In the last week, the Dow Jones Industrial average closed at a thirteen month high and, at the same time, unemployment hit double digits for the first time since the early eighties. I thought that the Dow Jones was supposed to represent how the economy was doing, but that’s not the case. What does it mean? What is the point of reporting it if it doesn’t mean anything?

The Dow Jones Industrial Average (often called “the Dow” for short) is an incredibly common piece of news, yet the purpose of it is often really unclear to newswatchers. Is it an indication of the state of the economy? Not really. Is it an indication of the state of the stock market? Not really.

Well, then, what is it? And why does it get reported so often?

What Is the Dow?
The “Dow” usually refers to the Dow Jones Industrial Average. It was invented by Charles Dow, a co-founder of Dow Jones & Company, which is a publishing and information company.

The “Dow” is simply an average of the value of one share each of thirty of the largest companies in the United States. It does not include any of the thousands of other publicly traded companies.

Of course, a bit of math checking would reveal that if you added up the current market value of a share of each of the thirty companies in the Dow and divided by thirty, you would not get a number anywhere close to the current value of the Dow. There are several reasons for this, but the most important reason is that companies sometimes choose to split their stocks, basically exchanging two new shares for one old share (or some similar exchange). In order to make sure that such an exchange doesn’t wreck the value of the Dow (because that would effectively mean one of the thirty companies just had a single share of their stock drop by half), Dow Jones & Company accounts for it by using a scaled average, in which they effectively keep track of past splits and multiply the values of each share accordingly. Thus, even when a company splits their stock, it doesn’t affect the Dow average at all.

So, basically, the Dow is just a quick summary of the current value of shares of thirty large companies.

The Value of a Share
But what is the current value of a share?

In simplest terms, it’s all about supply and demand, just like buying and selling anything. The stock market is basically no different than a giant flea market, with many, many people buying and selling thousands of items, all trying to make a profit. Depending on the news (and the behavior of others), the price of individual items goes up and down.

In simplest terms, if there are more people buying than selling, the price of a share goes up. If there are more people selling than buying, the price of a share goes down.

What causes this shift? Information about a given company or about the economy in general. Predictions about what the future holds. The behaviors of others. All of these affect whether people are buying at the moment or selling at the moment.

The Value of the Dow
In effect, the Dow is just an average of thirty items from this giant flea market. What information can we get from that?

Generally, it’s not ruled by news from one specific company. One company’s bad news can affect it a little, but not enough to make a huge difference.

It’s also not affected too much by how things are going right now. It’s important to remember that when people buy and sell stocks, they’re doing it based on what they think the future price holds. Thus, the value of the Dow will often go down well before real economic news (like the unemployment rate) turns bad, and the value of the Dow will often go up well before real economic news turns good.

To put it simply, at the first sign the economy is slowing at all – or that one sector is seeing real problems – the Dow will begin to drop, and often rapidly. At the first sign that a recession is slowing even a bit, the Dow will begin to go up, and often rapidly (and that’s what’s happening right now).

So, look at the Dow as a predictor, nothing more, nothing less. It’s a predictor of the general direction of the economy over the next year or so. If the stock market is going up – as it is right now – the economy will generally improve from its current state over the next year.

Why the big rebound? To put it simply, the greater world finally realized that the only thing we had to fear was fear itself. The economy didn’t collapse. Instead, we just find ourselves in the middle of – and perhaps moving towards the later stages of – a rather strong recession.

Naturally, as the economy begins to slowly come out of a recession, the stock market goes gangbusters. Companies are beginning to reawaken and slowly increase production, a radically different picture than the massive cost cutting of the past year. Unemployment is somewhat stable – it might go up a little more, but it’s no longer on the rocket ship that it once was.

In short, we’re getting through this and we see sunlight at the end of the tunnel.

What does this mean for you and me, as small individual investors? Does this mean we should convert all of our investments into stocks and ride the rocket ship?

To put it simply, no, it doesn’t.

Hedging your long-term investments on what you think the stock market (or any investment market) is going to do in the short term is called market timing, and it’s never a good idea.

My philosophy is simple, and it’s one that was taught to me by many, many wise investment writers and investment books: unless you’re a day trader or spend a significant amount of time daily studying the stock market, you’re a long term investor, and long term investors have nothing to gain from trying to time the market.

Simply put, the vagaries and complexities and huge sums dealt with on the stock market each and every day, with so much insider information floating around and individuals playing all kinds of manipulative gains, plus the total uncertainty of day-to-day world events (if you recall, for example, 9/11 was wholly unexpected), makes it a very unsafe place for the typical person trying to save for retirement or for another long term goal. Instead, their reward is to simply look at the stock market as a long term place to put their money for a long term investment with a payoff date more than ten years down the road.

It’s all about your goals and your risk tolerance. It has nothing to do with what’s going on today, tomorrow, or next week.

Don’t let yourself be swayed by huge positive returns in the short term – or huge negative returns in the short term, either. Just stay the course with what you’re doing. If you find that the stress of such swings makes you nervous, redirect your future contributions to something with lower risk, like bonds.

Otherwise, just let things ride. Tomorrow might bring a huge unexpected event that we can’t see coming – or that some CEO is keeping under wraps for now. Given time, the stock market will correct itself from that, but over the short term, it’s basically little more than gambling unless you have the time and resources to devote yourself to truly careful study – or you’re investing with a small sliver of your portfolio that’s there solely to play around with.

That strategy pretty much matches the stock market. In fact, if you choose to just invest in the Vanguard 500, it almost exactly matches the ups and downs of the S&P 500 stock index.

Let’s look at the other side of the coin. Let’s say you’re following normal stock picking advice. You have a portfolio of 20 individual stocks (so that no piece of your portfolio is more than 5% of your total investment – diversification, after all). You devote an hour a week to studying each stock in detail, so you know what’s going on with that company. You also devote five hours a week to finding new, worthwhile companies to invest in, potentially replacing the slots in your portfolio.

You’re able to invest $10,000 a year – and we’re not worried about brokerage fees at all. What’s your earnings per hour doing all that research?

Let’s say all that work manages to beat the Vanguard 500 by 1% per year. Historically, VFINX has returned 9.56% per year since its inception (remember, that number includes dividends and stock price increases and decreases, and it does include 2008), so we’ll use that number as an annual return baseline.

Over a ten year period, VFINX would turn your $10,000 a year into a sum total of $170,968.66. Meanwhile, that portfolio that beats the S&P 500 by 1% would turn $10,000 a year into a sum total of $181,005.77. Your extra effort of 25 hours a week for ten years has earned you $10,037.11 during that period – an hourly wage of $0.77. Ouch.

“Come on!” you say. “Stocks are a long term investment!” So let’s look at the thirty year mark. Over a thirty year period, VFINX would turn your $10,000 a year into a sum total of $1,061,590.42. Similarly, your 1% better investment portfolio, with 25 hours a week over ten years invested in it, will turn that annual $10,000 into $1,347,885.59. Your extra effort of 25 hours a week for thirty years has earned you $286,295.18 – an hourly wage of $7.34. Congratulations, your investing expertise has earned you minimum wage.

“Come on!” you say. “I can do better than 1% over the S&P 500 every year for thirty years!” (Of course, if you actually believe that, I have a bridge to sell you.) So let’s make it 2% – you beat the S&P 500 by 2% every year for thirty years. Your extra effort for 25 hours a week for thirty years earns you an hourly wage of $16.60.

If you have the intellectual ability to do enough rigorous analysis to beat the market by 2% year in and year out, you can most certainly be earning more than $16.60 an hour with your time.

But what if you can invest more than $10,000 a year? If you’re in that group, where you’re able to invest significantly more than $10,000 a year in whatever you want and you’re sure you can beat the market consistently over the long haul, by all means, choose the route that’s right for you. However, I argue the statement above still holds – with those kinds of resources and intellectual acumen, you likely have better ways to earn money.

Here’s the take-home message: individual stock investing, done with adequate research, is a lot of work. Unless you have a very large amount to invest, the extra work is simply not worth it in terms of the extra income per hour.

Now, that’s not to say that you shouldn’t dabble in individual stock investing. I see nothing wrong with taking a sliver of your investments and playing the market, so to speak. However, recognize that such investments are largely a gamble unless you do adequate research. And, if you do adequate research, you have to blow away the overall market to make it worth your time.

My conclusion is simple. If you’re an individual investor without a ton of money to invest, it’s simply not worth your time to chase individual stocks. The time that’s required to adequately study individual stocks and build a truly diverse portfolio will make the gains small enough per hour of your work that you might as well do something else with your time, like build your skill set for your career, improve your health, or start your own side business.

Instead, just invest in a very broad index fund and ride the market at a low price with little time investment of your own. Better yet, do it with a balanced portfolio – don’t put it all into stocks, so that you can ride through the down markets with less worry and smaller losses.

Like you, I think the stock market is near the bottom right now and will go up greatly in the next three to five years. I have some extra cash (about $10K) but I don’t know exactly what to do with it to get on board. How would you do it?

In fact, I’m already doing it. My wife and I made the decision to start investing much of our long-term savings for a home into stocks because we both feel that the market is at the bottom right now and is poised for a big rebound in the next five to ten years.

So, what are we doing?

What Are We Investing In?
Most of our investment is going into index funds. For those unaware, index funds are a way to invest in a lot of stocks at once at a cheap price. A given index fund is usually governed by a simple rule – all stocks in the S&P 500, for example. Index funds have long been lauded as a great way to easily diversify at a very cheap cost.

We’re investing all of our money equally into two funds – the Vanguard Total Stock Market Index (which basically covers all domestic stocks) and the Vanguard Total International Stock Index (which broadly covers all international markets). In other words, the money is as diverse as we can make it.

At the same time, there are a number of individual companies that my wife and I particularly believe in for one reason or another (Apple being one, for example). While we both recognize that individual stock investing is a risky proposition, we also know that our investment choices reflect the things we believe in.

So, we’re allocating a small portion of our overall investment into a diversity of individual stocks – 20, to be exact. Each month, we’re automatically investing a small amount into each of these twenty stocks. Our investment amount in individual stocks is about 25% of the amount we’re putting into index funds.

Who Are We Investing With?
Our index fund investments are handled by Vanguard. We’ve trusted them for years – they’re known for their low-cost index funds and their reliability, which is exactly what we want. They’re also managing my Roth IRA, which they’ve done quite well.

Our individual stocks are being managed by Sharebuilder, which we decided on after a fair amount of hand-wringing. Their automatic investment plans were simple and reasonably priced (without any of the factors that made us nervous about the few brokers that undercut Sharebuilder in price), plus we weren’t restricted in our investment choices (as many of the companies we wanted to invest in didn’t have direct plans for investing). Since we’re planning on just doing automatic investing until the time comes that we actually need the money and then we’ll sell all of it (no market timing here), the actual management of the money for tax purposes will be pretty straightforward, too.

Isn’t This Risky?
Undoubtedly it is. That’s why we’re not putting any of our emergency fund, any of our retirement, or any of our short-term saving goals at risk. The money we’re investing here is money that we will only tap in the long term (ten or fifteen years or so) for the place in the country we’ve always dreamed of. Ideally, the stock market will help take us there a bit quicker than we might be able to otherwise, but if it doesn’t work, we’ve not really risked anything that affects our day-to-day lives, then or now.

Also, this plan merely reflects what we’re doing. You might want to be more conservative with your own savings for long term goals like this, and you certainly wouldn’t want to do anything like this with money you will need to rely on in the future.

We’re only able to start doing things like this because we’ve cut our spending drastically over time and we live by a mantra of spending less than we earn. Because of that, we can now make choices like this, paving the way to our dreams.

What he told me boiled down to four principles.

I spend way less than I earn. By this, he meant he had enough saved up at age fifty to walk away from his work, but he kept at it for several more years so that he could build up even more savings. He wanted the investments to return substantially more each year than he would spend.

I keep a years’ worth of living expenses in cash and CDs. This isn’t just an emergency fund, but it helps him do okay through the ups and downs of his other investments. If they don’t return as well as he’d like for a quarter or two, things aren’t disastrous – he still has a lot of breathing room.

I roll the excess back into my investments. Whenever he starts to build up way more than a year’s worth of savings, he rolls it into more investments. He keeps pretty careful track of his spending and thus has a strong estimate of the year to come. If the amount in cash and CDs gets over fifteen months worth of living expenses or so, he cuts it down to twelve months worth and puts that difference into his investments. And what are they?

All of the rest of my money is in stocks which pay a good dividend. All he does is buy stocks in companies he believes in over the long haul that pays good dividends. He rattled off quite a number of stocks, but the four I remembered were GE, AT&T, Verizon, and Bank of America.

So how does that work? Let’s take a look at AT&T (Google Finance). As I write this, a share of AT&T is at 24.83 and has a dividend of 0.40. What that means is that every three months, for each share of AT&T that a person holds, AT&T pays that person $0.40.

So, let’s say that over time, our friend has bought 1,000 shares of AT&T – at today’s market prices, that would have cost him just short of $25,000. This means that every three months this year, AT&T is directly going to pay him $400. Over the course of a year, that would have added up to $1,600. And if that dividend holds, over ten years, the investment would pay out $16,000.

Obviously, the board of directors of a company can choose to raise or lower a company’s dividends – here’s a recent history of AT&T dividends. That’s why our friend chooses to buy only stable companies that have a long history of paying good dividends.

What about the stock price? Aren’t stocks tanking? For the most part, our friend doesn’t care about the stock price. All he cares about is the dividend – as long as it stays reasonable, it doesn’t matter to him how much or how little the stock can sell for. He intends to hold it for a very, very long time.

In fact, he’s actually ecstatic about the low prices on many stocks. He’s about to buy more of his dividend-earning stocks and given the low market, he can get more shares for his dollar right now.

Is this a good investing strategy for me? Provided that you’re willing to have a diverse selection of dividend-paying stocks (more than 10 with no more than 20% of your money in any individual company or any sector) and you’re willing to pay attention to it so you don’t end up holding a company as it falls down the Enron drain, this strategy can work. It’s often discussed in investing books as “dividend investing” and can work very well for you, not only as a retirement plan, but as a way to build steady income.

Do you want to know more? My friend strongly recommended that I read The Ultimate Dividend Playbook, a book produced by Morningstar that covers dividend investing in detail. I can certainly say I’m intrigued, and I’ve added the book to my to-be-read pile.

I have a friend who keeps cajoling me that I should become a day trader. “Come on!” he says. “You could write the stuff for The Simple Dollar while daytrading! It’s easy as pie!”

So one day I asked him to explain to me what he was doing. He offered up a bunch of explanations that basically amounted to technical analysis using a bunch of online tools.

Then I asked the $64,000 question: “Do you actually know anything about the companies whose stocks you’re buying and selling?” He responds, “Not too much, but I don’t need to.”

My friend is a speculator. That’s fine – it works for him. But it only works because he devotes his life to figuring out small inefficiencies in the market. He’s really passionate about finding them.

For most of us, though, we don’t have the time, patience, or interest to engage in that minutiae. We are investors.

Chapter 1 – Investment Versus Speculation: Results to Be Expected by the Intelligent Investor
Graham gets down to business. In only the second paragraph of the chapter, he specifies the difference between investors and speculators:

An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

In Graham’s view, an investment is something that you’ve analyzed carefully. You know exactly what you’re buying. You know it’s stable for the long haul. You also know that it will give you an adequate return, either through an increase in share value or through healthy dividends for the price you pay.

The ones that scream “BUY! BUY! BUY! WE’RE ALL GETTING RICH!” when the stock market is high and then scream “SELL! SELL! WE’RE ALL GOING BANKRUPT!” when the market is low are speculators. The people that look for undervalued companies no matter what the market is doing, buy them, then only sell them if they actually need the money or if they’re not undervalued any more, those people are investors.

Graham argues that one of the biggest dangers for investors is that they’re speculating when they believe they’re investing. They buy a stock, for instance, based on a hot tip that, if true, might make it a good investment. Or they purchase a mutual fund based on a television ad or magazine ad, without really doing the due diligence to see whether it’s a quality investment based on sound principles that ensures quite a bit of safety in the investment and some sort of decent return.

Furthermore, Graham states that the only way you can be an investor (and not a speculator) that beats the market is by having an investment philosophy that’s based on sound logic that’s not popular on Wall Street at the moment.

I immediately thought of Jim Cramer’s comment on Graham during the peak of the 2000 stock market bubble, which Zweig mentioned in his commentary in the introduction:

In February 2000, hedge-fund manager James J. Cramer proclaimed that Internet-related companies “are the only ones worth owning right now.” These “winners of the new world,” as he called them, “are the only ones that are going higher consistently in good days and bad.” Cramer even took a potshot at Graham: “You have to throw out all of the matrices and formulas and texts that existed before the Web … If we used any of what Graham and Dodd teach us, we wouldn’t have a dime under management.”

[...]

By year-end 2002, [...] a $10,000 investment spread equally across Cramer’s picks would have lost 94%, leaving you with a grand total of $597.44.

Interestingly, most of the internet stocks during the dot com bubble wouldn’t have passed the Graham test. Not even close. Score one for the unpopular method.

So, what can we learn here? Don’t invest without knowing what you’re buying. Study it very carefully before you buy. If you want to speculate, that’s fine, but don’t speculate with any money you’ll actually need for the future.

Commentary on Chapter 1
Zweig does a good job of boiling down Graham’s view on what investment is, summarizing it in three points:

* you must thoroughly analyze a company, and the soundness of the underlying businesses, before you buy its stock;
* you must deliberately protect yourself against serious losses;
* you must aspire to “adequate,” not extraordinary, performance.

If you want an absurd return that’s going to blow away the market over the short term, value investing probably isn’t for you. Having said that, though, Graham’s principles are intended to avoid huge losses as well. That’s because the entire idea is to seek out undervalued companies – ones that, for some reason, the market has overlooked. Maybe they’re boring. Maybe they have an undeserved bad reputation.

Zweig makes that point again a bit later:

If they beat the market over any period, no matter how dangerous or dumb their tactics, people boasted that they were “right.” But the intelligent investor has no interest in being temporarily right.

In short, investing fads are a joke. Just a few weeks ago, I scathed the book Millionaire by Thirty because it was just that – an investing fad with short term success that the author tried to parlay into this great investing strategy that was timeless. It wasn’t. Zweig points out at least a dozen more similar investing fads or shortcut formulas, all of which worked over the short term, and none of which work over the long term.

What does work, then? Knowing in detail what you’re investing in. Is it a good, stable, safe company? Is it undervalued? Does it pay solid dividends? Those are where the real values are at. They’re not glamorous, but if you can find them, you’ll always do well, no matter how the market changes.

Next Friday, we’ll look at Chapter 2: The Investor and Inflation.

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.

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.

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.

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.

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.

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.

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.

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.

I wrote out the case for index funds a while back: they’re easy and don’t require much time investment, they’re very cost efficient, and they outperform virtually all managed mutual funds. However, I wanted to point out that this argument isn’t mine and mine alone – it’s shared by a small army of people who write on investment topics. (In the quotes below, I’ve added my own emphasis.)

For starters, John Bogle, the founder of Vanguard, writes in The Little Book of Common Sense Investing (read my review of the book) on page 200:

Deep down, I remain absolutely confident that the vast majority of American families will be well served by owning their equity holdings in an all-U.S. stock-market index portfolio and holding their bonds in an all-U.S. bond-market index portfolio… The rationale for a 100-percent index fund portfolio remains as solid as a rock. It’s all about common sense.

Burton J. Malkiel, a Princeton professor and a former member of the Council of Economic Advisors, writes in A Random Walk Down Wall Street (read my review) on page 358 of the ninth edition paperback:

For many investors, especially those who prefer an easy, low-risk solution to investing, I recommend bowing to the wisdom of the market and using index funds for the entire investment portfolio. For all investors, however, I recommend that at least a portion of the investment portfolio – especially the retirement portion – be invested in index funds.

Malkiel also writes in The Random Walk Guide to Investing (read my review), paperback edition, page 136:

[Index fund investing] has outperformed all but a tiny handful of the thousands of equity mutual funds that are sold to the public. Let’s list all the advantages of an index fund strategy:
- Index funds simplify investing. You don’t have to choose among the thousands of individual stocks and mutual funds available to the public.
- Index funds are cost-efficient. [Many] have no sales charges and have miniscule expense charges. Moreover, index funds do a minimal amount of trading. Thus, they avoid the very heavy transactions costs of actively managed funds, which tend to turn over their entire portfolio about once a year.
- Index funds regularly produce higher returns for investors than do actively managed funds.
- Index funds are predictable. You know beyond doubt that you will earn the rate of return provided by the stock market. Yes, you will lose money when the market declines, but you will never own the fund that performs several times worse than the market.
- Index funds are tax-efficient. If you do own stocks in taxable accounts (that is, outside your IRA or retirement plan), then you need to invest in index funds that don’t trade from security to security and therefor don’t tend to generate taxable gains.

What about Taylor Larimore, Mel Lindauer, and Michael LeBoeuf, authors of the acclaimed Bogleheads’ Guide to Investing (read my review), on page 78 of the paperback edition?

Index funds outperform approximately 80 percent of all actively managed funds over long periods of time. They do so for one simple reason: rock-bottom costs. In a random market, we don’t know what future returns will be. However, we do know that an investor that keeps his or her costs low will earn a higher return than one who does not. That’s the indexer’s edge. More specifically, here are the cost and other advantages of indexing:

1. There are no sales commissions.
2. Operating expenses are low.
3. Many index funds are tax efficient.
4. You don’t have to hire a money manager.
5. Index funds are highly diversified and less risky.
6. It doesn’t much matter who manages the fund.
7. Style drift and tracking errors aren’t a problem.

William Bernstein, one of the nation’s top financial theorists, writes on page 98 of The Four Pillars of Investing (read my review):

Clearly, the best way to avoid [overpriced and underperforming mutual funds] is to simply keep your expenses to a minimum and buy the whole market with an index fund.

And then on page 102:

Failing to diversify properly is the equivalent of taking [your stock investment's] uncertain return and then going to Las Vegas with it. It’s bad enough that you have to take market risk. Only a fool takes on the additional risk of doing yet more damage by failing to diversify properly with his or her nest egg. Avoid the problem – buy a well-run index fund and own the whole market.

Paul Farrell, a former Morgan Stanley investment banker and financial reporter, writes in The Lazy Person’s Guide to Investing (read my review) on page 111 of the paperback edition:

Of all the predictors, the [Financial Research Corporation] concluded that the expense ratio is the only really reliable one in predicting future performance, because funds with low operating costs “deliver above average future performance across nearly all time periods.”

Conversely, all other predictors turned out to be unreliable – including Morningstar’s famed star ratings and the highly regarded Sharpe Ratio developed by a Nobel laureate in economics.

Bottom line: if you want predictable performance, pick cheap funds. That means no-load index funds. And since Vanguard has the lowest expenses, it should come as no surprise that its funds appear over and over in the lazy portfolios developed by so many independent sources.

The Sharpe Ratio? That refers to William Sharpe, winner of the 1990 Nobel Prize in Economics and professor emeritus at Stanford. In Investors and Markets, he writes on page 146:

An index fund investor can then come very close to achieving the expected utility attainable with large amounts of expensive research and analysis… [the argument that] few of us are as smart as all of us, it is hard to identify them in advance, and they may charge more than they are worth is perhaps the most realistic argument for investing much (if not all) of one’s money in mutual funds.

Even Jim Cramer, who couldn’t possibly be a louder advocate of individual stock investing, says the following in Stay Mad For Life (read my review) on page 87:

Invest in index funds or the lowest-cost mutual funds offered by your 401(k) plan. This is the conventional wisdom on Wall Street, but it’s the advice that most people fail to take. People always want to know which mutual fund will give them the best return, but it turns out that’s a bad question. Even before you add up the fees, actively managed funds fail to beat the market 80 percent to 90 percent of the time. That means that at least in your 401(k), you’re better off investing in an index fund with low costs that simply tries to mimic the performance of the entire market than in a mutual fund that tries to beat the market.

Here’s the scoop in a nutshell, people. If you’re like me and you don’t have hours every week to study individual stocks, but you want to invest in stocks and enjoy some of the tremendous gains you can earn, there is no better option available to you than a low-cost index fund. As of this moment, every single dime (outside of my retirement plan) that I have invested in the stock market is in Vanguard index funds. I’ve watched tons of individual stocks and mutual funds and how they’ve done over the last few years and these guys are all spot on – index funds simply get the job done, easily and effectively.

If you have extra money and want to invest it in the stock market, index funds are the way to go. I got started with Vanguard and they’ve treated me exceptionally well both in investment quality and customer service – I’ve never seen any reason to go anywhere else.

Peter Lynch is a Wall Street legend. He drove Fidelity’s Magellan mutual fund to some incredible returns in the 1970s and 1980s, year after year. From 1977, when he took over the fund, to 1990, when he retired, that fund grew from $18 million in assets to $14 billion. In those thirteen years, a single share of the Magellan fund increased 900% in value – a 29.2% annual return – and outperformed the stock market by 13.4% annually. That’s an incredible run, without much question the best run of more than ten years ever by a mutual fund manager.

As a result, I decided to dip my toes into his trifecta of books, starting with Learn to Earn, which is theoretically Lynch’s “beginner” book – and I liked it quite a bit. It was a great introduction to business and investing for people who don’t know the first thing about business or investing, and coupled with Lynch and Rothchild’s great writing ability, it was a very enjoyable and educational book. So, I know Lynch is a good writer and a great investor. This leaves me practically salivating to read Lynch’s One Up On Wall Street, the subject of this review.

One Up On Wall Street focuses on the idea that observations in your day to day life can help you identify individual stocks that you can make a killing on. What industries do you know well? What companies seem to be surging in that area, based on your observations? Right there, you have the beginnings of some great investing choices. Let’s dig in and see how Lynch describes this all playing out.

Looking Into One Up On Wall Street

The book opens with an impassioned argument from Lynch on behalf of seeking out “tenbaggers,” which refers to stocks that increase in value ten times from their initial investment – buy a stock at 10, when it goes to 100 you have a tenbagger. Lynch makes the astute point that if you buy six stocks, five of them go to zero, and one is a tenbagger, your rate of return is still 66% – an utter killing. Clearly, Lynch’s argument for individual stock investing is that you can occasionally hit a grand slam and make up big time for a few strikeouts.

Preparing to Invest
Most of this section focuses on one key point: ignore the analysts and “experts.” Instead of tuning into CNBC for the “hot” picks, do your own research and find the stocks that you understand and believe in. Also, don’t try to time the market or predict the economy. Very few people can do that well – if Ben Bernanke can’t do it all the time, how can you? The economy is incredibly complex – don’t get egotistical and believe that you know how it works.

Instead, focus on what you know. Look at companies and industries that you’re familiar with. Listen to what people you know are talking about and follow that to your investments. I know personally that I strongly encouraged one investor to buy Google at the IPO because I knew the search engine business pretty well. A friend of mine swore up and down that Starbucks was going to be huge circa 1992. Just listen to what people say, do your own investigating, and follow up on what you find.

Most important of all, Lynch offers three questions that you need to seriously answer before you start investing in individual stocks.

1. Do I own a house? If you don’t, buy a house first. It provides you a stable and permanent place to hang your hat. Some might argue with this advice, but the permanence and investment qualities of a home, the advice does make a lot of sense. That doesn’t mean fully owning a house, but just to be in one and have a stable non-adjustable mortgage that is building equity.

2. Do I need the money? Don’t invest with money that will leave you feeling sick if you lose it. Use extra money, money that won’t devastate you with each loss. You need to be able to stomach big losses with the money without breaking a sweat if you’re going to swing for the fences.

3. Do I have the personal qualities it takes to succeed? Lynch lists patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit mistakes, and the ability to ignore general panic. Notice that among these traits, a high level of intelligence is not found – you don’t have to be a genius to succeed at investing.

Picking Winners
The message of this entire portion of the book can be summed up in three words: do your homework. Sure, you should seek out inspiration for companies to look into from your day to day life – companies you observe doing good business and attracting strong positive word of mouth – but once you’ve identified companies, it’s time to dig in and do the research.

What kind of research? Lynch literally goes on for a hundred pages on the research one should do before investing. Basically, learn everything you can about the company – what their balance sheet looks like, who their management team is, how they compare to similar companies, and so on. Here are five big positive signs to look for, those these just scratch the surface:
- A low price-to-earnings ratio, especially as compared to similar companies
- A low percentage of institutional investors
- Insiders buying the company’s stock
- The company buying back its own stock
- A low debt-to-equity ratio, especially as compared to similar companies

Even if you’ve found a stock that looks really good according to the numbers, don’t invest just because of the numbers. Make sure you can describe why this business is a good business and why you’re buying this stock – and the fact that the stock is going up is not a good reason.

My favorite tip? The second you hear people on CNBC announcing that your sector of interest is “hot” or that the specific stock you own is “hot” is the exact second to start thinking seriously about selling the stock. Lynch all but says to do the exact opposite of what the analysts are saying, particularly in the media – the hot stocks are a bad idea, but the boring stocks are a good idea.

I really am just scratching the surface here. The amount of real meat in this section to dig into if you’re into individual stock investing is quite amazing.

The Long Term View
So, now that you have the tools to identify a stock, what next? The final section discusses assembling a portfolio, knowing when to sell and when to buy, and that conventional wisdom here, once again, is often bogus. Here are five of the best tips I pulled out of this section.

Sell the second that your reason to own the company changes, but not a second before. Don’t just sell to take gains – if your reason for owning the company is still true, you’re probably just guaranteeing that you’ll miss out on some additional gains. Along the same lines, you should know exactly what your reason for ownership is and know what exactly constitutes a change in that reason. If you own because of the owners, sell when the ownership changes, for example.

Buy when everyone else is selling (i.e., when the market is down). This just means that the market decided to put stocks on sale. Take advantage of that sale.

Be patient. As long as your fundamental reasons for investing don’t change, don’t get impatient. Sit on that stock. Sometimes it takes years for a stock to truly take off.

Don’t buy a company you don’t believe in just because the stock is a value. Lynch’s take on the value investing concept is that you shouldn’t just buy because a stock seems cheap – you should believe in the company with sound reasons backing up that belief. Don’t just blindly follow the numbers.

The single best tip of all: “If you can’t convince yourself ‘When I’m down 25 percent, I’m a buyer’ and banish forever the fatal thought ‘When I’m down 25 percent, I’m a seller,’ then you’ll never make a decent profit in stocks. In other words, don’t invest in a company unless you have a compelling reason to invest – and believe in that reason.

Buy or Don’t Buy?

This is perhaps the most thorough and enjoyable book I’ve read on individual stock investing, surpassing my previous favorite on the topic. It is a thorough grounding in what to look for when picking an individual company to invest in – and what those investment numbers actually mean. Best of all, it’s all wrapped up in Lynch’s writing style, which is quite good and very absorbing.

Some of the specific examples in this book are a bit dated, but with just a bit of work using online tools like Yahoo! Finance or clever Google searching, you can basically recreate the examples using current stocks. Better yet, when you do that, you find out that the strategies still work like a charm – for instance, when I first started utilizing the information in this book, I picked Apple (AAPL) at 94. It proceeded to break 200 within six months.

If you have any interest in individual stock investing at all, read this book. It’s well worth it – and it’s earned a coveted place on my permanent bookshelf – not many books do.

But how? For the average person, the diversity of options for investing in stocks are overwhelming. Should I buy a mutual fund? Should I buy individual stocks? How do I even get started when I’ve figured out what I want to do? What are my investing goals? How do I even describe those goals?

I used to feel overwhelmed by such questions until I sat down and did the research, but I discovered that for the beginning investor, there’s really only a handful of simple steps that you need to follow to make smart investment choices. If you’re at the point where your debt is under control, your savings account is getting quite fat, and you’re looking for better options, here’s how you get started.

1. Figure out your goals.
When you first start thinking about this, it seems nebulous. It’s often hard to tangibly state what your goals are, especially if you’re young and single. However, you often find that they day you get married, it feels like a flood of goals hit you at once – buying a house, having a child, and so on.

Here’s what to do to get started. Take out a sheet of paper and list every financial goal you have in your life right now. What are you saving for? What would you like to be saving for? Things that might wind up on this list are retirement, your children’s education, a house down payment, complete debt freedom, a car, “walk away from your job” money, money to start a business, and so on. Some of those will be important to you, some won’t, and you may have some that aren’t even listed there.

Then, take that list and rank them by importance to you (or to you and your spouse). Don’t worry about what society says, but I will say that younger people tend to undervalue the importance of retirement. Other than that, it’s really about what’s important in your own life – not in what society thinks or what someone else sees as being important in life.

I tend to argue in favor of focusing on the top two to four goals. This way, an average person can actually reasonably accomplish those top goals in a reasonable timeframe. Figure out that time frame for those top goals. How much time is it before you reach that goal?

This doesn’t mean that your goals are set in stone. Everyone’s life changes over time and your goals may in fact change. The point is that your investment decisions are led by your goals, so before you even start investing, you should have a good grasp on what your goals are.

In my own life, I have several goals: retirement (targeted for age 60), my children’s college education (targeted for about seventeen years down the road), a new minivan (targeted for 1-2 years from now), and a new house in the countryside (targeted for about twelve years from now). Each of these have a different investment strategy, which we’ll get to in a minute.

2. Know your risk tolerance.
One major piece of the puzzle that people don’t address before they start investing is their risk tolerance. Often, they overestimate their risk tolerance, then find themselves in an investment situation that leaves them feeling very nervous about their financial position.

Spend some time thinking about this. Would you not worry if you woke up and found out that you had lost 5% of your investment if you knew in the long run it would build up in value? How about 20%? If you had $10,000 in stocks, and then over a very bearish month, $2,000 of that vanished, how would you honestly react? Would you take your money out?

The reason this is important is that it is extremely dangerous to be invested in something that exceeds your risk tolerance. If you find yourself waking up in the middle of the night nervous about where your money is, you’re likely to make an emotional move, like taking your money out when it’s about to rebound.

As a general rule of thumb, if you feel nervous about losing money at all, you probably shouldn’t be invested in stocks. Keep it in cash, in either your bank account or in certificates of deposit. Don’t feel weird – my best friend is in this camp.

On the other hand, most people have some degree of risk tolerance, though, and if you find that losing 10% or so won’t make you scared and ready to pull out, then you should dip your toes into stock investment. We’ll get to the specifics later.

3. For short term goals (less than two years or so), keep the money in cash.
That means store it in a savings account or perhaps buy a short term certificate of deposit at a bank – whichever option gets you the best interest rate and enables you to have cash in hand on the day you need it.

Why? Keeping it in cash means that it won’t be exposed to the up and down nature of the stock market. Quite often, over short term periods like two years, it’s quite possible that not only will you not turn a profit, but you might actually lose a piece of your invested money.

4. For medium term goals (two to ten years), diversify at your comfort level.
If your investment window is more than two years, the odds that you’ll come out ahead on the stock market start to get better, but it still comes with some risk. The stock market is never a guarantee, and past performance is never a guarantee of future returns.

Another factor to consider: how much is your life relying on this money? It makes sense to be more conservative with retirement money than with, say, money you’re saving for a new car. That’s because a downturn in your retirement can force you to work for years longer, while a downturn in your car savings just means you might have to continue to drive an older car for a year longer. The more vital that money is to your life plans, the more conservative you should be with it. If you’re not sure, be more conservative than less – keep plenty in the savings account and just dabble in the stocks.

5. For long term goals (ten years or more), stocks are a pretty good place to put your money.
Over the history of the stock market, almost every period longer than ten years has seen a profitable return in a broad stock investment. Even better, during many ten year stretches, the returns are quite impressive. Because of that (even though past performance isn’t a guarantee of future returns), it generally makes sense to put long term money heavily in the stock market.

6. The best place for first-time stock investors to put their money is in a low-cost index fund.
There are several reasons for this.

First, an index fund allows you to be invested in a lot of stocks at the same time. That way, you’re not affected by the ups and downs of a single company just as you are getting your toes wet in stocks.

Second, a low cost fund means that the investing house isn’t eating much of your money. Look for a fund with a cost less than 0.2%. That way, the gains go into your pocket, not in the pocket of your investing house.

Third, an index fund will introduce you to the ups and downs of stock investing. While they’re nowhere near as volatile as individual stocks, they are volatile. Many index funds can go up or down 3% on a single day. In other words, it’s a great way to find out where your risk tolerance really is without a deep risk of losing a lot of your money.

Personally, I only invest in index funds, for reasons I’ve specified in the past.

How can I get started with these? The best way is to get an account with a large investment house and transfer your money in online – the interface is often like online banking. I personally use Vanguard when I invest (though I’m currently focused on eliminating debts), as Vanguard offers a wide array of low-cost index funds.

Once you sign up with an account, the best first fund to buy is an index fund made up of a huge number of domestic stocks. If you sign up with Vanguard, take a serious look at the Vanguard Total Stock Market Index. It has a total expense ratio of 0.15% – in other words, when you invest, each year Vanguard charges only 0.15% for managing the fund, which is very cheap – and includes virtually every significantly large company on the New York Stock Exchange.

Once you’ve started, set up an automatic investment plan so that you put in a certain amount each week or each month. Not only does this make it incredibly easy to keep up with your savings, it essentially automatically follows the investment strategy known as dollar cost averaging (which reduces investment risk).

Just sit on that for a while. Watch it. See whether you’re comfortable with the ups and downs of it. Learn more over time, and then you’ll figure out on your own where to go next. Maybe you’ll find that the volatility is too much for you and you’ll move the money to savings. Maybe you’ll want to diversify and buy an international index fund. Maybe you’ll have no problem at all with the volatility and dip your toes into individual stocks. It’s up to you.

Remember, though, that today is always the best day to get started.

I don’t particularly plan to invest a lot in individual stocks in the near future, as I’m primarily focused on paying off debts. However, I am quite interested in and trying to learn as much as I can about individual stock investing and the strategies one uses in picking, buying, holding, and selling individual stocks. Navellier’s book was my real introduction to the growth strategy and the ideas stuck in my head and bounced around in my thoughts until I just had to find a book that discussed modern growth investing for the individual investor.

That led me straight to Michael Moe’s Finding the Next Starbucks. It basically focuses on how to spot companies in their early growth phase, theoretically enabling people to invest at the IPO or shortly after in companies like Home Depot, eBay, Dell, Google, Starbucks, and so on. In other words, it focuses on a flavor of growth investing that seeks to find companies early in their growth curve.

Finding the Next Starbucks was recommended to me by several people as a great book to look at for a modern growth investment strategy, and they professed it to be well-written and easy enough to understand while laying out a strong strategy. Does the book actually live up to this hype? Let’s find out.

Looking Into Finding the Next Starbucks

1 – Star Search: Finding the Supernovas
Moe opens the book by arguing that the most lucrative investment opportunity available to investors is identifying and buying into a small company that has the potential to grow into a big company. If you can latch onto one of those, not only can you ride the actual growth of the company, you can also ride the surge of the herd of investors buying into the stock as it rises into the stratosphere, pushing the price up even more. This chapter is mostly just filled with specific examples of spectacular growth stocks, like Home Depot and Starbucks. In short, he makes the case that, indeed, growth stocks are a good investment if you can get in on that ground floor … but how do you do that?

2 – The Power of Growth: The Magic of Compound Interest
Here, Moe just reiterates the astonishing power of compound interest, showing that when you have the opportunity to ride a rocket ship for a number of years, sitting on a stock that sees very nice double digit annual returns, your actual profit will be enormous. It’s a fairly simple concept to those familiar with personal finance, but it’s quite important for your investments.

3 – High Earnings Per Share = High Internal Rate of Return (the Argument)
At this point, Moe makes it clear that he is trying to distinguish between growth stocks and growth companies. Growth stocks are merely ones that show signs of having a premium value for some reason, while growth companies are companies that show signs of entering (or being in) periods of rapid growth. Basically, most of the time, growth companies are a particular subset of growth stocks, and they’re a subset that he’s interested in. How do you find them? Moe identifies the biggest factor as being a high earnings per share, meaning that the company earns a lot of money compared to the number of shares of stock available for purchase for that company.

4 – Formula for Identifying and Evaluating the Stars of Tomorrow (the Process)
Here, Moe talks about the things he looks for in identifying a great growth company. For the most part, these factors are intangibles – ones that you can’t really break down into numbers. For example, he looks for companies that have great people (particularly great management) and also companies that are poised to take advantage of megatrends, or major shifts in society or industry. In other words, Moe looks at the company itself, not a numerical representation of the company found on the stock page.

This concept reinforces a fact that keeps popping up again and again in the books I read about individual stock investing: homework pays off. The people that manage to beat the market with individual stocks are the people who are able to invest the time and have the passion to do the research and find these good companies and good stocks to put their money in, and they have the mental attitude to stick with it through bumps and downturns.

5 – Megatrends
So what are these “megatrends” that Moe talks about? He spends about a hundred pages here identifying and looking carefully at a wide array of megatrends that he sees coming in the future. Now, to a degree, this material is pure speculation on Moe’s part, but he makes a compelling case for each one.

Moe’s biggest megatrend is the increased reliance of the U.S. economy on knowledge workers, ones that bring a specialized but important set of skills to the table. He looks to companies that provide IT services and health care as being industries that really benefit from this megatrend. In fact, he keeps going back to these two industries as ones that will see exceptional growth in the coming decade, because they fit a lot of his megatrends.

6 – The Four P’s
Finding the Next Starbucks identifies four P’s as being vital clues as to the growth forecast of a company:
People – does the management team have a plan in place and the skill to move that plan forward?
Product – is the company providing a product that is compelling?
Potential – does that product have a lot of room for growth in the current marketplace?
Predictability – is it easy to see where and how this company’s growth will occur?

I thought of Starbucks when reading about the four P’s. It was pretty clear that they had the people, the potential, and the predictability, but I’m not sure I would have believed in the product outside of the coffee-happy Pacific Northwest.

7 – Valuation Methodology
This chapter dove pretty deeply into the math of what a particular company should be valued at, which is useful when you’ve found a growth company and are considering buying. Moe’s math is fairly complex, but in a nutshell it relies on the company’s P/E ratio and the value of a ten year treasury bill. It makes sense, as it uses the status of the treasury bill as an indicator of where it makes sense for investors to put their money – if the t-bill has a low return, investors are going to be more into the stock market, thus you can expect to pay a higher price on a stock when the t-bills are low than when they’re high. He almost insinuates that the time to hunt for good deals is when t-bills are high, but doesn’t quite make it.

8 – Sources and Resources: Finding Ideas
Finding the Next Starbucks repeats the “homework, homework, homework” mantra here. Moe gives a long list of the resources he uses to find ideas and companies that may be poised for breakout success. For the most part, I think his list is pretty mainstream and expected – he tracks some of the most high-profile investment papers and websites and a few top blogs, as well as keeping some very close tabs on the actions of some venture capital companies (by searching Google News and likely Google Blog Search, too).

If I were doing this, I would likely pick a specific sector or two and know that sector cold. If you spent time following Moe’s ideas, you should find yourself with a handful of sectors to concentrate on. Dig deep into those sectors and look for companies that are making waves. To a degree, Moe’s resources show that he does this, but he doesn’t explicitly mention it.

9 – Think Tomorrow, Today: Hot Areas for Future Growth
Earlier in the book, I was fairly frustrated that Moe didn’t explicitly discuss specific sectors and how they related to his identified megatrends. He gets around to that here, and it makes some sense why he kept them separate – these sectors and individual companies are like surfers on the waves of megatrends – some of them will catch the wave and ride it to success, while others will fall off the board and land flat on their face. That’s what the four P’s are about – trying to figure out which is which.

Most of the sectors Moe identifies here are either directly related to the internet and communications or are connected to health care, both of which are unsurprising. While his sectors make sense, in some cases he misses out on the individual company lists. For example, he excludes Apple from the list of companies that would ride the cell phone sector, but when Apple dropped their iPhone in 2007, their stock doubled in a year. I think Moe’s sectors make a ton of sense, but do your own homework when looking for individual companies.

10 – Case Studies
Moe closes the book by looking at a bunch of case studies, either examining specific companies or comparing two companies within a sector (like AMD and Intel). He repeatedly uses the methods from the book, tying the sectors to megatrends, then identifying the four P’s within the evaluated organizations. When two companies are compared, he usually concludes that one is poised for more growth than the other, and he’s pretty good at it – he predicted that Best Buy would continue to outgrow Circuit City and now Circuit City is having some serious problems, for example.

This was actually the best part of the book for me because more than most personal finance books, Moe actually effectively tied everything he talked about earlier in the book into real-world examples that could be followed and comprehended. It took a book that I was rather wishy-washy about and turned it into a book I quite enjoyed, because I found myself flipping back, rereading earlier parts, and really getting a better understanding of the whole book.

Buy or Don’t Buy?

There are parts of this book that are dry and boring, and there are a few instances where Moe seems to have an ego. For much of the book, Moe seems to be talking in terms of concepts that are hard to describe in concrete black-and-white terms.

That sounds like I’m going to slam the book, but I’m not: Michael Moe’s Finding the Next Starbucks is actually a very good read if you want to learn about how to invest in growth companies. More than any stock investing book I’ve ever read, Moe takes conceptual elements, builds on them, and then shows how they really apply to real stocks.

Bear with the slow parts: eventually, the book gets around to tying these all together into a very sensible package. I found myself quite bored during the Megatrends chapter, for instance, but later on the ideas presented there seemed a lot more concrete, interesting, and applicable. Stick with it, and this book will be well worth your while.

Several times this year, the stock market has dipped more than 1% in a single day. If you read the advice of some writers, like in this article by Ben Stein, there is some strong encouragement out there that a dip in the stock market like that means it’s time to buy a broad-based index fund. On the other hand, if you follow the advice of other columns, like this one by Ben Stein, you’ll hear that market timing is bad.

Which is right and which is wrong? There’s not a really easy answer to this one, so let’s look at both sides.

Market’s Down? Buy!

If you look at the long term history of the stock market, stocks go up in value. There has never been a thirty year period where stocks are down, and over the entire twentieth century, the broad stock market increased in value 20,000%. Because of that, it’s reasonably safe to assume that stocks are a lucrative long-term investment.

Now, on any given day, if the stock market drops in value, you can effectively buy in at a cheaper price than the day before. Let’s say you could buy an index fund for $1,000 that included a bit of every stock on the New York Stock Exchange. Then, in one day, the market drops 4%. You can now buy that same share for $960 – it’s effectively a sale!

In other words, buying a low-cost index fund when the stock market drops is the equivalent of buying it on sale. Any time you can buy a solid long-term investment on sale – and it’s all legit – is a deal you shouldn’t pass up.

Ignore Timing and Stick With a Real Strategy

In a mathematically perfect world, the above scenario would be just fine. If the long term trend is up but the very short term trend is down, and you knew that for a fact, you really could clean up on the stock market. Unfortunately, it’s not all perfect like that.

For example, down days on the stock market have different meanings. A day where nothing much happens can be a slight down day, but devastating financial news can be a monster down day. There are all sorts of varieties of individual days on the stock market, and they may or may not be part of larger trends.

Since 1950, using the S&P 500 as an indicator, any random day has a 53.8% chance of being a positive day. There’s also a 54.1% chance that a down day will be followed by another down day and an up day will be followed by another up day. In other words, if you buy on a down day, the odds are better than half that the next day will also be a down day, which means you bought at an elevated price.

The market is effectively random on a day-to-day basis, so playing games like timing the market by buying when the market is down tend to offer not much reward (and often some loss) in exchange for the effort of playing the game. An intelligent investor will simply follow a “buy and hold” strategy or a dollar cost averaging strategy (by buying in at regular intervals, regardless of the market) and sitting back and ignoring the day-to-day changes in the stock market.

My Take

If time were not a factor, it might be a worthwhile endeavor to try the “buy when the market is down” approach over a long period of time. Due to the randomness of the day to day stock market, you wouldn’t gain a whole lot, but you might be able to eke out a small positive return, on the order of a fraction of a percent, over a long period of time (with possible bigger gains or a small loss over the shorter term).

However, the time investment to follow this strategy day in and day out would make it not worth one’s time, unless one did it on a fully automated basis.

To me, market timing makes the relatively volatile investment that is stocks even more volatile and thus not worth the time. I see no problem if you’re about to buy in and jump on board immediately after a down day, but to invest with such timing as a regular strategy probably won’t afford you much serious gain. There is perhaps a tiny gain to be made here, but not a significant one in terms of the time invested.

I often get two or three spam emails a day touting a specific stock. I’m smart enough to realize that this is some kind of scam, but how exactly does it work?

This type of scam is called a pump and dump, and you’re far better off ignoring such emails completely than looking at them at all.

They all generally follow the same form: they identify a company and a stock you’ve likely never heard of and give some astounding reason as to why this stock is going to go crazy in the next day or two, usually some sort of “news” that came out after the market closed yesterday.

Here’s exactly how the scam works:

1. Overnight, a con man sends out the spam emails identifying this “hot” company. The email usually encourages people to track the stock.

2. The next day, right at the start of trading, the scammer buys a fair amount of the stock, causing it to make an initial jump in price.

3. The scammer then often posts on message boards or on blogs about how this stock is hot, pointing to the huge upward trend to start the day.

4. The scammer usually continues to buy in bits and pieces throughout the day, keeping the demand up and lifting the price even higher, but this isn’t always necessary.

5. At some point during the day, though, the scammer executes a sell-limit order, meaning that his brokerage is to sell all of his stock if it reaches a certain level. For example, the stock might start the day at 1, the scammer is able to buy enough so that the price goes up to 6, and he executes a sell-limit order at 10, meaning that the instant the stock hits 10, all of his shares go up for sale.

6. Often, after a half day of doubling or tripling in price, some of the scammed people decide to buy in, driving the stock even higher.

7. When the scammer’s sell-limit price is surpassed, all of his shares go up for sale at the elevated price. Anyone who has fallen for the scam will then buy these inflated stocks.

8. The scammer gets out of the stock entirely, selling all of them at an inflated price and making a big profit. The people who believed in the scam are now holding onto vastly overvalued stocks, which will rapidly plummet in price down to their low level.

If you buy this stock, you’re going to be the person left holding the overinflated stock that’s rapidly losing value. In other words, you were just talked into buying a $1 stock for $10 or more – and very quickly, that stock will go back to $1.

How can you fight this? First of all, ignore all emails promising a hot stock tip. If it’s an unsolicited tip from someone you don’t know, someone’s out there scamming a buck – and you’re the one who’s going to get scammed if you pay attention. Second, if you must follow up on a stock tip, do some research. Find out if the company actually files reports with the SEC – if they don’t, that’s a sure sign of a giant scam. If they do file reports, very, very carefully investigate the “big news” – and only accept the news if it comes from reputable sources (AP, Wall Street Journal, and Reuters, basically). Better yet, don’t waste the time and just delete that email entirely – it’s not worth the risk.