All too often lately, I receive plaintive requests of the following form:

> What kind of things should I be looking for? High risk since I'm so young?
> Stocks, money markets, real estate? HELP!!! PLEASE!! Advise me.

Well, here's the modern portfolio lecture in a small nutshell. There are 2 types of investment instruments: debt (bonds (gov't, corporate)) and equity (stocks, stock mutual funds). To really simplify, 'risk' and 'expected return' are proportional. With debt instruments, the risk--and return--are low. At the really low end, government bonds (really short term bonds are called 'bills') are virtually risk free. Essentially, the government is borrowing some money from you--for a FIXED rate of interest--and you know they are going to pay you back. You will get your principle back, with, like, 4-8% interest (depending on the term of the instrument, and general interest rate levels). The only risk associated with these instruments is a sort of opportunity cost associated with interest rates. For instance, if prevailing rates are like 4%, and you buy a gov't bond at like 4%; and then rates shoot to 7% the next week... your money is locked into earning 4% in that bond, when if it were free, you could earn 7% elsewhere. You CAN GET OUT, simply by selling the bond. HOWEVER--how much do you think that 4% bond is going to be worth in a 7% market? That's right--less than you paid for it. So, basically, you'll be slapping your forehead if you buy a bond right before interest rates shoot up.

CORPORATE bonds have slighly better returns, and slightly higher risk. Here you are loaning money to a company, for a fixed rate of return, and they promise to pay you back. You can tell how likely they are to pay you back by the RATING of that bond. You've heard of AAA bonds? Down to A, and B, etc. The higher the rating, the lower the risk--and the lower the return. Basically your risk (in addition to the interest rate risk described above) is 'default risk': the company could go under, or declare bankruptcy, etc. Probably won't happen unless you're buying so-called 'junk bonds'. The reason the risk is much lower than stocks issued by, maybe even those same companies, is because of how the law works in the event of bankruptcy or going out of business. When the business assets are liquidated, first they pay off the accounts payable debts (like bills for office supplies, eg). Then they pay off bond-holders (basically, folks who have loaned them money). Then, if there's anything left, they pay off stockholders, who were basically risk-sharers in the fortune of the company, and deserve what they got. Corporate bonds can return anywhere from gov't levels (5%) for AAA, up to like 12% is the realistic ceiling.

In reality, you most likely will not be buying any individual bonds (though anyone can, through their broker, whenever a gov't auction rolls around, like every 3 months or so). A more likely scenario would be to buy a MANAGED BOND FUND. Here some money managers own a whole bunch of bonds, and keep rolling them over and reinvesting the money. There are gov't only bond funds; and corporate only bond funds; and mixed bond funds. There are even international bond funds.

So, basically, one buys bonds when one has a 'low risk tolerance', or (and this is much the same thing) a 'short investment horizon'. If you're going to need your money to retire, or buy a house, or send somebody to college in like 3 years, you can be pretty sure the money will be there, with an okay rate of return, in 3 years.

The other type of instrument is 'equity' (or stock). Here you are buying a piece of a company, and the value of your piece of that company goes up and down with the success (valuation) of that company. Here there are virtually no guarantees. The stock price can do anything (particularly in the short run), and if it goes way down and you lose money (when you could have made a nice safe 6%), that's what you get for being greedy. However, the fact is that stocks have historically earned about 12%/year on average--IF YOU HOLD ON TO THEM LONGTERM. A so-called 'bear market' (when stocks go way down) can last as long as 5 years. We had a 3 year bear market in 88-91. If you bought stocks in 88, you would find in 91 that you had earned exactly 0% for three years, which could be depressing. EXCEPT, that as a stock investor (and a non-idiot), you realize that you are investing for the long term. So, rather than being stupid and selling when you were down (or even), you just blindly held those stocks for the next like 7 years, and in 98 you would have found that you had tripled your money. Not bad. The only reason you might not use this strategy is if you had a kid going to college in 92--or if you were an idiot (which most individual investors are).

So, what advantage does a young investor have? A REALLY LONG INVESTMENT HORIZON. Figure out your projected retirement date. Let's say it's 25 years from now. What do you think it's overwhelmingly likely that stocks are going to do over the next 25 years? GO WAY UP, that's what. They could do anything tomorrow. They could go through the floor next month--or even next year. But why do you care? All you care about is what they're worth in 25 years. That's why a REALLY SMART longterm investor won't even read the financial pages. Just invest regularly, and forget all about it. Saves you a lot of the heartburn you get when you read that you just lost (on paper) several thousand dollars in one day of bearish trading.

Okay, before we talk about how to buy stocks, here's the 90-second blurb on 'modern portfolio theory.' MPT says that the goal is to increase return (i), while decreasing variance (n). (Variance being rockiness.) In general, these are the things the average investor wants to do. After a lot of math, where you get to is that you want to have an extremely diversified portfolio of bonds of different maturity dates, and stocks from lots of companies, industries (and even countries). When the value of your stocks go down, the value of you bonds go up--decreasing variance. However, as I said, this is for the average investor. The young investor doesn't give much of a shit about variance.

So, what do you actually buy? Most people, between our age and our parents age, investing for retirement, buy 'mutual funds' or 'managed stock funds.' What these are is a bunch of investment banker types, who are sitting around running mathematical models, looking at charts, researching company fundamentals, etc., and buying individual stocks. They buy these stocks with the pooled money from investors like you, and keep a big pile of them, and try to diversify them a bit (usually), and hope against hope that the total return for their basket beats something called the S&P500.

Now, there's something extremely smart about buying mutual funds: IT MEANS YOU ARE NOT BUYING INDIVIDUAL STOCKS. Let me stress this: PEOPLE WHO BUY INDIVIDUAL STOCKS (unless they have some inside information) ARE IDIOTS. Remember I said the stock market has always gone up about 12%/year? That's THE MARKET. Individual stocks will do ANYTHING. You have no idea what's going to happen to a given company. To take an example from my Theory of Financial Markets class in the UVa Econ dept.: Say you had bought the most promising looking stock in the entire market in 1974. That would have been IBM. By 1988, you would have lost your shirt--IBM was down like 60% from its 1974 price. However, if you had bought what we call 'the market' (ie a basket of stocks representative of the market as a whole), you would have cleaned up. And you wouldn't have even had to trouble your head to try and figure out which companies were likely to do well.

And this brings us to what's extremely stupid about buying mutual funds: THE FUND MANAGERS (these really smart MBAs) CAN'T EARN THEIR SALARIES. That is, despite all the smart thinking they pour into which stocks to buy, their piles of stocks (funds) almost never beat 'the market' as a whole. 'The market' is usually represented by the 'S&P500', which is a basket of 500 U.S. stocks which are considered to be reasonably representative of the whole U.S. economy. (For some reason everyone talks about the Dow, but it's the S&P that's the performance benchmark (though, they usually more or less move together).) A FEW mutual funds every year 'beat the S&P'--that is, achieve a higher rate of return than the market, or U.S. economy, on average. But, like, 88% of them do not. ON TOP OF THAT, they take management fees out--like 1-5% of the earnings. WHAT ARE PEOPLE PAYING THOSE PEOPLE FOR?! One thing they claim you're paying for is LOWER VARIANCE. They say they protect you in down markets. But if you look at the numbers, they do not. Managed funds go down about as much as the market as a whole in bear markets. Really, people pay fund managers, and participate in mutual funds, because they feel better having an actual (smart) human being looking after their retirement/college money.

However, the reality is, you are very likely to do better (earn a higher rate of return) simply by buying the market yourself. This is easy to do--they are called index funds, which simply mirror (in a braindead fashion) major market indexes. In particular, there are S&P500 index funds, which basically earn what the S&P does. You can usually get into them for like $2500 to start. Through your work retirement program, you can almost definitely get in for no money down.

And the wonderful thing about an S&P index fund, is that it matches the S&P every single year--something mutual funds can only aspire to do.

The only catch in this whole argument of longterm investing in a market basket is a philosophical one--in particular, David Hume's 'scandal of induction'. Hume was looking at causation, our idea that some things cause others. He said it's made up of 3 parts: 1, contiguity. If A causes B, A has to be touching B (or touching something that is touching B, and so on). 2, precedence. If A causes B, A has to happen first, always. 3, necessity. If A is said to be a cause of B, then WHENEVER A HAPPENS, B *MUST* HAPPEN; it can't be random. However, what he pointed out is that 3 is bunk. When we flip the light switch, the only reason we think the light is going to go on is because it has every other time we've flipped the switch. Next time, we could as easily blow up the world by flipping the switch, for all we know. We are assuming the past will be just like the future, for no good reason--mainly out of habit.

So, all this stock theory is based on the assumption that 'just because the market has always gone up (for over 100 years), it will always continue to go up in the longterm.' YMMV.

A couple of notes on 'timing the market' and 'dollar cost averaging': Many of these smart people with charts and computers are trying to 'time the market.' They look at historical data, and say, "Well, every time the market's been up 24% on the year, and there's been a Democrat in office, but not a leap year, and P/E ratios have been high relative to valuations, there's been a big jump in the market on that Tuesday. BUY, BUY, BUY!!!" The problem is that stock prices seem to be subject to what's called a 'random walk'--which is self-explanatory. They just do not move in a predictable way. And the real problem here, is that whenever you analyze any data whatsoever, somebody else has already recognized it and taken action. In other words, if you read in the paper that IBM is going to buy NetObjects, or that NetObjects has this cool new product, or whatever, and go to buy their stock--well, everyone else already knows this, too... has acted accordingly... and so that information is ALREADY REFLECTED IN THE STOCK PRICE. Other folks have already bought a bunch of it (on that news) and driven the price up, so the news is now valueless. This is called 'perfect information'. The only exceptions are insider information (which is illegal) and gut hunches (which are highly fallible). [One OTHER possible, and funny, exception to perfect information is what I call 'too perfect information'. If a bit of company news appears, for instance, on the front page of the Sunday Times, then the data tends to indicate that you can (on average) do well trading on that information--simply BECAUSE IT'S SO PUBLIC, that other investors assume it's aleady been acted on and useless, and so they don't act on it. Do this at your own peril, though.]

So, you can save yourself the mental energy, and not try to figure the market out--just invest in it. How? Regularly. There's this nice phenom called 'dollar cost averaging'. All this means is that if you invest $500 in the stock market every month, without fail, always the same amount, you will get a slight bargain. BECAUSE, at the end of the month, if stock prices are high, you will buy less. If prices are low, you will buy more. So, your average buying price for a unit of stock (or fund) over a year, will be LOWER than that stock/fund's average price for the year. Cool, huh? This is another way work investment programs are cool.

Do you always buy stock (or, rather, stock index fund)? No. When retirement approaches, you slowly start to shift some of your portfolio to debt instruments, and then even to cash ('cash' means, like, money market funds, 2-3% earnings; as long as there's 'high liquidity', ie you can get your money whenever you want it (and zero risk, of course)). Why? Because you know you will need some IN LESS TIME THAN A REASONABLE STOCK INVESTMENT HORIZON. Remember, you don't have any good idea of what stocks are going to do, inside of, like, 5 years. If you'll need money in a couple, and keep it in stocks until then, you could do well--but the stocks COULD BE WAY DOWN at that time, forcing you to sell when you are down. WHICH SUCKS!!!! [Special note: These people who get worried and sell when the market is down (and there are plenty of them) are idiots. How hard is 'buy low, sell high?' Jeesh.] So, since you know you can't hold all your money long enough to be pretty sure that stocks will do well, you settle for a lower, surer return (on some of it). Pretty smart, huh? By the time you've hit retirement, you've shifted ALOT of your portfolio (like maybe 60%) into debt, and enough into cash to take care of your actual day-to-day cash needs. But, of course this all depends on your situation and needs. If you are going to be in retirement for 20 years, obviously it's not a bad idea to keep some money in stocks. Conversely, if you have enough in your portfolio to live on 6% return from it, maybe you want to put it all in bonds, and sleep better at night. But, in general, on the young end of investment: equity heavy (or even total equity). As you slide toward retirement, you slide toward bonds (and even cash).

Do I practice what I'm preaching here? Yeppers. All I buy anymore is S&P500, and will until such point as it looks like retirement's forthcoming, then I'll start to shift. Do I buy managed funds? Heh. I bought the best looking managed fund I had ever heard about: Technology Value Fund. They were the only fund based in Silicon Valley, and they were all about computer and medical technology. Plus, they had been scorching the earth with like 60%+ returns/year. So, a little over a year ago, I bought $2500 worth, which stake is now worth like $1800. Yeehah. They've basically been getting killed all year, with the Asia crisis, and the hits the technology sector has taken. Most likely it will go up in the longrun--but I'm mainly glad b/c I've learned an important lesson: namely, I'm never going to buy another managed fund in my life. I mean--Why?

The only place I deviate from this party line I've laid out is in market timing. I, and a lot of other folks, consider big market dips to be buying opportunities. According to the 'you can't time the market' party line, trying to buy when the market is down won't work, because it's just as likely to drop again. HOWEVER, if we're assuming the market goes up in the long run, then any drop is a statistically good time to buy. When the market is way down off of its peak (as it was the last few weeks), A) you can figure it's pretty likely that it's going to go way up over that (I mean, your whole strategy is predicated on that), and B) you can consider it bargain basement buying. To put it another way, all the S&P I bought when the Dow was at 9000 is going to be worth a lot at retirement time, when the Dow is at 50,000. However, on that last dip, I bought some at 7000, which is going to be worth even more yet at retirement time.

However--to personalize it again--that's sort of my discretionary investment spending. The employer withholding and contribution is the same no matter what. I just up the ante a bit on dips. So, basically the strategy is a slight modification of "buy low, sell high." It's

BUY LOW, AND NEVER SELL.

In summation, the only qualms I have about this strategy are A) Hume's scandal of induction, and B) the Japanese market which is, like, 40% down from where it was 9 years ago. Like, if you were to buy a bunch of stock now, and hold it, and in 2007 the Dow was at 5000, you'd feel pretty shitty. But, hopefully, you still wouldn't sell.

The other last point is that the MOST IMPORTANT FACTOR IN THE VALUE OF YOUR PORTFOLIO AND HOW SOON YOU REACH RETIREMENT is NOT the rate of return you earn--IT'S HOW MUCH MONEY YOU PUT INTO IT (and how early). Save early and often. Compounding works miracles. Before I buy something, I think, "Mmm, do I really want that $400 stereo component? Or would I prefer to have $116,000 in 40 years? Mmm, the stereo component, or working an additional 2 years. Well, that's pretty easy."

HTH,
Michael