Archive for Sunday, February 10, 2002

What’s a nervous investor to do when markets soften? Plenty

February 10, 2002

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What do you do, as a small investor, if you no longer believe in the system?

With the Enron-Arthur Andersen scandal swirling on top of last year's revelations about the double-dealing of Wall Street analysts small investors can be excused a crisis in faith.

If you don't trust the analysts and corporate executives who have so much power in determining stock prices, should you bail out of the stock market and bury your college savings and retirement money in the yard? No.

There are ways to insure your investments against such market hazards. In fact, this is a good time to get started, using the fresh data arriving in yearend financial statements.

In theory, the strength of U.S. financial markets rests in what the pros call "transparency." It means an investor can get lots of timely and accurate information with which to assess the risks and opportunities presented by a stock, bond or other security.

In practice, transparency isn't as good as it ought to be. Sure, public companies have to file reports with the Securities and Exchange Commission. But, as we see in the Enron case, there are lots of ways for executives and their accountants to dress up the results to make a money-losing company look like a winner.

And a company doesn't even have to lie to mislead. Often, key information is buried in footnotes or other obscure corners, couched in language no ordinary person can decipher.

You may expect Wall Street analysts to do this for you, but they may ignore the warts because, as we learned with last year's dot-com implosion, they want to curry favor with corporate executives who can toss rich underwriting deals to their firms.

So what's the solution?

One approach: Rely on a different set of analysts those who work for mutual fund companies. These are known as "buy-side" analysts because their goal is to find good stocks or bonds for their fund managers to buy. Buy-side analysts are free of the kind of conflict of interest that can dog sell-side analysts at many brokerages, where the goal is to find stocks to sell to investors.

Turn to a simple index

If you really don't trust anyone, invest in index funds, which don't use buy-side analysts. Indexers simply buy and hold the stocks represented by market gauges such as the Standard & Poor's 500. Over long periods, indexers' returns tend to beat those of managed funds partly because their fees and annual tax bills tend to be lower.

Mutual funds also provide another key safeguard against Wall Street wrongdoing: They offer automatic diversification. With a good fund or, better yet, several funds of different types, you can own hundreds of stocks. They can't all be cooking their books, and the collapse of a few that are should not do too much damage to a portfolio that spreads its eggs among many baskets.

For a further safeguard, prudent investors would allocate a sensible portion of their portfolios to funds that specialize in bonds, and have a "cash" reserve held in safe money-market funds.

People in or near retirement generally should put more into bonds or bond funds, though they should keep some money in stocks and stock funds in hopes that higher growth rates will help them keep up with inflation.

How much, and where?

How much of your portfolio should go into each type of fund? That depends on a range of issues, from your age and income to your temperament, or ability to handle risk. Most fund companies offer guidance on this asset-allocation question, and there is help from financial software such as Quicken and Microsoft Money.

Just be careful not to take any computer program's recommendation too literally. If you make the program think you're a nervous Nellie, it may steer you to an overly conservative portfolio that won't grow enough to meet your financial goals. A good, human adviser might show you that you're worrying too much.

Scandals like the Enron-Andersen case make stocks look pretty dangerous, and, indeed, many individual stocks are. But, overall, the U.S. markets are the most honest in the world. And stocks, held over the long term in well-diversified portfolios, tend to serve the investor well a lot better than a coffee can in the garden.

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