sm stockmarket bk rev

Chris Farrell’s

SOUND MONEY GUIDE TO

INVESTING in theSTOCK MARKET

“We’ve had 10 years of a huge bull market where

we’ve brought more and more peopleinto the game because they thought it was simple.Now, we’re coming to a period where people aregoing to be very suspicious of the stock market.

This is where you really see the value opportunities created.”

Steve Leuthold

WA L L ST R E E T V E T E R A N S are fond of saying the

most dangerous phrase in the markets is,

“This time is different.” Yet, in a vital sense,

“This time is different.” For the first time, more

than half of all American households earn a paycheck

and own stock either directly or indirectly though a mutual

fund. Workers are investing in the stock market to fund

their retirements, their children’s college educations and

other long-term savings goals.

Little wonder investing in the stock market is a hot topic

at work and at neighborhood gatherings. And, as of this

writing, many investors are reeling. The stock market put

on a once-in-a-lifetime performance in the 1990s, espe-

cially the tech-laden Nasdaq composite index. But the

Nasdaq collapsed in 2000, and the rest of the stock market

faltered. The stock market has recovered somewhat since

the beginning of 2001. Still, many workers are worried

about their stock investments, especially their retire-

ment nest egg. What should they do? Stay the course?

Trim back their holdings? Or get out until the good times

return?

You can’t get rid of the uncertainty. But you can improve

the odds of doing well by concentrating on a few core finance

principles, focusing on the long haul, keeping your costs

low and your moneymaking expectations realistic.

1Investing in the Stock Market

STEVE LEUTHOLD is chairman of The Leuthold Group,

a Minneapolis investment research organization, and

president of Leuthold & Anderson, a money manage-

ment firm. He is a nationally known expert on the stock

and bond markets and is frequently quoted in noted

business and financial publications.

You can read and hear all of Chris Farrell’s interview with Steve Leuthold online at www.soundmoney.org.

CHRIS FARRELL is host of Sound Money, heard on public

radio stations nationwide, and of public television’s

Right on the Money. Farrell is also a contributing eco-

nomics editor at Business Week magazine and chief

economics correspondent at Minnesota Public Radio.

He holds degrees from the London School of Economics

and Stanford University.

THE EQUITY FUNDAMENTALS

“People talk about contrarians,and I guess, in a lot of ways, I am.

The less people like the stock market . . . the more I do. People’s dislike for the stock market isbuilt into the depressed prices that exist in the

market. Really, investing in stocks is about buyingcompanies that are cheap that produce earnings

over a long period of time.”

Steve Leuthold

EQUITIES ARE OWNERSHIP SHARES in a company.

You are an owner of General Electric even if you

only buy one of its nearly 100 million shares out-

standing. Equities represent the uncertain returns

to entrepreneurship, and it is corporate profits that

largely determine stock prices over time.

The price of a stock will change depending on how

investors assess a company’s earnings prospects. A

software company with growing sales and cash flow will

sport a higher stock price as investors anticipate addi-

tional gains ahead. But investors will drive down the

stock price of a software company with dwindling sales

and an incoherent management strategy.

Many companies also pay a dividend, or regular cash

payment, to their investors. Historically, dividends

account for about half the long-run return earned by

investors. The total return of a stock, the best measure

of its performance, comes from the sum of dividend pay-

ments and any price appreciation or loss.

Stocks are volatile, more than twice as volatile as bonds.

(The annualized volatility of stocks is about 20 percent


This booklet is designed as a brief introduction to equi-

ties. The suggestions for further research and study at

the end offer a much deeper look into the risks and

returns associated with saving money in the capital

markets.

2 Sound Money Guide to

Wall Street slices the stock universe intomany categories. Here are four especially sig-nificant distinctions.

GROWTH STOCKS are glamour stocks.These are fast-growing companies with agood story, such as computer, software, tele-com and biotech. Investors are looking forcapital appreciation, since these companiestypically don’t pay a dividend. Growth stockcompanies invest all their cash in expandingthe business. Think Apple Computer orMicrosoft when they were fledgling firms.

VALUE STOCKS are out-of-favor companies,old-line firms with dividends and companieswith a low stock price relative to earningsand assets. Value investors are contrarians.

LARGE CAPITALIZATION STOCKS arecompanies with a market value of $5 billionor more. (You calculate market value by tak-ing a company’s share price and multiplyingit by the number of shares outstanding.)Coca Cola, Nike, Wal-Mart and IBM are alllarge cap stocks.

SMALL CAPITALIZATION STOCKS arecompanies with a market cap of under $1billion. These are usually less seasonedenterprises with fewer financial resources—but more potential.

Hold on to your wallet. Trying to beat the market is a

loser’s game. Investing may be the world’s most compet-

itive business as millions and millions of investors

struggle to uncover good stocks and steer clear of com-

panies with poor prospects. Terrance Odean and Brad

Barber, two finance economists at the University of

California, Davis, looked at the trading accounts of more

than 66,000 households at a large discount brokerage

firm from 1991 to 1996. The stock market recorded an

annual return of 17.9 percent during those years, yet

active traders only earned an 11.4 percent return.

There is no evidence that trading in and out of the mar-

ket will line your pockets. But there is abundant evidence

that a disciplined, long-term approach with minimal

trading and low costs will increase the odds that you will

reach your long-run financial goals.

EQUITY MUTUAL FUNDS

“The mutual fund industry,unfortunately, promotes what sells. And

what sells is past performance.”

Steve Leuthold

TH E M O S T C O N V E N I E N T A N D S E N S I B L E WAY to

invest in equities is through mutual funds. The

big divide in equity mutual fund investing is

between passive and active strategies.

I favor building a core portfolio around the passive

investment approach, better known as indexing. It’s

called passive investing because there is no professional

money manager pulling down a multi-million dollar salary

trying to beat the market. Instead, the mutual fund


versus 8 percent for bonds and 1 percent for cash.) The

volatility reflects the greater risk of stocks relative to

bonds or cash. When a company encounters financial

trouble, bondholders have first dibs on corporate cash

flows while equity holders carry the brunt of any losses.

Still, the only way to create an opportunity to earn a high

return is to take greater risks. And stocks leave bonds

and cash far behind in the performance sweepstakes

when held for the long term. Over the past two centuries

the return on U.S. stocks has averaged 7 percent, after

adjusting for inflation, according to finance professor

Jeremy Siegel of The Wharton School. The respective

return on bonds and cash is 3.5 percent and 2.9 percent,

after adjusting for inflation.

TRADING IS HAZARDOUS TO YOUR WEALTH

“The biggest problem of allthat people have is psychological in that

when fear hits the front pages, they tend to . . .sell at the wrong time and not buy back until

the market makes new highs.”

Steve Leuthold

EV E RY B O D Y WA N T S T O P O C K E T H U G E R E T U R N S

in the stock market. Wall Street brokers linked to

an army of research analysts and computer ter-

minals promise to find you stocks that will

“beat the market.” Mutual fund managers trumpet their

market-beating performance. Television shows proclaim

the ten hottest stocks of the New Year. Internet sites

offer the hour’s hot stock.


the fund from selling securities, and capital gains again

when you sell the fund shares (assuming you make a

profit). Every year, mutual fund companies mail their

investors IRS form 1099 detailing their tax liability on

income and capital gains distributions.

Check out the fund’s trading activity or turnover rate.

For example, the average equity mutual fund has a

turnover rate of 90 percent, meaning a $1 billion fund

does some $900 million in trades every year. The fre-

quent trading will boost your tax bill. Indeed, some

mutual funds that rank high on the return sweepstakes

fall toward the bottom of the list once the tax conse-

quences of their frequent trading are taken into account.

A few mutual fund companies are marketing tax effi-

cient funds where the money manager takes into

account the tax consequences of buying and selling

stocks.


replicates the performance of a market index, such as

Standard & Poor’s 500, the Wilshire 5000, and the

Russell 2000. Although there are all kinds of equity index

funds, I prefer the broad-based indexes for participating

in domestic and overseas stock markets.

A majority of professional money managers fail to do

better than index funds. A major reason is the low cost

of passive investing. The annual fee for investing in the

Standard & Poor’s 500 index is some 0.2 percent versus

an average of 1.5 percent for actively managed mutual

funds. Index funds are also relatively tax-efficient

because trades are made only when a stock is dropped

or added to the index.

Still, many people prefer an actively managed fund.

Although there are thousands of actively managed equity

mutual funds, you can cut through the list fairly quickly

by checking them against your goals. For instance, if

you’re just starting out, you’ll want an equity mutual

fund that invests in many different industries. I would

steer clear of most sector funds, aggressive growth

funds, option funds and other fringe investments,

which tend to be very volatile and carry high fees. Avoid

the temptation to join the performance sweepstakes

derby. Some funds do really well one year—only to

collapse the next. It’s best to find a fund with a long-

term track record.

You don’t need to worry about taxes if your mutual fund

investments are in a tax-deferred account, such as a

retirement savings plan. Outside of those accounts,

however, if you are a mutual fund owner, you can get hit

with taxes in three ways. You’ll pay income tax on divi-

dend income, capital gains tax on any profit earned by


PICKING INDIVIDUAL STOCKS

“The business is about making money,and when you buy companies that have no

prospects for making any money, and they’re giving away their product and yet investors are going bananas over them, this is really

the height of speculation.”

Steve Leuthold

PI C K I N G S T O C K S I S F U N , especially online. But

here you should invest only your “mad” money.

For most individuals, it should come out of your

entertainment budget—the money you can

afford to lose. I wouldn’t put my standard of living in

retirement, my children’s college education, my emer-

gency savings, or the down payment on a first home at

risk to my stock-picking prowess.

If you want to buy individual stocks, it pays to develop

an investment philosophy, spend time researching a

company, and buy stocks you want to own for the long

haul. There are quite a few strategies from which to

choose. Among the best-known is fundamental analy-

sis. It’s the technique of valuing a stock based on a

company’s cash flow and earnings prospects. This kind

of analysis includes studying industry trends, capital

investment and management strategy.

Another popular technique is technical analysis, which

is based on the belief that studying a company’s bal-

ance sheet and income statement isn’t important. All

that information is already reflected in the stock price.

Instead, what counts is market psychology. Are investors

optimistic about a company’s prospects or not?

Technicians create all kinds of charts plotting the

9Investing in the Stock Market8 Sound Money Guide to

Here are some common measures

for unearthing the value of the stock

market or a stock.

THE PRICE/EARNINGS RATIO is

the share price of a stock divided by its

per-share earnings over the past year. If

a stock sells for $100, and the company

earned $5 a share over the past 12

months, its P/E is 20. The P/E ratio is

a time-honored indicator of investor

expectations for a company. The higher

the P/E, the more investors anticipate

strong future earnings growth, and

vice versa.

THE PRICE-TO-BOOK RATIO is the

per share price of a stock divided by its

book value. The book value of a company

is the value of its assets, such as its real

estate and machines, minus any debt.

THE PRICE-TO-SALES RATIO is

calculated by taking a company’s stock

price and dividing by its revenues per

share. The idea is that a company’s

share price should keep up with the

growth in sales.

RISK MATTERS

“Long term, it’s very true that stocks have outperformed

other investment classes. But there have been periods for as long as 20 years where

the stock market has lagged. ”

Steve Leuthold

RI S K I S A R I C H W O R D with many shades of

meaning. It hints at dangers to be avoided, such

as health risks from smoking cigarettes. But

risk also suggests daring images of entrepre-

neurs starting their own company. Risk means different

things to different people.

Similarly, there is no one definition of risk in the capital

markets. To finance professionals, risk is synonymous with

volatility. High volatility increases the odds that you’ll

suffer a loss if you need to sell an asset to raise money,

and the returns to very volatile assets are uncertain.

But most people carry a different definition of risk. It’s

not having the money you need to live as well in your

seventies as you did in your fifties. Risk is the possibil-

ity of not reaching your financial goals.

Time is a critical factor when thinking about risk. If you

want to buy a home three years from now, putting your

$25,000 down-payment into the stock market in the

hope of making more money is a mistake. Equities are

too volatile for such a short-term time horizon, and the

risk is too great that your $25,000 could shrink in value.

But the odds of losing money in the stock market

lessens—although it does not disappear—with time.


performance of stocks and the market to divine the mood

of investors. Technical analysis is an expensive strategy

since the technique encourages frequent trading.

Peter Lynch, the famed money manager, popularized

another method. Lynch champions the idea of individu-

als buying stocks in companies they encounter in their

everyday life—it’s the personal experience method.

Your family discovers a new restaurant, and you think

it’s terrific. Well, is it a publicly traded company? If so,

check it out. Or you find out that you and your neighbors

are all shopping at a particular store for much of your

household needs. Start researching it.

Investment clubs are a good way to learn about investing.

An investment club is much like a book club, except a group

of individuals gets together to put money into stocks, and

the investment club is a legal partnership. Investment

clubs stress research, education and investing for the

long haul. You won’t beat the market, however.


DIVERSIFY, DIVERSIFY,DIVERSIFY

“So many people are used to a defined benefit program.

They know exactly what they’re going to get in terms of a pension benefit. But now, with thedefined contribution plans, it’s entirely different.

It’s your responsibility to act prudently and make sure that a nest egg is

going to be there.”

Steve Leuthold

ECONOMIC RESEARCH SUGGESTS that for all the time

people spend trying to pick the right mutual

fund or stock, how you divide your portfolio

among stocks, bonds, cash, real estate, and

international equities (the main portfolio options for

most people) is the main determinant of your portfo-

lio’s long-term performance. Fortunately, the task of

creating an optimal asset allocation for you has been

made easier with the creation of a new generation of

sophisticated computer software and Web sites.

The essence of asset allocation is the balance between

risk and expected return. Stocks offer the highest poten-

tial return but at greater risk than, say, short-term

Treasury securities. That’s why it pays to heed the age-old

mantra of spreading your investments among equities,

bonds and other assets to diversify your risks.

Diversification, the notion of “not putting all your eggs

in one basket,” is among the most celebrated concepts

in modern finance. (Economist Harry Markowitz even got

a Nobel Prize for turning your parents’ oft-repeated

advice into mathematical equations.) Diversification

both reduces investment risk and increases the odds


The key question is: How much investment risk can you

tolerate? To find out, you could take one of the risk toler-

ance tests offered by financial services companies on

the Web. It’s a start. But you’ll get a better handle on

your appetite for financial risk by studying your reaction

to a falling market and declining stock price. And think

about your attitude toward risk elsewhere in your life. For

instance, did you seize the opportunity to leave a good

job at a stable company for a smaller, more entrepre-

neurial outfit, or did you decide the switch was too risky?


A MARKET SNAPSHOT

Long-term total returns

10 years annualized, January 2001

return

Russell 3000 17.18%Russell 2000 15.12%S&P 500 17.37%Nasdaq Composite 20.94%Dow Jones Industrial 17.51%Treasury bills* 6.49%Treasury bonds** 0.34%

*1-3 year maturity

**15 years

DATA: Aronson + Partners

RESOURCES

John Bogle on Investing: The First 50 Years, by Bogle

(McGraw-Hill). A collection of speeches, this book

distills the investing wisdom of a giant in the business.

A Random Walk Down Wall Street (7th Edition),

by Burton Malkiel (Norton). Malkiel translates into

layman’s language an enormous body of academic and

historic research into investing.

Stocks for the Long Run, by Jeremy Siegal (McGraw-Hill).

A finance professor at Wharton, his book illuminates

the superior long-term returns investors have earned

on stocks.

Global Bargain Hunting: The Investor’s Guide toProfits in Emerging Markets, by Burton G. Malkiel

and J.P. Mei (Touchstone Books). A sound guide for

any investor eager to put some money at risk in the

world’s frontier economies.

The Warren Buffett Way, by Robert Hagstrom (John

Wiley & Sons). A systematic overview of the invest-

ment techniques of Warren Buffett, the greatest

stock-picker of the post-World War II era.

Investing for Dummies, by Eric Tyson (IDG Books

Worldwide). You can’t go wrong tapping into Eric’s

expertise.

The Intelligent Investor, by Benjamin Graham

(HarperCollins). A classic on investing with discipline

and your head, rather than haphazardly and with

emotion.

Everything You’ve Heard About Investing Is Wrong,by William H. Gross (Times Business). Gross is a legend

among bond investors, and he offers up astute comments

about investing in this short book.


that you’ll earn a decent return over time. By mixing

some of each asset class into a portfolio, you give up

some performance, but you will lessen the risk of having

your savings all go down the drain at once. But diversi-

fication is a much more subtle idea than simply creating

a margin of safety. Since no one really knows which

markets will soar or sink in the future, investing in all

the major asset classes creates an opportunity to catch

the next big market upturn.

Investing in the stock market is fun. Yes, most of us

would choose to read a mystery novel rather than a

prospectus. Yet the stock market, with its price changes,

is a dazzling economic and social institution for com-

municating all kinds of information and knowledge in a

global economy. And investing in stocks is sound

finance. Good luck.


WEB SITES

www.berkshirehathaway.com. Warren Buffett is head

of Berkshire Hathaway, a holding company for a wide

range of business. His witty annual letter to sharehold-

ers is a terrific read—and a genuine education in

investing.

www.better-investing.org. The National Association

of Investment Clubs offers plenty of good stock-

picking information.

www.fool.com. The Motley Fool’s “Fool School” is an

educational resource.

www.aaii.com. The American Association of Individual

Investors offers some of the best guidance available on

buying and selling individual stocks.

www.bigcharts.com. How has a stock done over the

past year? What is its price/earnings ratio? You can find

out here.

www.marketguide.com. A Web site that offers

investors price charts, key financial ratios, research and

so forth.

www.moneycentral.msn.com. Microsoft’s Web site is

a huge cyber portal for investors.

www.quicken.com. Quicken is another giant Web site

with all kinds of stock screens.

www.vanguard.com. The library and education sec-

tion of this Web site is well worth exploring.

www.morningstar.com. The company is best known

for its mutual fund rating system. But it offers much

more, such as stock research.

www.efficientfrontier.com. Bill Bernstein is a financial

advisor and author of The Intelligent Asset Allocator. He

does some of the best research and commentary on

investing available on the Web today.


Valuing Wall Street: Protecting Wealth in TurbulentMarkets, by Andrew Smithers and Stephen Wright

(McGraw-Hill). The authors largely focus on why they

thought the market of the 1990s was overvalued, but

they also provide a lot of good information for

investors.

It Was a Very Good Year, by Martin Fridson (John

Wiley & Sons). A readable history of extraordinary

moments in the stock market, starting in 1908.

Reminiscences of a Stock Operator, by Edwin Lefevre

(John Wiley & Sons). Published in 1923, this is a

fictionalized biography of Jesse Livermore, a great

19th-century speculator.

Short History of Financial Euphoria, by John Kenneth

Galbraith (Viking Penguin). A gifted writer and wry

observer, Galbraith is a delight with his short excursion

through the madness of financial crowds.

Devil Take The Hindmost: A History of FinancialSpeculation, by Edward Chancellor (Farrer-Strauss-

Giroux). Chancellor does a terrific job describing some

of the most famous—or infamous—speculative binges

in history.

Against the Gods: The Remarkable Story of Risk, by

Peter Bernstein (John Wiley & Sons). Peter Bernstein, an

economic historian and investment advisor, has written

an engrossing history of risk, gambling, probability and

the financial markets.

Asset Pricing, by John H. Cochrane (Princeton

University Press). This book is only for the academi-

cally inclined, but Cochrane is at the leading edge of

finance economics today.


Sound Money ® is produced by

Minnesota Public Radio and distributed by

Public Radio International. It is carried on public

radio stations across the country. Contact your

local public radio station for broadcast times.

For more information on Sound Money go to

www.soundmoney.org

Chris Farrell’s Sound Money Guide to Investing in

the Stock Market is published by Minnesota Public

Radio, 45 E. Seventh St., St. Paul, MN 55101.

© February 2001 Minnesota Public Radio.All rights reserved.

The information in this booklet is of a general nature and not intended for application to specific cases. You should discuss specific

circumstances with your lawyer, accountant or financial advisor.

Chris Farrell’s Sound Money Guide to Investing

in the Stock Market was produced with assistance from

Primevest Financial Services, and their PrimeVest Investment

Executives, dedicated to providing investment and

insurance solutions and strategies.

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