INVESTING BASICS

Paul Samuelson: this Noble Laureate who is Professor Emeritus of Economics at MIT was interviewed in Dow Jones Asset Management magazine in 1998. Obviously I have read a number of his works previously-as with many other economists and analysts as well. However it was clear that many of his commentaries-which you have seen me paraphrase in the past-should be identified once again.

He noted that "many people now believe that if they simply hold stocks long enough they will not, cannot, lose money for statistics have shown that since 1926 the U.S. equity market has not suffered a loss in any given 15 year." He calls it a fallacy, as do I. We both concede that it is truly likely that it you hold stocks over long periods of time that they would tend to produce returns higher than other assets. But to believe that it is a god given statement is simply not correct. "Risk does not go to zero over long periods" but there are many articles that reflect how standard deviation goes down the longer the time period. What is seldom introduced is the fact that if there is a significant onetime loss, it can be monumentally overwhelming. This is explained more fully in my investing section under standard deviation. In any case he notes that "the problem is that when stock prices do turn down (as inevitably happens even in the strongest of bull markets) you're optimistic equity exposure can overwhelm your gut level risk tolerance, leading to poor short-term judgments and even outright panic."

He also commented on how people should invest based on his exploration into the predictability of stock prices. His conclusion: researchers couldn't find any pattern. He states that "what will happen tomorrow cannot be known." While I fundamentally agree with that position, I do believe there are economic scenarios that may lead an investor to perceive a stronger market than otherwise at certain times and in certain sections. I am primarily referring to my extended commentary elsewhere regarding what Volcker and, subsequently, Greenspan did in reducing interest rates and inflation and providing an opportunity for far stronger U.S. growth than had been seen in decades. Along with that you can add technological innovation that found a solid foothold that portends continued opportunities well into the future. Admittedly, I have no idea if a Japanese/Asia meltdown or something else in the future could ruin everything, but I must be able to believe in some reasonable direction at least for the short to medium-term. In that aspect, there may be some disagreement. But he did note that "when your broker says hurry, hurry, you have just enough time to buy, you know that's almost certainly wrong. The efficient minds of the market will have long erased any price discrepancy in a given stock." To be clear, the market is not totally efficient and certain discrepancies may exist that provide a profit under unique conditions. But those conditions do not include buy recommendations from a broker.

One of his most notable comments, and one that I addressed repeatedly in regards to index funds is this: "accordingly, without much hope that Wall Street is paid with overlooked gold nuggets for eagle eyed portfolio managers to scoop up, most investors, unless they possess intimate knowledge of a company's prospects, are better off placing their bets with a market index." I'll go further by stating that even if one DID possess intimate or insider knowledge about a company, does the "investor" have the requisite skills to understand, properly interpret and correctly analyze the information. It is my opinion that few investors have such fundamental knowledge of investments per se and therefore such analyses will not be particularly valid. Notice I am NOT stating that the stock may not still rise- but it was due to a separate matter of statistics, luck, good fortune rather than necessarily that specific work of the investor.

As regards the increasing price earnings ratio, Samuelson notes that as "more and more people recognize the statistical long-term trend in stock returns and investing accordingly, it is going to raise the price to earnings ratio of the marketplace. As to just how high it can go before becoming irrational, nobody knows. But looking at where Japan is today might give you a good idea of what euphoria and perceived unlimited growth to the future can portend." Such concern may also be reflected in the extremely low dividend yield on stocks- which historically meant an immediate drop in stock prices. But if you look solely to past statistics in defining your current portfolio, you can make serious mistakes. Obviously, in viewing the high P/E ratio of the past years, many people would have been out of the market (and have been) and have lost some major appreciation. I simply learned- don't fight the tape. Keep reviewing economics for your investment direction- don't get caught up in innumerable formulas as the sole direction for investing.

Samuelson also comments about the fact that there could be some problems in 2010 when the baby boomers start retiring. I have commented for many years that they may be a maelstrom coming due to a further parting of the haves and have nots in our society. Putting these two issues together may mean some significant societal and economic problems very close to our doorstep.

Readers will also note my commentary about the pathetic risk profiles offered by literally every magazine and every mutual fund company. It is not what an investor has done, nor necessarily what they would like to do. The issue is, after recognizing everything about that investor, his/her family, actuarial lifetime, income, budget and a host of other elements, that it leads you to what they should or must do to accomplish their perceived  goals or needs. Within that context, Samuelson notes that people retiring at age 65 still have about 25 years remaining "and to be in those 20 years without equity holdings may be a misunderstanding of your own risk tolerance. The case for changes in equity tolerance through investment horizon is a much gentler case at best, and no sure thing at all".

Samuelson also addressed the issue about market timing. Basically, if you going to be a timer, be a modest timer. He tells people, "you want to leave excitement outside the door when you go into investing. If you want excitement take five hundred dollars and go to Las Vegas. Get it out of your system." I have said, for at least the last 15 years, that there is no such thing as emotionalism in investing. It is just research- which means reading- and an ability to relate current economics into a basic fundamental investing formula. If you intend to play all the rest of the "exciting" investment games, it is possible to win, but it is undoubtedly due to luck, statistics, and extra risk. Part of this is identified in an article called the determinants of portfolio performance by Gary Brinson in 1986. While the results have been fodder for some subsequent pundits, I submit that the basic numbers do reflect a reality to investing. That is, that at least 90%+ of the returns on a portfolio are identified not by the energy in selecting individual securities, nor certainly by any attempt in doing market timing, but by research into the various areas in which to invest. Most notable however is the column (below) on what investors are told and how remarkably different it is from the Brinson study. The point being however, is that a good number of individual investors are still spending an inordinate amount of time seeking the holy grail of individual securities.

TRUTH AND THE PERCEPTION OF TRUTH

Dow Jones Investment Advisor, April 1998

Factors Determining Portfolio Variance	What Investors are told	What the Brinson Study Found
Stock Picking	65.1%	4.2%
Market timing	7.6	1.7
Asset Allocation	7.6	93.6
Other	19.7	0.5

Samuelson also addressed the element of rebalancing-that is the restructuring of your portfolio to maintain a consistent or risk profile. For example, if one part of your portfolio has done exceptionally well- say stocks- then you may wish to reduce, or sell, part of that portfolio."That's a great way of controlling risk as against what is in effect pyramiding or letting your gains run."

Lastly, Samuelson had commentary about actively managed funds and the portfolio managers. "There are very few people or organizations who have any presumptive edge over a low-cost, no-load set of indices, particularly on a risk corrected basis. People used to say that you're settling for mediocrity. Isn't it interesting that the best brains on Wall Street can't achieve mediocrity?" That, however, does not mean that indexing will continue to flourish in the future or that no actively managed funds can outproduce an index. As addressed in many other article's on this WebSite, it is possible for actively managed funds to outproduce literally any index. The problem, however, is that the fund that outproduces this year is not likely to be the fund that outproduces the next year, or certainly the year after. That means an investor must continually chase the (supposedly)  hottest fund. So, which one is it? That identified by Money Magazine, or Smart Money, or Worth, or the Wall Street Journal, or Morningstar, or what?

In summary, the basics of investing apply- normally keep it simple, separate and cheap. Indexing- while not a panacea for every condition or investor- can only be dismissed as an investment tool only AFTER the investor has done competent research and clearly determined that something else is "better".

Further, that risk, diversification and the other fundamentals are obviously not being recognized by investors since the securities industry knows full well it would reduce sales. Therefore it is incumbent for investors to read, READ, READ! Don't expect friends, relatives or co- workers to have a clue about investing. Don't use referrals to brokers who probably don't have a clue either. I'm sorry to report that, as differentiated from AARP or AAII or Money Magazine or whatever, investing is NOT easy WHEN YOU DO NOT HAVE A CLUE TO SECURITIES FUNDAMENTALS AND APPLICATION. Further it can really be a minefield if you do not listen to the likes of Paul Samuelson.