A number of people have asked me how I’m saving for retirement now that I’m self-employed, and several more asked yesterday when I mentioned that I was signing up for a SEP-IRA. In order to clarify everything, here’s exactly how I’m saving for retirement as a self-employed writer.

For comparison’s sake, my previous retirement savings were exclusively in 403(b) and 401(k) plans. Even though I planned to open a Roth IRA in 2007 (and even went so far as to fill out the paperwork), I eventually elected not to do it, primarily because of the costs associated with purchasing a house in 2007 and the fact that I was already rolling about 20% into my retirement plan. In fact, my savings in there is quite a bit above what’s considered “normal” for a 29 year old - I have substantially more than a year’s worth of my old salary in there, and it’ll just do nothing but grow over the next 30 years.

My current self-employement retirement planning is handled exclusively through Vanguard. I’ve invested with them in the past, I feel wholly comfortable with the way they do business, I agree strongly with their company’s investing philosophy, and I want to put all of my retirement into index funds, which is what Vanguard specializes in.

So what did I do? Almost as soon as I moved to self-employment, I opened up a Vanguard Roth IRA. A Roth IRA is a retirement account that almost anyone can set up (well, anyone with a Modified Adjusted Gross Income below $114,000 for an individual or $166,000 in a married couple). Each year, you can contribute up to $5,000 to the Roth IRA out of your after-tax money - it isn’t pulled straight out of your paycheck like a 401(k) is. However, once it’s in the account, it’s sweet - as long as you follow the very simple withdrawal rules (basically, no withdrawing until the account is more than 5 years old or you’re over 59 1/2 years of age), you can withdraw the earnings tax free - you don’t have to pay income tax on any earnings in the account (you can also withdraw your contributions at any time without penalty). For a lot more detail, read up on Roth IRAs at Wikipedia.

So, basically, each month I put a few hundred dollars into my Roth IRA at Vanguard - just enough so that after the year’s up, I’ll have contributed my total $5,000 (my wife is considering opening one as well, so that will make our combined contribution $10,000 for the year if she does that). Ideally, then, I’ll contribute $5,000 each year over the next thirty years into this account, taking me right up to retirement age. If I do that, and it earns even just 6% per year, that’s $395,290 I have access to at age 59 1/2, all of it tax free. If I get an 8% return on it, that’s $566,416 - tax free. That’ll certainly help with retirement.

What about the SEP-IRA? So, as I mentioned yesterday, I’m setting up a SEP-IRA through Vanguard as well, mostly because I wanted to contribute more towards retirement than the $5,000 a Roth IRA allows for me. A SEP-IRA allows a self-employed individual to contribute up to 20% of their profits to the SEP-IRA. I’m allowed to invest up to (approximately) 20% of my self-employment income into this plan (though I’m not going to be putting in quite that much). This plan is tax-deferred, meaning that I put in money before paying taxes on it and then pay income tax on everything I take out later on. For the purposes of most people, it’s like a 401(k) for the self-employed, except that you don’t get employer matches.

Right now, I’m contributing roughly 5% of my income each month to this plan - that’s in addition to the Roth IRA, but way under my contribution limits for the year.

How did I invest? In both cases, I set up a regular investing schedule and bought into the Vanguard STAR fund because I didn’t want to put in the $3,000 minimum for other funds. I’ll sell the STAR shares when it reaches $3,000 and move it to another fund. Eventually, I plan on having all of it split among a few funds just to ensure diversity - I want some international stocks, some domestic stocks, etc.

For most self-employed people, particularly those under the cap for a Roth IRA, this is a solid path to follow.

Yesterday morning, I wrote a fairly controversial article where I described individual stock investing as akin to gambling for the average investor.

The impetus for that article was Jim Cramer’s appearances on CNN just before the Bear Stearns collapse, shouting loudly that Bear Stearns was in great shape. Check it out if you want to get a taste of Cramer’s demeanor and “advice” that turned out to be almost the complete opposite of reality:

Here’s the scoop in a nutshell for those of you who don’t follow such things. Jim Cramer is probably the most vocal and best known advocate of individual stock investing in the United States. Following a very successful stint as a hedge fund manager, Cramer began hosting what became the top-rated show on CNBC, entitled Mad Money, where he basically acts hyperactive, yelling and running around the set voicing his opinions on various individual stocks.

On March 11, 2008, Cramer loudly said on his show that the large investment bank Bear Stearns was in fine shape and that no one should pull their money out of the stock. Within a week, Bear Stearns was being bought out by J.P. Morgan and the stock value had dropped 90%.

When this all unfolded, my reaction was that this was evidence that individual stock picking was basically gambling. If Cramer didn’t know what was coming due to a lack of information, how would anyone else? Even more so, Cramer was adding bad information to the pool - people strictly taking Cramer’s advice would have completely tanked. As I said yesterday morning, individual stock picking is all about information and knowing how to find the right pieces to look at, and if someone who is supposedly a true authority at stock picking couldn’t see something that huge and devastating coming down the pike, an average individual investor has no chance at all.

After some more thinking, I turned the whole situation around again: what if the problem is Cramer himself?

The Cramer Effect
In stock trading, the “Cramer Effect” (or Cramer Bounce) is the positive bounce that most stocks get as soon as they’re mentioned on Cramer’s television show. Because Cramer has such a large audience, there are a lot of people who simply go out and buy a stock based on his recommendation.

However, when I look at the “Cramer Effect,” I think of it more widely. To me, Cramer’s real important effect is that he has built up a substantial interest among a casual crowd in individual stock investing. His show is exciting, loud, and colorful, and thus has attracted an audience that might have otherwise been watching SportsCenter or something like that. Instead, they’re watching Cramer, learning about individual stock investing, hearing about specific instances of incredible returns, and then getting involved themselves.

Is this a financially healthy thing for those people? I think it depends on what they take out of Cramer’s message. Let’s look at both sides of the coin.

Why The Cramer Effect Is Bad
On Mad Money, Cramer has a segment called the Lightning Round, where viewers call in, name a stock, and Cramer gives a buy, hold, or sell recommendation within a second. He does this by simply drawing a very fast conclusion about the sector that stock is in and whether that stock is the best stock in the sector. It’s not based on any sort of thorough research, yet people buy and sell in the real world based on what he says. That’s pretty scary - because someone on television mentions buying or selling a stock based on one second of off the cuff thought, people change their financial position.

The most obvious indication that this phenomenon really does exist is that “Cramer Bounce” I mentioned above - it’s observable and real. A lot of people out there are buying based on what Cramer recommends on his show, and as I said above, that’s pretty scary. Even worse, it teaches really, really poor investment discipline - someone on TV thinks about a stock for one second, makes an off-the-cuff guess, and you’re changing your investment approach? That’s not sound investing at all.

The Beauty Is In The Details
Yet I’m not quite ready to toss Cramer into the trash can. If you actually take the time to sit back and read his books - particularly Real Money, which is by far his best one - you’ll find that the message he talks about is about as far from the Lightning Round as can possibly be.

The big message that you get out of actually reading Real Money is homework, homework, homework. He flat-out says you should not own a stock if you’re not willing to do an hour a week of research on that stock: reading annual reports, listening to conference calls, watching what stock moves the insiders do, reading the news, and so on.

That’s something I can agree with and stand by. You should not own an individual stock unless you have a specific and compelling reason to own that stock. Furthermore, you need to invest the time to make sure your specific and compelling reason hasn’t gone away, which would mean it’s time to sell the stock. If you can’t invest that time, then you might as well go toss your cash on the roulette wheel.

Why Irrational Is “Cool”
So why isn’t that sensible message talked about on television? It is, on occasion - Cramer talks regularly about doing the homework. But that’s not the part of his show that seems exciting. It’s when he shouts, does something crazy, screams “Boo yah!” and such that grabs the attention, and that’s the stuff that’s directly associated with stock picks.

Just a few weeks ago, I talked in detail about Dan Ariely’s book Predictably Irrational, which focuses in on why people make irrational decisions - like, for example, basing your investment strategy on an off-the-cuff remark from a television personality.

Ariely reveals two reasons why Cramer’s seeming irrationality is followed by many people. First is the idea of relativity - they feel a need to be on the cutting edge of stock investing ideas. This is similar to why we feel some sense of jealousy and drive when our neighbors have a nice new car. This is largely the reason why people would watch CNBC and read specific stock investing advice. They feel a need to have “insider knowledge” as relative to others in their cohort - in other words, other individual stock investors, thus they follow stock tips.

The second idea is that of passion. Cramer brings more passion, energy, fire, and drive to the table than about anything else on television. It oozes out of the man - he plainly loves stock investing and that love comes out quite clearly on his show. It rubs off, and that’s how he’s attracted an audience - people like to see others with passion and they tend to believe others that show passion (think of televangelists, for instance).

Combine these two factors, plus the fact that his show has a very action-oriented sensibility, and it’s fairly easy to see why people would follow the quick pick advice and not necessarily follow the “do an hour of research per stock per week” advice.

Some Final Thoughts
Cramer’s got some good things to say if you know where to look and where to listen. The problem is that this isn’t the stuff that excites people and gets high ratings - the stuff he says that’s valuable is the boring stuff. Thus, it’s very easy to just see Cramer’s advice for the excitement, where he runs around on stage like a maniac yelling “BUY BEAR STEARNS!” even though he’s not done the research.

If you really want to get into individual stock investing, read Cramer’s books and do a lot of homework. Don’t jump on an individual stock pick just because you heard about it somewhere - do it for a compelling reason and keep your eye on it carefully to make sure that reason still exists.

And listen to Cramer, too. Listen to the part where he gives advice on how to do the homework, not the part where he yells, tosses a chair, hits a buzzer, and screams “BOO YAH!” That won’t get you very far down the road of financial success.

I have a lot of fun following individual stocks in my spare time. I keep tabs on a small handful of companies that I have a personal interest in - Apple, Nintendo, Herman Miller, and Ford, namely. I watch for news articles on the company, read their annual and quarterly reports, and stay up to date on pretty much everything about the organizations.

For a short while, I owned individual shares in Apple and Herman Miller in mid-2007. I bought into Apple in late July, purchasing about 40 shares when the stock was at 140. Over the following three weeks, I watched Apple drop like a stone to below 120, then I sat there through late August and early September as it rose back up to 140. I sold immediately. Over the same rough period, I bought 50 shares of Herman Miller at 32, watched them sink and struggle to rebound, and sold the shares in late September at 29.

In the end, I didn’t lose too much money. What I did lose is a lot of sleep. The second I owned those stocks, I became obsessive over those two companies. I read every single morsel of information that came out about them, read reports, studied numbers, sweated, didn’t sleep at night, and a few times I even queued up panic sales of these stocks.

The second I finally sold all of them, I felt much better, and I walked away with a bitter taste in my mouth. Individual stocks are basically gambling pretty much sums up the way I felt and since then, I’ve barely written or even thought about individual stock investing.

But is that the right lesson to take away from the experience? Let’s dig into the idea a bit.

Information Games

Most forms of gambling that aren’t merely chance, such as blackjack and poker, are games of partial information. You know some of the information out there - the cards you hold, perhaps some of the cards the dealer holds, any revealed cards, and the “tells” that the other players have shown you. At the same time, key pieces of information are hidden - what the others are actually holding.

The same statement is true of stock investing, except the story is a bit different. Most of the information you’d really need to know - in fact, virtually all of it - is right out there for you to see. The only problem is that it’s like trying to find a water droplet at Niagara Falls - there’s so much information out there that processing it all is impossible.

As a result, stock investors often choose specific pieces to focus on. Perhaps they look at the P/E ratio for a company, or maybe they look at the backgrounds of the company leaders. I’ve read tons of books about different strategies, but most of them boil down to isolating a few key pieces of information about companies and using them as a judge about when to buy and when to sell.

The problem is that no individual metric is perfect. One can’t ever boil down the complexity of Apple’s entire business into just one factor. What would happen to Apple’s stock if tomorrow morning Steve Jobs dropped dead of a massive heart attack? Do you have any idea? Obviously, it would go down, but how far would it go down? Would Apple weather that storm? Those are both huge unknowns, but investing in Apple stock means you’re making some sort of prediction on those questions. You’re using one view of the information to make a judgement about a whole company.

The Investor Mindset

Some people respond to this glut of information and the inherent risks quite well. They focus in on specific things and just blot out everything else. They do the homework they need to do and walk away from it. Are these people gamblers?

What about others, like myself? When I was invested, I was almost driven crazy by the desire for more information. I knew that there was more to know about where my money was sitting, and I needed to know it. Am I an information addict?

Personally, the risk itself didn’t bother me so much - I was merely overwhelmed by the actual level of information in that information game. But what about a person who knows why he’s investing, but is ready to throw up after a 1% drop? I have a close friend like that - he basically can’t invest in anything that isn’t fully guaranteed. Is that person far too conservative?

It all comes down to personal makeup and psychology. Some people are predisposed to play this information-rich game; others simply aren’t. I put myself into the “not predisposed” category - I could invest if I had money that was truly “play” money, but not if anything of any importance relied on that money. It would move from being a dalliance to being an obsessive information hunt - and that’s the result of my psychological makeup, not the game itself.

Mister Market

So far, all I’ve really done is convince myself that stock investing really is gambling, but there’s one big factor that draws me back from making that leap. It’s the fact that the stock market as a whole grows in a positive direction, not a negative one.

In a typical gambling situation, the house “rakes” - meaning that the house takes some small fraction of the winnings. In stock investing, the “house” (in other words, the stock market as a whole or, for that matter, capitalism as a whole) adds to the pot over time.

How does that happen? Over time, innovations make it possible for companies to produce more and more with the same amount of resources. Think computers, for example - they’ve radically changed almost every industry. Innovation has a lot of different effects, but one of the big ones is that it constantly adds more value to the company itself in the form of increased productivity. The result is that all companies gradually become more valuable over time, simply because they can produce more with what they have - or produce the same amount they always have with less resources.

Think about a patch of farmland. Two hundred years ago, a farmer grew whatever corn he could lay his hands on, tilled a few acres with a horse drawn plow, tossed the seeds into the ground, and hoped for ten bushels of corn production per acre. Fast forward to today: tractors, fertilizer, and hybrid corn now make it possible for that same patch to produce 150 bushels of corn per acre. That means the entire farm is more valuable - and thus shares in that farm are more valuable now as well.

Over time, value is constantly added to the stock market (assuming everything else stays the same - when the market goes down, something else is changing). This addition of value is the one real difference between stock investing and traditional gambling.

My Conclusion

Individual stock investing is something like playing blackjack at a casino where, on every hand, the dealer is wagering just a little tiny bit more than you, but there are thousands of people around you shouting out suggestions. If you can concentrate enough and take the time to sift through the information overload correctly, you can potentially go on a very nice winning streak - and the odds are slightly in your favor. At the same time, though, as with any game where you don’t have all the information, you can very easily go on a losing streak.

My solution to all of this - and the solution that leaves me sleeping well at night - is to buy index funds. That’s kind of like going to that casino and playing 5,000 hands at once with earmuffs on. Because of the huge number of hands, the luck of any individual hand is negated and eventually you end up with a small overall win without the stress, time, and focus needed to win at an individual hand.

I think investing in individual stocks is a fine diversion and a potential way to earn a lot, but far from a guarantee and the work needed to get those earnings is tremendous. For the casual investor who hasn’t invested the time to really learn the game and the investment and learned how to fight through the information noise, individual stock investing might as well be gambling.

Over the last several months, I’ve had the opportunity to review all five entries in the Little Book investment series. For those unaware, the Little Book series by Wiley Publishing is a series of small hardcover books. Each entry in the series seeks to explain in layman’s terms a specific investment strategy and how an individual can execute that strategy.

After my review of the fifth entrant, The Little Book That Builds Wealth, several readers wrote in to ask what my views on all of the books in the series were in comparison to one another. Thus, here are my thoughts and recommendations when it comes to the Little Books series as a whole.

Best Investing Advice
The Little Book of Common Sense Investing - John Bogle

Out of the five books, I only found one had a clear and thorough enough argument to actually convince me that the advice was worth following, and that book was John Bogle’s The Little Book of Common Sense Investing. The book itself isn’t the best written one in the series - in fact, much of the book seemed merely to be a simplificiation of Bogle’s earlier book Common Sense on Mutual Funds.

What really carries The Little Book of Common Sense Investing is the strength and logic of the argument. The idea of investing in index funds is simple and it makes a lot of sense - just invest as broadly as you can and minimize the fees you pay. This way, you aren’t completely destroyed by the bad moves of one company, but you don’t get to ride the tidal wave of a single company’s success, either. Instead, you ride the overall waves of the entire market. While doing that, though, you make choices to minimize the amount you have to pay to the investment house for their services - and it can be very inexpensive to invest in index funds.

Taking in the complete argument, Bogle’s is really the only one yet that has truly convinced me of the benefits of that strategy. It’s simple and it works - the exact concept that the series as a whole is trying to espouse.

Most Worthwhile Read
The Little Book of Value Investing - Christopher Browne

Although I think that Bogle’s advice is probably the best to follow, I thought that Chris Browne’s The Little Book of Value Investing was perhaps the most compelling read.

One of the books you’ll see on pretty much any investing reading list is Benjamin Graham’s The Intelligent Investor. It’s generally considered to be the definitive book on value investing - it lays out the strategy in thorough detail and the author has a great deal of reknown and prestige among real-world investors (for example, Warren Buffett considers Graham his mentor). The only problem is that it’s dense. The Intelligent Investor is a challenging and demanding book, and for most armchair investors attempting to gain a well-rounded basic understanding of investment strategies, reading The Intelligent Investor is like using a cannon to kill a ladybug.

The Little Book of Value Investing solves that problem by taking the ideas of The Intelligent Investor and rewriting them in a form that beginning investors could swallow. It doesn’t get into the nuances and the analyses to the level of The Intelligent Investor, but The Little Book of Value Investing nails the concepts. Because of that, it’s almost worthwhile for anyone to read The Little Book of Value Investing first and then follow it with
The Intelligent Investor if they need more.

I’ll say this: reading The Intelligent Investor was much easier the second time through, primarily because I read (and enjoyed) The Little Book of Value Investing just before tackling it. The Little Book of Value Investing taught me the big concepts, then Graham just refined them a bit for me.

Worst Entry
The Little Book That Beats the Market - Joel Greenblatt

This first entrant in the series only really succeeds in one respect: it explains in extremely simple terms how the stock market works. After that, it gets into an investment strategy that seems to be flaky at best - it’s vaguely based on value investing, but it really only uses two metrics to find stocks to invest in, not a thorough investigation of those stocks.

The Little Book That Beats the Market is a fun read, and it can be a good one if you have no idea how the stock market works at all, but if you’re looking for an investment strategy to use, this is one to avoid. The actual strategy within is, as far as I can tell, basically arbitrary - it seems to be “pick two stock metrics and find the companies that do well in both, and then just buy ‘em.” That’s not a winning strategy by any stretch of the imagination.

The Rest
The other two entries in the series, The Little Book That Builds Wealth (on competitive advantage investing) and The Little Book That Makes You Rich (on growth investing) both do good jobs of laying out their specific strategies and are good follow-ups to The Little Book of Value Investing in that they can provide a great background on specific individual stock-picking strategies. They’re not particularly weaker than The Little Book of Value Investing, but I found that one to be a touch more enjoyable to read and the strategy to have much more additional material available to learn from.

In a nutshell, The Little Book of Value Investing is the best one to read for learning (along with The Little Book That Builds Wealth and The Little Book That Makes You Rich, which also do a good job on teaching individual strategies) and The Little Book of Common Sense Investing is the best one to read for application. You should probably avoid The Little Book That Beats the Market unless you’re a complete beginner, but you shouldn’t ever follow that strategy unless you deeply understand why you’re doing it (and the book won’t really teach you that).

Good luck, good reading, and good investing.

Each Friday, The Simple Dollar reviews a personal finance book.

The Little Book That Builds Wealth is the fifth book in the Little Books series from Wiley Publishing, each of which focuses in on describing a particular investing strategy in layman’s terms.

This time around, the focus is on competitive advantage, or “moats” - the basic idea that Warren Buffett uses when investing. The author, Pat Dorsey, is the director of research at Morningstar, the well-known investment research firm, so he’s fairly authoritative on the subject.

When I read a book like this one, I’m hoping to really learn the nuts and bolts of an investment strategy, enough so that I can understand how it works and how I might use it to compare companies to one another and decide which one I should invest in. If I learn that without being bored to death, I look at the book as a success - if I’m at the end and still confused, or if the book lulls me to sleep, then I’m not impressed.

Does The Little Book That Builds Wealth live up to this standard, or does it fall short? Let’s take a look.

Looking At The Little Book That Builds Wealth

Chapter One - Economic Moats
The book opens by defining the concept of a moat. In a nutshell, a moat is a significant competitive advantage that one company has over another. The great example used in this chapter is McDonalds - in 2002 and 2003, Mickey D’s caught a lot of bad press because of their poor customer service and perceived slipping food quality. For a restaurant chain without a huge moat, this could have been devastating - for example, look at the implosion of the Little Sambo’s chain in the 1970s, which went from 1,200 restaurants to one in less than a decade. However, McDonalds had some very important moats that gave them time to survive and retool a bit - they had a globally recognizable brand and strong customer loyalty. Those provided a nice moat for McDonalds to keep the competitors from attacking too fiercely and gave the company time to fix their problems and rebound.

Chapter Two - Mistaken Moats
From that explanation, it’s easy to visualize moats for almost any company. Any company with any size is doing something right, and it’s easy to confuse immediate success with competitive advantage. However, quick success usually has very little to do with true competitive advantage. Take Tommy Hilfiger, for example. Once, it seemed they were building a globally competitive brand - but now you can find Tommy clothes on discount racks. The dot-com busts like Pets.com are in the same boat - they seemed to have a competitive advantage because of the internet, but it was a mistaken advantage. There are really only four sources of true competitive advantage: intangible assets (like patents or licenses), customer switching costs (meaning it’s hard for a customer to give up that specific product - think Microsoft), network economics (like an ingrained shipping network), and cost advantages (control over some method of making the product cheaper than competitors are able to). A company with at least one of these and a nice return on capital is a good one to invest in.

Chapter Three - Intangible Assets
Intangible assets are those that don’t have physical form but do produce value. For example, a brand strong enough that people will pay a premium price for it. Take Tiffany’s - if you buy an item from Tiffany’s, you’re going to pay a significant premium for that little blue box, yet the company is consistently able to charge premium prices and customers are willing to pay it. On the other hand, look at Sony - their brand is valuable, but people are quite often willing to choose an identical item with a different brand on it (is your DVD player a Sony?). Patents and regulations are also good moats, but the most valuable ones are those that are composed of lots of small patents and regulations, not a few big ones.

Chapter Four - Switching Costs
I’m a Photoshop user. I know how to use the program quite well and I also know that I’m often frustrated when I attempt to use other image editing packages. For me, there is a large intangible switching cost for abandoning Photoshop, and I’m loathe to pay that cost. This is a clear-cut example of a moat - Adobe can charge a high price for Photoshop because many image editing folks are trained in it and it’s difficult to switch. Lots of businesses have moats along these lines - banks, software vendors, and so on.

Chapter Five - The Network Effect
Any company that has an already-running distribution network for their product, like Anheuser-Busch, has this type of moat. Because of the cost and effort in getting a distribution network set up - and often the challenge of fighting through distribution agreements - a pre-existing distribution network can be a huge moat. It is this reason why it is almost impossible for another large-scale beverage company to independently become as large as Coca-Cola or Pepsi - they can’t afford the costs of distribution. A similar logic occurs with internet companies - they use the internet as their network and reduce brick and mortar costs that way.

Chapter Six - Cost Advantages
Cost advantages come in the form of better locations, better access to resources, and better processes. All of these allow a company to cut costs in ways that their competitors cannot. However, some cost advantages are stronger than others - for example, another company can easily copy the cost advantage of a process, while they can’t easily copy the advantages that a maple syrup company would have in a giant forest of old maples.

Chapter Seven - The Size Advantage
Larger companies simply have a natural advantage over smaller ones. They can execute their plans on scales much larger than the smaller companies and because of their size find efficiencies and discounts unavailable to smaller groups. They can use their size as leverage, promising plenty of business to suppliers in exchange for exclusivity, for example. They can also find efficiencies in processes that smaller companies can’t, like having a person devoted to one tiny nuance of the production while other companies must multitask their workers. Thus, large companies often have an inherent moat, albeit one that can be superceded by other companies over time.

Chapter Eight - Eroding Moats
Obviously, moats can erode over time. One of the biggest factors in moat erosion is technological change. When a new technology arrives on the scene, particularly one that has the potential to change that market significantly, there’s usually a big opportunity for a competitor to severely erode the moat of another company. Similarly, when a company with a moat begins to make bad decisions, they cause their own moat to erode - think of the earlier McDonalds example.

Chapter Nine - Finding Moats
There is no true sure-fire way to find a moat. You have to investigate the business, see how they operate, and then see if they have anything that might be construed as a true moat. Some industries have many companies with moats; others have basically none. Your only true recipe for success is learning how a company really operates, and that takes some research.

Chapter Ten - The Big Boss
Many investment strategies put a lot of importance on the leadership of a company. However, Dorsey makes it quite clear that moats and leadership have little to do with each other. A great leader is not a moat, and a truly great leader cannot usually create a moat, either. On the other hand, even a merely average CEO will not erode an existing moat. Thus, if you’re looking at competitive advantage as a reason to invest, don’t spend much time worrying about the CEO - worry about the business itself.

Chapter Eleven - Where the Rubber Meets the Road
There is one strong way of finding companies that might potentially have a moat, although it’s not a sure indicator: long-term return on capital. Dig into online research tools like Yahoo! Finance and take a look at a company’s return on capital, especially compared to competitors. Is it substantially higher than the competitors? If so, that company may in fact have a moat, and it’s worth your time to start digging into information about the company to see if you can identify their moat.

Chapter Twelve - What’s a Moat Worth?
This chapter is basically an argument for value investing. In other words, a company with a great moat can still be overvalued. Rather than offering an exact recipe for the value of a moat, Dorsey instead suggests looking for companies that are reasonable values to begin with (using factors like a low P/E ratio) and then identifying from among those which ones have moats.

Chapter Thirteen - Tools for Valuation
Dorsey recommends looking at the price-to-sales ratio as well as the price-to-book ratio. The P/S is particularly useful for companies that are temporarily unprofitable, while P/B is great for companies that offer services, particularly financial service firms. P/E (price-to-earnings) is a good general indicator, but make sure that you study this one over the long term in order to minimize the fluctuations in the economy.

Chapter Fourteen - When to Sell
Homework, homework, homework. Moat-based investing isn’t for people who don’t want to put in the time to do some homework. Basically, if you buy a company’s stock, you should have a specific reason for doing so. When that reason changes or goes away, that’s the time to sell. Better yet, that specific reason should have nothing whatsoever to do with what other people are doing in terms of buying and selling - if your reason for investing still exists, you shouldn’t sell it just because the herd is panicking because of a down market.

Buy or Don’t Buy

Much like the other entries in the Little Books series, The Little Book That Builds Wealth is a strong introduction to a particular investment strategy. After reading it, I feel I have a pretty strong grip on how to invest in companies based on competitive advantage and I know some of the basic techniques for identifying companies that might have a good competitive advantage.

Dorsey’s style is perhaps not as animated as others, but he still gets the point across. His writing actually reminds me of an old economics professor in a rumpled sweater, teaching in a world-weary style that doesn’t necessarily make you leap out of your chair and take action now, but holds your attention and makes you think.

If you’ve ever wanted a good introduction into the model of investing that Warren Buffett uses, this is a very good place to start. Dorsey lays it out in a very approachable way and offers up enough concrete examples that anyone can actually see the principles at work. That, my friends, makes for a worthwhile read.

In the past, while planning out exactly how I was planning on investing, I discussed a number of different options that I was considering. In March 2007, for example, I discussed this plan, which included four different Vanguard index funds.

Well, a year later, I’ve actually begun investing in a taxable account. Not in a retirement account - in a place where I can easily withdraw it and do with it what I wish. My goal with this investment is down the road a bit, perhaps twelve years: I want to directly finance the building of the exact home my wife and I have dreamed of. This home would be out in the country with woods on both sides, but besides that it wouldn’t be too much different than our current home with the exception of having two floors instead of three and a larger master bath.

The portfolio To reach that goal, I’m putting all my money into Vanguard into a portfolio consisting of just two funds:
50% Vanguard Total Stock Market Index Fund (VTSMX)
50% Vanguard Total International Stock Index Fund (VGTSX)

That’s it - half in one, half in the other. Simple as can be, and I’m invested about as broadly as I possibly can, as the first fund basically invests in all American stocks and the second invests in most international stocks.

How I got started For each of these funds, I merely saved up the initial amount I needed to buy in ($3,000) in an ING Direct sub-account. I saved up for VTSMX first, then VGTSX.

Now, each month I automatically deposit a specific but equal amount into each of the funds and don’t really worry about how they’re doing day to day. I just sit back and let them do their thing.

Rebalancing I have not yet rebalanced these funds, but my plan is once a year to take an extra month worth of contributions and contribute that to whichever fund has the lower balance. So, for example, if I am contributing a total of $500 a month to the funds right now, once a year I’ll take $500 and put it in whichever of the two funds has a lower balance. This serves to keep the two funds approximately equal in value to each other over the long haul.

Future plans I really can only foresee two significant changes to this plan. My target date is 2020 for fruition, so in 2010, I am considering adding a bond fund to these two funds to reduce the effects of a negative period. In 2018 or so, I’ll likely clean the entire fund out and put it all into a high-yield savings account so that it’s not at risk from any last-minute losses.

What can you do? What is the take-home lesson here?

First, getting started in investing isn’t complicated. For a long time, I was overwhelmed by the idea of actually investing my money in something other than a bank account. The world of stock investing seemed overly complex and arcane to me, so I just avoided it. That’s simply not true - in about fifteen minutes, you can set up an online account that makes investing in the stock market about as easy as signing up for a bank account.

Second, your actual investment choices don’t have to be complicated, either. I read a lot of different books on investing and personal finance and found that they basically offered the same simple advice - buy some index funds and hold them. That’s it. I just chose the two broadest ones I could find and put my cash into them.

Third, patience is really a virtue with this. There are times when I see the stock market dropping like a rock and I get a bad feeling in my stomach. But, over the long haul, this investment will rebound. Even better, when the market is down, the money I put in for that month will buy more stocks than ever before - because they’re on sale! These thoughts make it easy for me to just sit back, not worry about it, and let the money build up over time.

Finally, you can get started, too. Put $50 a week into a savings account and you’ll soon have enough to get started. I chose funds with a high minimum because I think they’re good investments, but there are many options out there with a lower minimum investment. Just put what you can into a separate savings account each week and let it build up, then drop it into some sort of investment. Then wait and watch it grow. It might buy you a car or help you buy a house in a few years.

On December 31, 2007, the S&P 500 closed at 1,468.36. Just two months later, on February 29, 2008, the S&P 500 closed at 1,330.63. That’s a 9.4% drop in just two months, an incredibly painful loss for almost everyone invested in the stock market. Even people who were invested in a highly diversified index fund felt the bite from this big drop.

Think about it - if you had $10,000 in the Vanguard 500 on December 31, your investment is now worth about $9,060 (give or take a dollar or so) - a loss of $940. Poof! Gone like that.

A lot of people see this as a reason not to buy stocks or to sell them. In fact, a lot of people do just that. They look at these losses and see danger - and they don’t want danger, so they stay out or they sell.

Let’s look at it another way.

On December 31, 2007, you could have spent $10,000 to buy shares in the Vanguard 500. On February 29, 2008, those shares are now on sale for $9,060. You’re buying the exact same thing, except now you’re saving $940.

Nothing fundamentally has changed about the investment itself. You’re still buying the same pieces of a wide array of large American companies. The only difference is that right now, these stocks are on sale.

Let’s keep this logic going. Let’s say over the next two months, the stock market rebounds and it goes back up to 10,000. You’ll score a very quick 10.3% return on your investment.

On the other hand, if it goes down yet again, your losses now are much smaller than if you had bought in on December 31.

What’s the idea? A down market isn’t a time to sell. It’s a time to buy. You don’t go to the supermarket and stock up on produce when the prices are expensive - you wait until things are in season and the prices are low.

What if I already own that index fund and I just took that loss on the chin? What if you came into this downturn already owning a fund, and you’re sitting there swallowing losses? This is the scenario where it’s tempting to sell and stop the bleeding.

Look at it this way, though. You’re already stuck with this loss - there’s no way of getting out of it. On the other hand, you’re currently holding an investment that’s at a discounted value. If you’re investing for the long term - and if you’re in stocks, this really should be a long term investment - then you need to hold onto that stock, not sell. By selling it now, you’re basically asking someone else to come in and take that discounted investment from you at a nice bargain price.

What if I own individual stocks? Individual stocks are potentially different. First of all, if you own the stock of a specific company, you should have specific reasons for owning it. Perhaps you have high confidence in the current management, or you believe in a specific product of the company. The reasons can vary, but if you don’t have a clear reason - and also a clear definition of what needs to happen for that reason to go away, you shouldn’t own the stock.

Let’s say, for example, that you own Apple stock and you do so because you believe in Steve Jobs. As long as he’s firmly in as CEO, you’ll keep holding Apple stock. When word starts being whispered that perhaps Jobs is about to retire, it may cause some serious tremors in Apple’s stock, and it might have gone down a bit when you hear the news. Of course, your reason for owning Apple is now gone, so you should sell - but that reason to sell has nothing to do with the stock price at the moment.

In the end, keep one thing in mind: stocks are a long term investment and if you sell based on what the price is doing today, this week, this month, or even this year, you’re asking for a smarter and more patient investor to take your money. Don’t sell any investment unless you have a reason for selling it, a reason not based on that day’s price.

When I first sat down to write the Investing in Yourself series, I was mostly thinking about financial investments - how can you invest money in yourself in order to increase your earning potential? What the series actually pointed out to me, however, is that investments really take on a lot of forms and you can often transform one type of investment into another.

For example, take The Simple Dollar. For me, it’s a money investment (hosting fees), a time investment, an intellectual investment, and a bit of an emotional investment, too. What do I get out of it? I reap some financial rewards, increased knowledge and understanding (as a result of the research), improved writing skills, a network of acquaintances, and the wonderful feeling one gets from helping someone. Is it enough reward for the time investment? I believe that it is, but it’s probably not an exchange everyone would see value in.

There are lots of ways to invest in something.

Money is the most obvious investment. It’s very easy to see how financial investments increase in value over time just by itself, let alone how you can use money in effective purchases to improve your situation. Most tangible goods in some way fall under money, as they have some sort of direct monetary value.

Time is also rather obvious, and for me it’s the more valuable investment. An hour of your time should reap some sort of reward, and that’s why I think that many people were frustrated with my recent article about personal appearance and hygiene - for some, the benefits of the investment of time in cleaning yourself is so obvious as to be idiotic (and thus some seemed to be insulted by the article), but yet for others it’s not something worth investing their time in because they don’t really see the benefit. The comments on that post make that dichotomy clear (and convinced me that I made the right call in posting it).

There are other investments as well. Emotional involvement is one - whenever you become emotionally involved with something or someone, you’re hoping for a positive outcome. I immediately think of my sister-in-law here, who works at a job that she’s deeply emotionally involved in without much pay. For her, it’s much more than just a time investment. It’s passion.

Intellectual investment is another important one. For example, I often come home from my regular job with my brain completely drained of mental energy. It’s almost all I can do to raise up the mental energy to engage with my family in the evenings at times.

Along these same lines, not all investments pay dividends in the form of money, either. There are rewards in the form of time, in the form of emotion, and in the form of self-improvement as well. Again, looking at investment rewards from this perspective brings my sister’s job into clear view. She works at an emotionally involving job, investing her time and emotions greatly into her work. What does she receive as a reward? Money’s just one part of it - it leaves her with a great deal of emotional reward, too, from the upfront happiness of bringing a positive change to people’s lives to the overall satisfaction of doing something that fills a true social need. Overall, the equation balances out for her, even if looking at it from a time-for-money perspective makes it look as though she’s getting a raw deal.

When you start looking at investments from a wider perspective, lots of interesting aspects of life come into view.

Time-wasting activities seem more wasteful than ever. I’ll be the first to confess that the hour a week I spend watching Lost is probably not the best time investment. I spend an hour of my time, a bit of my mental energy, and a tiny bit of money on a show solely for the entertainment factor. Do I get enough out of that time to make it worthwhile? It’s rather hard for me to make that case, even for a show that my wife and I both get a lot of enjoyment out of, thus it’s almost impossible for me to make the case for just flipping on the television and staring.

Things that previously didn’t seem like investments seem more like investments. The personal appearance and hygiene article comes to mind again. Most people don’t think about this as an investment, but that’s exactly what it is. You’re investing time and a bit of money in exchange for a better appearance and slightly better health. For most people, this investment seems like such a no-brainer that it’s not even something to think about, but for others, the costs of this investment (mostly the time lost) isn’t worth the reward.

Maximizing the value of your investments takes on a whole new light. It goes beyond maximizing the cash value of an hour of your time. If you can spend an hour doing work that’s incredibly grueling and draining for $20, or you can do something very easy for that hour for $18, the $18 is a far better investment opportunity because it leaves you with energy for other tasks. I think back to a time two years ago where a penny-pinching travel companion of mine insisted that we sit in an airport for eight hours to save $30 on an airline ticket - for him, that was a good investment because he could cozy up in a chair and read, but for me, it was a terrible investment because I wanted to see my infant son quite badly.

Think about things in your own life that drain your emotions, your mental acuity, and your time. What rewards do you get from those activities? Are there other opportunities where you could get more value out of your investment?