm: Small Cap Value, Small Cap Stock, New Horizons. American Century: Intnl: Intnl Discovery, Intnl Growth; AmLg: Equity-Income, Income & Growth, Value; AmSm: Ultra.

Scudder: Intnl: Global Discovery, Global Fund, International; AmLg: Growth&Income, Large Company Value, Classic Growth; AmSm: Small Company Value, Development Fund.

CHAPTER 3 GET YOUR HEAD ON STRAIGHT

Now you have equal amounts, about $3,000 to $4,000, invested in each of four mutual funds, three in stocks and one in bonds (more in bonds if needed for emergencies), all with the same fund family. During the time you are increasing your investments to this point, you should be making a strong effort to develop substantial investing knowledge and experience through research and reflection.

If it takes you less than about 18 months to get $9,000 to $12,000 total in stock investments, you should stop at that point while you study up on investing. Additional savings can be put in shorter-term bonds while you experience the thrill of watching your money in stocks occasionally gain and lose 5% or more in a single month. You can expect this to happen twice a year on the average. You don't know what investing is until you have experienced the pain of losing such a big chunk of money at once and the fear that the markets could soon drop even more (yes, you will almost surely experience a loss of 20% at some point in the next few years, maybe next month). Fear and pain temper the greed.

If one of your four funds experiences a big change in size, you may need to move some assets from one stock fund to another; but you should try to avoid this in after-tax funds, because it can cost you in income taxes. Also in after-tax funds, be sure to keep records of dividends and capital gains reinvested, as well as other purchases, for income-tax purposes. And do not have the check-writing option on any fund except on the money market account, because that complicates your tax reporting even more. You can switch assets from short-term bonds to the money market by telephone when you need to.

While you are acquiring an education in investing and accumulating more money in your safer shorter-term bonds, you should give serious thought to paying off any loans you have that cost you over 10% in interest, except loans that are deductible on your income taxes (mainly mortgage and home equity loans). The reason is that the average after-tax return on stocks is 7 to 10%, which is worse than your gain with 10% loans that are not tax-deductible.

For example, paying off a 10% non-deductible car loan will put $100 annually in your pocket for every $1000 paid off; getting 11% return on stocks and paying 2% of that in state and federal taxes leaves you with $90 in your pocket for every $1000 invested. So paying off such loans is a better deal than the average for investing in stock, and with a more certain return.

Special Situation #1: Maybe you are starting out with a large amount to invest. This might be because you inherited a large amount, or because you have a lot in bank CDs and have suddenly realized that is really dumb. In this case, you should normally start with only $3,000 in each of the three stock funds, even if you have more money; be cautious until you have experience. But if you are fortunate enough to have over $60,000, you could put up to perhaps 5% of your total assets in each of the three stock funds. The rest should be put in shorter-term bonds, except for some emergency cash reserves in a money market (homework: research the concept of "laddered treasuries").

If you are in that fortunate position, you may add a little to each stock fund once every three months after you start your initial 5% amount. So at the end of 3 months, rebalance to around 7% in each stock fund. At the end of 6 months, rebalance to around 9% in each stock fund. Continue until, 17 to 18 months after you start, you have almost exactly 15% of your assets in each of the three stock funds. This is a form of dollar-cost averaging (except for the initial minimum investments).

Special Situation #2: Maybe you have inherited a large holding that already includes substantial stocks. It is generally best to not make any substantial changes right away except:
1. You should pay off your high-interest debts. 2. If you feel uncomfortable with the stock portion being too high, you could make a moderate reduction in the percentage that is allocated to stocks. The reductions should tend to prune and simplify your stock holdings to take you roughly in the direction of one-third in each of the three categories of stock funds specified -- American large-cap, American small-cap, and International. Then spend the next 18 months getting used to your new-found fortune and responsibilities, making only minor changes, while you study up on the art of investing.

In this second kind of special situation, get some help and advice from a trusted friend or paid financial advisor, especially on the tax consequences of any changes. But be sure that any advice outside the parameters discussed above is very well justified. In particular, kindly refuse their offer to shift to a different kind of stock investment "because it will perform better." They may be right, but it is your money and you will have to suffer the consequences of an error, so wait until you can independently decide for yourself whether that particular shift is a good idea. You can lose a friendship if the other person's suggestion turns out wrong, and any such suggestion has at least a small possibility of losing a lot of money.

So what do you do in that 18 months? You study books and magazines about investing, and talk with others, and interact on bulletin boards such as www.fundsinteractive.com/wwwboard. You will need to acquire a good education before you make these decisions. In particular, you need to read a lot in order to understand the logic behind the arbitrary-sounding rules that are laid out in this discussion.

Some good suggestions for books on investing are:

• Andrew Tobias, The Only Investment Guide You'll Ever Need
• Lavine & Liberman, Complete Idiot's Guide to Making Money with Mutual Funds [ed. note: see the excerpt from this guide at www.fundsinteractive.com/newbie.html]
• ???, Neatest Little Guide to Mutual Fund Investing
• Burton Malkiel, A Random Walk Down Wall Street
• Roger Gibson, Asset Allocation
• Frank Armstrong's material, at www.fundsinteractive.com/21st
• William Bernstein's material, at www.coos.or.us/~wbern/ef/996/basics.htm
• Funds 101, at www.morningstar.net
• Tweedy Browne fund family, What Has Worked in Investing (free pamphlet available when you order a prospectus at 1-800-873-8242)

CHAPTER 4 THE FOUR-CORNERS STRATEGY

After 18 months or so of study, research, and reflection, including at least a year of watching your stock holdings rise and fall alarmingly, you have established a strong enough understanding of investing that you can confidently make your own independent decisions. Now you may:

(a) Consider stock funds outside the family you started with.

(b) Consider longer-term bonds or junk bonds, particularly when you have more than 25% of your total assets in bonds.

(c) Consider buying stock in individual companies when you get up to over one hundred thousand dollars. But you should not do this until you have had several years experience in the stock market with mutual funds.

(d) Consider whether you should shift between different kinds of stock investments, depending on market conditions. Many people feel that this kind of active management of your assets will increase your earnings substantially; but many people feel that it will not make a significant difference to your returns in the long run. You will have to make your own decisions on these and similar matters.

(e) Consider whether you should shift between stocks and bonds depending on market conditions. This is called market timing. Many people think that this is profitable. Others think that the effect of even the better market-timing methods which keep you out of the market X% of the time is simply to get about the same results as always having X% of your assets in cash, perhaps with less variability. Still, you should make up your own mind. It is your money to lose. Some people are very profitable at market-timing, though they generally spend a lot of time and effort doing it.

NEVER EVER RELY ON ANYONE'S SUGGESTION TO MAKE A PARTICULAR PURCHASE, EVEN FRIENDS. Always make sure that you yourself understand why a purchase is the best thing for you, based on your own research. It is fine for someone to tell you, "You should look into investment X because it has such-and-such characteristics, which may be suitable to your needs." Anything beyond that should be an independent decision by you. Never buy what you don't know and understand thoroughly and verify independently.

So, you say, didn't this discussion just dictate to me what to buy -- equal amounts of this, that, and the other? No, not really. The warning above is to never choose X instead of Y without understanding both X and Y thoroughly. This discussion doesn't tell you what to choose, it avoids choice by telling you to buy one of everything (well, not EVERYTHING, but small interests in hundreds of different companies from all over will give virtually the same results as buy-one-of-everything in the long run).

If you want the lazy way out, there is a simple reliable strategy for investing that only requires a few hours every year. You should in any case spend a dozen or so hours learning the basics of investing (in that first 18 months), but if you do not want to spend much more time than that on investing, the rest of this discussion presents a strategy that is very simple to understand, easy to use, and known to give very good results. It is based on the buy-one-of-everything principle.

Many professionals say that the kind of strategy discussed below is the best strategy (but many disagree). It is excellent for beginners, but it can also be used indefinitely by anyone. Research by T. Rowe Price showed that this particular strategy outperformed the majority of full-time professional money managers over the 20-year period 1973-1992, and with significantly less risk, so it is in any case a very good reliable strategy; it beats the strategy of the average individual investor. Most any other decent investing method requires more time and effort, though you may get 1 to 5% more return each year (or you may not; in the stock market, effort does not always pay off in higher returns).

This strategy is one particular "passive asset allocation" strategy, called the "four-corners" strategy. You already have the foundation for this strategy: You keep the four kinds of mutual funds specified, usually with a CONSTANT RATIO of 25% each, except the bond part might be more than 25% if that makes you more comfortable or if you need that much for emergency reserves. Other passive asset allocation strategies have different percentages in the various classes and sometimes more classes, but the principle is the same.

RULE 1: First decide on a percentage of your total assets that you want to keep in bonds. Most people find it comforting to have at least 25%, but it can be less. It should be whatever YOU are comfortable with (if in doubt, put more in bonds for now and reconsider the situation in a year or two). Bonds have a much lower rate of return than stocks, but they vary much less in their month-to-month values. Money saved for retirement should not have more than 50% in bonds, unless you are already retired. Stick to a comfortable combination of a standard Total Bond Index and shorter-term bonds (including individual U.S. treasuries) with most in shorter-term bonds for stability of returns.

RULE 2: Split the rest of your assets equally among three stock subclasses: American large-cap, American small-cap, and International. (A 40-20 example: If you decided on 40% bonds in Rule 1, you would have 20% in each of the three stock subclasses). For each subclass you should use only 1 or 2 funds. (If you have learned enough about investing that you can make intelligent independent choices, and if you have several hundred thousand dollars, you could extend this to perhaps 3 or 4 funds of each subclass.) Use one mutual fund for a subclass only when you have under $20,000 in that subclass or when you use an index fund, otherwise use two distinctively different mutual funds. Indexing works extremely well for American large-caps and for bonds, but only about average for the other two subclasses. Besides, index funds for the other two subclasses are harder to find.

RULE 3: Once each year, rebalance the four subclasses to your predetermined percentage allocation (e.g., for the 40-20 example, you would shift assets to restore 40% in bonds and 20% in each stock subclass). If each of the subclasses has the right amount plus or minus 1% (in the 40-20 example, 19-21% in each stock class and 39-41% in bonds), you need not make any adjustment at all. However, if at any time you hear that the stock market has risen or fallen by more than 20% since your last annual adjustment, it wouldn't be a bad idea to rebalance at that point.

RULE 4: Every few years, reconsider your chosen bond allocation to see if it should be changed based on your personal circumstances and comfort level. For instance, a person might gradually shift from 25% bonds to 50% bonds as she gets closer to retirement age. Or a person in her thirties might have originally had 60% in bonds because she was uncomfortable with less, but after several years feels that she can and should tolerate 40% in bonds. It is important that shifts be done gradually; you should not change your bond proportion by more than 5 to 6% every 3 months. You should also review your choice of non-indexed stock funds once a year to be sure that they still measure up to the five criteria given earlier.

RULE 5: When you add money to your assets, keep the ratios fairly close to your chosen proportions. In the 40-20 example, you might add the first $1,000 to bonds and then the next $500 to stocks, once for each of the three stock classes. This method works extremely well in the long run as long as you KEEP TO YOUR TARGET PROPORTIONS REGARDLESS OF MARKET UPS AND DOWNS. Similarly, when you take income from your assets (e.g., in retirement), keep the ratios of what remains fairly close to your chosen proportions.

If you are a person who inherited a large amount including a sizable stock ratio, then presumably you have already adjusted the percentage of bonds to be comfortable for you. Analyze the stock holdings you have and group them into the three subclasses described. If you are quite happy with the current percentage distribution and if avoiding shifts has tax advantages, leave it; you can apply this strategy with the exception of unequal proportions, and it works about as well. Otherwise, you should tend over time to gradually prune and shift so that you have roughly equal percentages in the three stock subclasses. This makes the annual rebalancing easier.

Rebalancing in post-tax accounts can have adverse tax effects if not done carefully; a third of the time you will find you have to shift over 5% of your assets (but virtually never more than 10%). A good idea is to have all post-tax stock dividends and capital gains distributions paid into the bond fund as they arise and rebalance from there. But as long as you have at least 20% of total assets in IRA-like vehicles, you can rebalance easily: Just keep the four different kinds of funds in the IRA, possibly even the same four that you keep post-tax. Then make apparently massive shifts within the IRA to make the overall total come out correctly rebalanced.

Why does this four-corners strategy work well? First, you buy one-of-everything in stocks, so you must logically achieve average performance. No matter what other investors do, about half of their stock investments must do worse than yours (think about it, and you will see that it is inevitable). Second, your fund manager does not expend time and money trying to find the "best" choices; this cuts your expense ratio by about half-a-percent annually. Finally, this annual rebalancing can be shown mathematically to produce a gain in the long term of between 0.5 and 1.5% annually over what buy-and-hold without rebalancing would produce. In effect, rebalancing requires that you sell part of a subclass when it has risen more than average, and buy into another that has risen less than average; in effect, it forces you to buy low and sell high. So, in the long term, you are sure to beat the average investor by 1 to 2% overall annually with the four-corners strategy, and do so with less wild swings in value. You can still lose money in the short term, just not so much.

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