Over the last three or four days, I’ve received a bunch of emails from readers asking me why I’m not talking breathlessly about the chaos at Freddie Mac, Fannie Mae, and IndyMac. I’ve read dozens of long explanations of why this is disastrous and why it’s the worst thing people have ever seen, and I’ve read many, many people shouting that they should completely get out of all investments right now and put their cash in a little green box buried in their back yard (or some similar crazy scheme).

Here’s my take: I think there’s almost nothing to worry about, and if you’re actively selling any broad investments right now, you’re actually making a giant mistake.

Here are five reasons why you shouldn’t be panicking right now.

One: Panics happen every few years
Right now, we’re having panics in the banking and housing sectors. A few years ago, corporate accounting was destroying everything. Remember the tech sector collapse of half a decade ago? The savings and loan failures before that?

These booms and busts happen for one reason and one reason alone: most investors are sheep. They follow whatever has been hot lately, and they run away whenever there’s a bad sign. These processes are rarely rational - in the 1630s, people bet their entire life fortunes on tulips.

It took only a glance at housing prices over the last decade or so to see that there was a big bubble going on. This bubble turned out to be mixed in with the banking industry which was funding this bubble. Now we’re seeing that bubble collapse. In a few years, when all of those ARMs adjust, people will be running around yelling “PANIC” about some other sector.

Two: The talking heads shouting “PANIC!” make money from “PANIC!”
If you run out right now and sell your stock, guess who makes money? That’s right, brokers and fund managers. These people want churn. They want you to buy and sell so they can make profit on the buying and the selling. The people who are on CNBC and TheStreet.com shouting “PANIC!”

If I was a broker or an investment manager and I knew that if I shouted “PANIC!” I could make myself a mint, I’d be tempted to shout “PANIC!” I probably wouldn’t do that because it would actually not help my clients, but there are other philosophies out there. Some believe that alerting their clients to “PANIC!” can help them avoid losses. Others could actually care less about the clients and just want to profit.

There’s big money to be made in “PANIC!”

Three: Stocks are not short term investments
Unless you’re day trading (and thus making an effective career out of very short term movements), stock investments should never be short term investments. The stock market is extremely volatile over the short term - annual losses of 20% or more in stock investments are somewhat regular occurrences.

So why invest in stocks? Over the long run, the gains exceed the losses over the stock market as a whole. Here’s a quote from David Swenson, the author of the excellent book Unconventional Success:

To the extent that history provides a guide, the long-term returns for stocks encourage investors to own stocks. Jeremy Siegel’s two hundred years of data show U.S. stocks earning 8.3 percent per annum, while Roger Ibbotson’s seventy-eight years of data show stocks earning 10.4 percent per annum. No other asset class possesses such an impressive record of long-term performance.

The stock market returns very well on average. The only problem is that it’s an average of some very nice positive numbers and some very painful negative numbers - that’s the nature of an open market.

Why should one believe the stock market is going to go up in value? THIS IS THE END! Stocks will continue to go up in value over the long term for one simple reason: worker productivity. Companies over time will earn more money per employee because each employee is able to produce more value. As long as humans are innovative creatures, coming up with new technologies and ideas, then companies that implement those ideas will increase in value.

Four: Down markets are never a time to sell
At some point, the stock market will return to its previous level - there has never been a twenty year period of loss in the overall stock market.

Since the stock market is down this year, and we believe that the stock market will eventually match the previous high, now is not the time to sell. Now is the time to buy.

Let’s look at it visually using the S&P 500 from about 2000 to about 2007:

Obviously, it’s great to sell at the top - you’ll make a killing. The problem is that one never knows exactly where the top is. The market will start to drift downward and many people will think it a normal fluctuation. After a while, the talking heads on CNBC and other financial papers will begin to notice that it’s going downward and start shouting “BEAR! BEAR!” to get people to “SELL! SELL!” so they can make a profit on transaction costs. Most people still don’t move right away - it takes a little while for the “panic” to build.

Eventually (as marked above), it becomes conventional wisdom that things are disastrous - that’s where we’re at now, well into the down trend. Now, if we believe that at some point in the future things will eventually return to their original level and we can clearly see that things are way down from their original level … why would you sell? Instead, it looks like a time to buy to me.

Five: If this event is making you worried about losing everything, then you’re not appropriately diversified.
My last point is for those people who have a ton of money in the damaged sectors right now. If you’re afraid that you’re going to be losing “everything” in this down situation, then the problem isn’t the stock market. It’s your investment strategy.

Diversification is what saves you from a bubble blowing up in a particular sector. Many advisors suggest having 5% of your total assets or less in any one sector simply to a void this. That way, even if one sector loses everything, you lose at most 5% of your money - a 20% drop in one sector means only an overall 1% loss for you.

In other words, don’t put all of your eggs in one basket and you won’t panic quite so much when a basket falls to the floor.

Throughout all of this tumult, I’ve lost a fair amount of money in my retirement account. Right now, I’m contributing significantly more money per week than I was three months ago. And I feel fine. I hope you do, too.

In the reader mailbag yesterday, I alluded to the idea that I would only buy individual stocks from companies that I was strongly familiar with and whose products I used myself and not only trusted, but that I found enough value in that I would laud them to others. In other words, I’m a big believer in “buy what you know.”

Unsurprisingly, several people wrote to me asking what stocks I was referring to, and so I’ve decided to list out the seven-stock portfolio I’ve been keeping my eye on for the last several months. These are the seven stocks I would invest my money in if I were going to invest in individual stocks. At some point, I will pull the trigger and do this, likely using a buy and hold strategy and allowing all of the stocks together to comprise about 10% of my overall investments, but I’m going to assemble a strong index fund portfolio first.

Here are the seven single stocks I’d buy, likely in equal amounts. I’d buy and hold each of these unless something dramatically changed about the company - in particular, if I lost confidence in the company’s products. Together, the companies are a diverse portfolio (all are in different industries) with a few traits in common - all of them have strong products that provide value to me personally, all are financially stable and have clear plans for the future, and most of them are among the most ethical companies - three appear on Ethisphere’s list of the world’s most ethical companies in 2008.

This is not investing advice. I’m merely listing the companies I would invest in and why, in hopes that you might understand my decision-making process and perhaps add something to your own decision-making process when it comes to stock investing. I’m also not looking to day trade - I want to buy and hold over a long period of time. I also tend to lean more towards companies who behave ethically while producing products I believe in instead of the investment that will quickly maximize my buck.

Here goes.

Herman Miller (MLHR)
If I were to invest my stock in one company, it would be Herman Miller. Herman Miller is a furniture manufacturer that focuses on office chairs, and they do superb and environmentally friendly work. I own one of their Aeron chairs, and it’s simply one of the most elegantly and superbly constructed items I’ve ever owned. I was introduced to their chairs in the workplace and was so genuinely impressed that I eventually purchased one of my own - and I began carefully following the company as well. Their chairs are ecologically sound as is their factory and they’re one of the most admired companies in America, placing at the top of Fortune’s list of admired furniture companies for the past eighteen years. Their business model is stable and the business is steadily expanding, so I’m on board for the long haul.

ING Groep (ING)
For those of you who have heard me talk positively about both ING Direct and Sharebuilder on this site, this shouldn’t come as a surprise. I’ve used many different online banks and found ING Direct to be by far the most usable, and aside from Vanguard, I’ve had the easiest time with Sharebuilder for brokerage needs. The business is growing rapidly while their stock price has held largely steady, indicating to me that the company is on very solid ground financially for the long haul. A happy customer plus a solid financial standing equals a company I’ll bet on for the long haul.

Apple (AAPL)
If there’s a “bet” on this list, it’s on Apple, who produce computer products that I rely on every day. As I type this, I’m using a Mac and I’d hesitate to say that I’d ever want to go back to using a PC ever again. It’s stable, incredibly user friendly, and reliable. Their product design all around is impeccable and their sales are growing like gangbusters. The biggest reason this feels like a bet to me is that I feel like more than almost every other company, the strength of Apple is tied to its leader, Steve Jobs. I follow Apple pretty closely and I just don’t see anyone waiting in the wings, which is worrisome because of the “cult of personality” leadership at Apple. If Steve goes, I fear Apple may stumble, which is a worry over the long haul. But for now, I’m incredibly pleased with their product and their company is clearly on the right track.

Honda (HMC)
I have a lot of faith in both Honda and Toyota as car manufacturers, and all of my research has pointed me towards them as the source for my next car purchase and my experience with both companies as a driver has been very positive. I give Honda the nod over Toyota (since I don’t want to invest in two car manufacturers) because I generally believe they’re thinking more long term and their product lines are more diverse. Honda’s revenue is heading upwards and they’re recognized for their business ethics.

Costco (COST)
If there were a Costco fairly close to me (the nearest one is in West Des Moines, simply too far away), I would happily be a regular customer. I am a frequent customer of Sam’s Club in my area and I prefer Costco for product selection and employee treatment reasons. Warehouse shopping is a concept I strongly support, especially when it’s paired with ethical treatment of employees and strong prices. As with the other companies on this list, their profits and revenues are steadily marching upwards while maintaining the ethical standards they’ve become known for.

UPS (UPS)
I like UPS because they work. I’ve had dozens of packages delivered to my home without a missed delivery (as compared to FedEx, which has an atrocious 0-for-2 record since my move) and occasional earlier than expected deliveries, plus I’ve never had any issues with shipping with them, either. Given their role as a large-scale delivery company, they’re heavily involved in improving fuel economy and moving towards green solutions with their GreenFleet, plus they’re committed to high ethical standards as part of their business model. Couple that with their steadily improving financial success and it’s clear why I’d buy and hold this company.

General Mills (GIS)
My final pick is probably surprising to some given my commitment to fresh foods, but their commitment to health-conscious food production in that they’ve switched to whole grains for all of their cereals (plus my son’s incessant love for Cheerios) has slowly won me over, as has their commitment to ethical business practices. I’ve been satisfied with their products as a customer, and their financial record is strong, which all adds up to a strong picture of the company as a whole, strong enough for me to pick the stock for buying and holding.

Steve wrote in with a good question recently:

What does it actually mean to own a stock? Do you own a piece of that company? Are you just gambling that you think a company’s value will go up or down? I guess I don’t really understand the stock market.

Steve asks a good question, so let’s take a simple walk through what exactly a stock is, what owning one means, and why a person would want to own a share of stock in a company.

What is a stock? The word “stock” refers to a share of ownership in a particular company. If you own a stock, you’re an owner of some very small fraction of that company. Take, for example, Exxon. Exxon has 5.28 billion shares of stock outstanding, meaning that they have divided ownership of their company into 5.28 billion pieces. Owning a single share of Exxon stock means that you own 0.0000000189% of Exxon. That’s a very tiny fraction, but Exxon is a huge company, so that little fraction has some value.

How much value does that one share have? Right now, that one share of Exxon stock is worth $90.70 (as of this writing). Shares of Exxon are traded on an open market, meaning buyers and sellers can both make offers and sales only occur when buyer and seller agree on a price, so that $90.70 is literally the dollar amount that someone recently agreed to sell a share of Exxon stock for and someone else agreed to buy it for. In other words, that’s the value that the public estimates a single share of Exxon stock to be worth.

Right now, Exxon’s stock is worth 90.70 per share, and thus with 5.28 billion shares outstanding, that means Exxon has a market capitalization of $479.23 billion. Market capitalization is the estimate of the total value of the company based on the number of shares out there and the value that the market places on each share.

Why would you want to own a share of Exxon? There are several reasons.

First, stocks pay dividends. Exxon pays an annual dividend of $1.60 per share. A dividend is a piece of the company’s profit that a company pays out to each shareholder. With 5.28 billion shares outstanding, Exxon paid out $8.448 billion in dividends total over the last year, meaning each shareholder got $1.60. That $8.448 billion is Exxon profit that they chose not to reinvest in the company and instead pay out to shareholders.

You also own a piece of whatever would be earned if the company decided to close up shop. Exxon has a book value per share of $23.31. That means if Exxon decided to quit the business and just sell all of their assets, the shareholders would get $23.31 per share. While that wouldn’t recoup the value of the stock purchase (it’s currently $90.70 per share), it is something.

Adding the two together and one can see that a share of stock does have some cash value. It generates dividends for you while the company is in business and has some value when the company goes out of business and sells off their assets.

Larger shareholders also usually gain some voting rights when it comes to making decisions about the company. Obviously, with Exxon, an individual shareholder owns such a small portion of the company that if they allowed each such holder to have voting rights, nothing would get done with the company. Thus, there’s usually some threshold that people have to cross before they have voting rights and get to participate in corporate decision making. With some companies, that comes in the form of special voting shares - only some shares allow you to actually vote. In other companies, if you own a small amount, you vote by proxy - you basically assign someone else to vote on your behalf.

So what does that value add up to? At the moment, $90.70. The stock market is basically a free-for-all of trading where buyers and sellers can quote whatever prices they want. The “value” of a stock is whatever the buyer and seller agree on as a fair price and the $90.70 value is a recently agreed-upon value between an individual buyer and an individual seller. Other buyers and sellers then use this as a thumbnail when deciding the value of the next trade - if Exxon has good news, then it might go up to $92. If something bad happens, it might go down to $88. If things are neutral, it’ll fluctuate a bit, but stay near that value.

The chaos you see on the floor of stock exchanges is basically the chaos of tons of these trades happening at once, with people running around trying to make it happen. Much of the activity happens electronically, too.

Thus, when you buy a stock, you’re buying a piece of a company. That piece pays you dividends and also indicates ownership of a small sliver of the assets of the company. This obviously has a value, and the stronger the company is (or is predicted to become), the more value it has. Ideally, you hope to re-sell it at a higher value than you bought it for - that requires the company to demonstrate that for whatever reason it’s stronger than it was before - but in the interim, you can collect dividends and wait until you’re ready to sell it. That decision point - when to sell - is the topic of countless investment books.

If I want to buy a stock, what’s the process? In its simplest form, you basically state a price you’re willing to buy a stock for and then seek out someone willing to sell it to you at that price - this is called a “limit order.” You can also issue a “market order,” which means you’ll buy the stock at whatever price the market is currently selling it for.

Most individual stock buyers and sellers go through a stockbroker. A stockbroker is an organization that actually participates in those exchanges (it’s rather expensive to get a seat on a stock exchange). An individual, like yourself, goes to a stockbroker and pays them a fee to use their resources to get that stock for you. They might own it themselves and be willing to sell it to you, or they might have to go buy it from someone else. Either way, your fee pays for this service (and their profit margin).

Alternatively, you can buy stocks directly from individual companies. This saves on the broker fees, but it means you deal with only one company at a time and it’s also somewhat difficult to sell the shares back to the company.

In a nutshell, brokers are much more convenient for both buying and selling, but they charge a fee for the service.

So what’s a mutual fund? A mutual fund is just a collection of stocks. A typical mutual fund has their stocks chosen by a fund manager and the fees with that fund go to pay the fund manager’s salary (and the salaries of anyone working for the manager). An index fund is a mutual fund without an active manager - it operates based on a clearly-specified set of rules that do not require active intervention. Thus, the fees for an index fund are much lower. Some people prefer having an actual person manage the fund; as for me, I’ll take the index fund almost every time.

Good luck, Steve. Once you have this basic info in hand, there’s an almost infinite amount of material to learn about the stock market.

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.

As I’ve mentioned many times before, all of my taxable investing, as well as my Roth IRA, is done directly through Vanguard.

I use Vanguard because I trust them - they’re a nonprofit that has a stellar long-term record and their index fund investment options are quite strong. I’m not alone in feeling this way - for example, Paul Farrell, in his book The Lazy Person’s Guide to Investing (read my review) states the following on page 167 of the paperback:

Specifically, Vanguard’s no-load index funds hav become the benchmark and the standard against which every other fund, index or active, and all fund families are measured. They are the proverbial pain in the [rear] for the vast majority of their competition in the mutual fund industry.

… and that’s after the quote from the other day where Farrell said “Bottom line: if you want predictable performance, pick cheap funds. That means no-load index funds.”

In a nutshell, if you’re looking for a place to sock away your money for the long term (more than five years, at least), Vanguard is a great place to put it.

There’s only one problem: most of the funds that Vanguard offers have a $3,000 minimum for investing. For a lot of people just getting started, that’s a hard minimum investment to swallow. A lot of people want to get started with just $50 a month or so - with that amount, it’d take 60 months - five years - to build up the minimum just to buy in. That’s a long wait.

So what are the options? Let’s look at a few of them.

Save up the cash in a savings account. This is the method I used when saving up for my first fund purchase. Since I use ING Direct for my primary checking and savings, I just set up a sub-account specifically for that purpose, then I set up an automatic transfer of a small amount into that account each week. Then I just sat back and waited, using the interest on that account as a bit of wind in my sails.

The “save up cash in a savings account” option has the advantage that your money will slowly grow over time as you save towards the goal - it’s not at risk at all.

Invest in another fund. There are similar index funds to the Vanguard offerings sold by other investment houses, often with lower minimum investments required. However, in almost every case, these funds have a higher expense ratio - meaning that the investment house skims more off the top for the investment. For example, the Vanguard 500 (VFINX), which matches the stocks held in the S&P 500, has an expense ratio of 0.18% - over the course of a year, for every $1,000 you have in that fund, Vanguard uses $1.80 for the expense of managing the fund. Many other similar funds to the Vanguard 500 at other houses have expense ratios at 0.5% or above - for every $1,000 in that fund, the company uses $5 for fund management.

While there are deals out there if you dig for them (and I’m pretty much expecting someone to find a fund with a competitive expense ratio and then comment about it), Vanguard’s funds are easy because they’re so consistent across the board. They’re always among the cheapest.

Buy an ETF through a brokerage. Another popular option is to just buy a very similar ETF through a brokerage. For those unaware, an ETF is an exchange traded fund - basically, it functions like a single stock that matches the value of a particular index. A specific exaple is the Spider ETF, which matches the S&P 500 in much the same way that the Vanguard 500 does.

There are some big benefits to this. You only have to match whatever minimums your brokerage sets out for you, and these are usually quite low. Their expense ratio is usually very low - Spider’s expenses are lower than the Vanguard 500. Plus, if you use a fee-free brokerage like Zecco, you don’t have to pay any commissions on buying and selling.

However, in the end, they’re still not the best deal, as pointed out by this Forbes article. For starters, ETFs hold onto your dividends for quite a while, whereas funds pay out dividends quite quickly. There can be as much as a three month difference between the two, and if you’re reinvesting, that alone can easily make up the tiny difference in expense ratios. Plus, when you buy in, you effectively have to pay a small premium on the value (the bid-ask spread) in order to find someone selling that ETF - for Spider, this is usually around 0.07%. If you’re using a brokerage that charges fees, that’s another extra cost - investing directly with Vanguard doesn’t cost a dime. These make up the difference and more, making ETFs a slightly worse deal than investing directly in funds.

My recommendation? Set up a savings account and start saving your nickels and dimes. With a little patience, you’ll be there in no time and then you can buy into an excellent fund.