The

Disciplined
Investor
Essential Strategies for Success
The

Disciplined
Investor
Essential Strategies for Success

Andrew Horowitz, CFP

Second Edition

HFactor Publishing
The Disciplined Investor: Essential Strategies for Success
Copyright © 2008 Andrew Horowitz, CFP
Published by HFactor Publishing
1555 NorthPark Drive, Suite 102, Weston, Florida 33326
[email protected]
or visit www.thedisciplinedinvestor.com

All rights reserved. No part of this book may be reproduced (except for
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This publication is designed to provide accurate and authoritative informa-

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The Disciplined Investor: Essential Strategies for Success

Andrew Horowitz, CFP

Library of Congress Cataloging-in-Publication Data

Horowitz, Andrew.
The disciplined investor: essential strategies for success / Andrew
Horowitz.—2nd ed.
p. cm.

ISBN 10: 0-9787083-7-7

ISBN 13: 978-0-9787083-7-5
1. Title 2. Author 3. Personal Finance/Investments
Library of Congress Control Number: 2007939925

Printed in the United States of America

10 9 8 7 6 5 4 3 2
 Acknowledgements and Dedication

The process of writing a book is not an easy one. There are

countless hours that need to be dedicated, all requiring focus
without distraction. To help me, I had input from many
individuals. They have all helped to bring The Disciplined
Investor from its idea stage in early 1999 to the final written
and bound product. A big thank you is due to all that have
come together in an amazing show of support.
Time, proofreading, and research are just a few of the essen-
tial tools that this special group of family, friends, and
colleagues provided. All of these are integral parts of the process
that helped me achieve the finished product.
The first and foremost person that I would like to
acknowledge is my wife, Jill, for her dedication to me and our
family. Without her, I would wander aimlessly day by day. She
is my north-star and my best friend, now and always.
My children, Lauren, Erica, and Brett will be the first to
get copies of the final print. They are my biggest fans, and I am
theirs. Each of them has a way of making me feel personally
and professionally successful from the moment they wake to
the time they go to sleep. Just looking at them fills me with
overwhelming pride when I think of the fine people they have
become.
Marnie Goldberg is my right hand as well as my left. She
is my Radar O’Reilly; she seems to know what I am thinking,
even before I do. As an Assistant, there is none better. As a
friend she has no competition. She is a rare jewel that I hope
will be a part of my personal and professional life for a very
long time.
 Dedication, creativity, and organization are the hallmarks
of anyone who is successful. That clearly defines Michelle
McMillan, who has helped to organize this book from the pre-
proof stage. Michelle has an amazingly positive attitude and
brings a fresh edge to her work. All in all, she is the kind of per-
son that has your back and helps to bring calm to the everyday
chaos.
A special thank you goes out to many of the people who
helped bring information and research to the meetings when I
first began planning the contents for this book. One particular
person who had a hand in the process and should be recognized
for his hard work is Kirk Adamson, MBA. He was a great help
and many of the early ideas for several chapters can be traced
back to his work and efforts.
I would also like to thank all of my family, friends, and
clients for their continued support throughout the years.
Without you this book would not have been possible.
Finally, while there are scores of others that have had their
hand in the process, without Henry, “The Hammer,” and
“Pooker” I am not sure if this would have ever been completed.
You know who you are… Thanks!
 Table of Contents

Chapter 1
Creating a Discipline............................................................1

Chapter 2
Quantitative Analysis ........................................................29

Chapter 3
Technical Analysis ..............................................................53

Chapter 4
Fundamental Analysis ........................................................73

Chapter 5
Risk Management ............................................................103

Chapter 6
Why Mutual Funds? ........................................................129

Chapter 7
Annuities and GICs..........................................................159

Chapter 8
Tools of the Trade ............................................................179

Chapter 9
Implementing the Plan ....................................................209

Chapter 10
Putting It All Together ....................................................229
 PREFACE

The reason I have dedicated so much time to writing this

book is to provide you with the tools you need to make your
financial dreams a reality. It is my hope is that you will take
from these pages the important ideas that have helped so many
others reach their personal financial goals. They have done this
by simply utilizing the core investment practices explained in
each chapter and now proudly consider themselves
“Disciplined Investors.”

As you begin to read this book you may find it beneficial

to browse different sections rather than reading it straight
through. It is by no means essential to read the material in the
exact order in which the chapters are laid out. Rather, you can
scan over most of the book in order to get a good understand-
ing of how the information is presented. In fact, to save time
during your initial scan, mark the pages you are most interested
in—and then go back and read them thoroughly. After, focus
on the chapter(s) that you found to be the most
relevant to your particular situation, concentrating on the
specific topics you want to master.

Along with a small amount of dedication and a large

amount of desire, you are about to embark on the ultimate
journey toward financial success.

Read on, Read on…

 FOREWORD

Investors over the last two and a half decades have benefit-
ed from the greatest boom in history. Despite two strong
crashes in 1987 and 2000 - 2002, stock returns have been
higher than any time in U.S. history. The recent bubble in
housing saw the greatest appreciation in history from
2000 - 2005. Outside of a few years in the early 1990s, most
investors have never seen house prices go down for an extend-
ed period of time. But this bubble boom is coming to an end.

The massive baby boom generation has been driving this

unprecedented boom as they simply aged–earning and
spending more money and buying more houses and cars and
etc. In the next decade they will be slowing in their spend-
ing—just as occurred in Japan in the 1990s and early 2000s.
When this occurred in Japan, the Nikkei declined 80%
between 1990 and 2003. There will not be increasing numbers
of buyers for the McMansions the baby boomers own. This
housing slump is not almost over, it is just starting. Home
prices in Japan declined 60% from 1991 to 2005 when their
baby boom aged past their peak spending years. The next
generation will be looking for apartments and low cost starter
homes. The explosion in technology trends is now close to
saturating consumer households with wireless, Internet and
broadband penetration at 80% of households in 2007 and
approaching saturation at 90% by late 2008. The last time we
saw such a powerful cluster of technologies saturate our econ-
omy was in 1928 -1929—just before the Great Depression.
 The incredible gains in most investment trends have bailed
many investors out of investment strategies that lacked plan-
ning, discipline and risk management. Managing risk and
getting more realistic about returns will be much more critical
to success in the next decade that will see even more volatility
and more downside than upside.

In this book, Andrew Horowitz gives investors the proven

planning and risk management tools to succeed in an increas-
ingly challenging environment ahead. This is the time to get
serious about your finances and your life plan—before this
bubble really starts to burst, most likely between late 2008 and
late 2010.

Harry S. Dent, Jr.

Author of The Roaring 2000s and forthcoming, Bubble Boom, Bubble Bust
 Chapter 1

Creating a Discipline

“Where do I begin?” For some, this can prove to be a challeng-

ing question. For others, it can be so difficult to answer that it
actually creates a kind of mental paralysis. It frustrates and
annoys them to a level where they never begin a task in the first
place. This same query represents the most often pondered
question of the true procrastinator. To them, not starting is
better than starting and never finishing.

Even if you are the most polished of procrastinators, the

pages ahead will help guide you to success. With this book, we
will work together, step by step, to formulate a detailed per-
sonal investment discipline. Whether you are a novice or
seasoned investor looking to hone the skills you have acquired
over the past few decades, there is something here for you.

No matter what your level of experience is, structuring a

program with deliberation and discipline can only help you to
become more successful. As time goes on you will also find it
critical that you continue learning as the markets change.

Let us take a look at some examples of why an investment

discipline can be worthwhile:

1
2 The Disciplined Investor

Ted, a retiree, has built a sizeable portfolio that he has been

managing on his own for years. Until now, he has been relying
on basic information supplied by his broker and obtained from
newspapers and magazines. He has had the tendency to try to
reinvent the wheel with each investment decision. Recently he
has begun to realize that the daily investment process is taking
up more of his free time than he would like.

One issue Ted faces is that many of his stocks carry a low
cost basis, and he does not want to accept the tax implica-
tions when they are sold. In addition, he has been traveling
more lately—and, as such, has been leaving his portfolio
without daily management, which is creating another concern.

 COST BASIS
The amount invested in a given security or portfolio. The for-
mula is rather straightforward: Multiply the total shares that
you have purchased by the share price. Next, add in any
commissions paid. Tracking this is important; it is the indi-
cator for figuring out if you are making or losing money.
When you eventually sell the security, you will need this
information to compute your taxes. For mutual funds, you
need to add in all of the dividends and gains that have been
reinvested.

Ted is the classic, modern-day investor. The rewards that

come with the daily grind of managing his portfolio are bitter-
sweet. On one hand, he enjoys the challenge. On the other, it
drives him crazy. As his portfolio has grown, he has become less
comfortable with handling it, yet he does not want to give up
control.
Chapter 1 Creating a Discipline 3

For Ted, the problem lies in the fact that he does not have
a model that he can reproduce. By creating price targets (see
Chapter 4) and using covered calls (see Chapter 5), he could
save himself the aggravation of experiencing excessive losses
caused by holding on to investments for too long. He would
finally be able to go on vacation without worrying that, in his
absence, his portfolio might crash and burn.

By creating an appropriate asset allocation plan (see

Chapter 9), he would have the ability to manage his assets
logically without the emotional second-guessing most people
encounter.

Here is another example:

Brandon and Emily are young, first-time investors that

have no idea where to begin. They have met with several finan-
cial experts, yet they are not comfortable with any of them.
They both feel that with some measure of effort, they are capa-
ble of building an investment plan for the long term. However,
they lack the tools and knowledge to make decisions on
individual mutual funds and stocks.

For these types of investors, a lesson in stock selection

(see Chapters 3 and 4) along with an introduction to solid
investment tools (see Chapters 2 and 8) will help them dis-
cover which stocks are appropriate to invest in. They should
also plan to monitor their portfolio on an ongoing basis in
order to compare relative performance. More likely than not,
mutual funds will prove to be an appropriate choice, as they
take some of the management responsibilities off of the
investors’ shoulders (see Chapter 6).
4 The Disciplined Investor

As we see from the examples above about people, just like

you and me, wealth is important. However, each of us sees
it differently as it has a tendency to appear in many shapes and
sizes. Make no mistake—it is not solely related to money and
finances. Those who believe it is usually end up losing in the
investment game due to greed.

 WEALTH
Pronunciation: ‘welth’ also ‘weltth’
Function: noun
Etymology: Middle English welthe, from wele weal
Date: 13th century
1: obsolete : WEAL, WELFARE
2: abundance of valuable material possessions or resources
3: abundant supply : PROFUSION
4a: all property that has a money value or an exchangeable
value
b: all material objects that have economic utility; especially:
the stock of useful goods having economic value in existence
at any one time <national wealth>
(Source: Merriam Webster Dictionary)

Through the many studies conducted on the subject of

investing, it is now known that the mentality and perception
of money and the definition of wealth have dramatically
changed over the past 25 years. According to a 1980s survey
conducted by The American Council on Education, 75 per-
cent of the 200,000 incoming college freshmen polled felt that
being well off financially was either “an essential” or “a very
important end” to achieve. In addition, 71 percent of the stu-
dents said that the primary reason they were going into college
was to attain high-paying jobs upon graduation.
Chapter 1 Creating a Discipline 5

Unfortunately, however, only 29 percent of those aspiring

young people believed that it was necessary to develop a mean-
ingful philosophy on life. That is, at best, a very troubling
statistic.

Today’s mentality has many people believing that money is

easily acquired. If they lose some now, they can always recoup
it later. Warren Buffett, one of the world’s most respected
investors, has simple yet sage-like advice on this subject. He
says, “The first rule is not to lose money. The second rule is not
to forget the first rule.”

With that in mind, this book does not present the stock
market as a fast track toward riches. Yet for many the various
markets remains the most well-known and often-utilized area in
which to accumulate wealth. While it is true that time has effec-
tively and thoroughly tested the validity of that statement, do
not make the mistake of thinking that what was will always be.

Have you taken notice that our world has very recently
changed? Unless you have been hiding in a cold, dark cave, you
realize that information is available to everyone, everywhere, at
any time. Just think back to a few years ago, when a fax
machine was the quickest way to exchange documents on an
“I need it now” basis.

Fax machines are now considered old technology designed

to provide paper-based documents for those who still do not
have the ability or desire to utilize digitized files. The recent
shift from “overnight” to “immediate” has taken place in a
period of less than five years—astounding even the most tech-
nologically astute visionaries.
6 The Disciplined Investor

The ultimate price for this gift has not been the desired
actualization of increased quality of life. Rather, it has trans-
formed us into a species that has adopted an always-on
mentality, which has us moving at record speeds 24 hours a
day, 7 days a week, 52 weeks a year. The Internet is always
open with information flowing freely.

At almost any given time of the day, some market around

the world is open for investing. To top it off, information is
being thrown at us from all sides, forcing us to believe that
access now equals knowledge. Do you remember when you
had to wait until the following day to find out at what price
your stock closed? In those days, newspapers were the most
common providers of post-market information.

Today it is a much different story. Most of us have our

computers turned on and tuned in during market hours,
enabling us to watch each and every tick of our investments.

The Internet phenomenon that began in 1995 caused a

growing number of investors to believe that they could beat
the odds and take the daily management of their portfolios
into their own hands. Massive stock market gains forced a
change to the risk assumptions that many investors had held
on to for decades.

Then, almost overnight, it was as if a large number of the

level-headed individuals among us were replaced with aliens
from a world where money matters were a game. One of the
rules must have required open discussions about investment
triumphs (and the rarer story of a loss) at every opportunity.
Dinner parties, weddings, breakfasts, and even shuffleboard
games served as acceptable gathering places for mini-seminars.
Chapter 1 Creating a Discipline 7

Prosperity permeated the air and was coupled with an insa-

tiable desire for wealth accumulation, which served as the
primary catalyst for change.

People were talking about the greatest return they made

that week while hiding from the obvious concern that they
could actually lose money someday. Stories of the “old stock
market” were banned from discussions as the “new era” of
investing was clearly here to stay. Investigations and reports
concerning excessively high price-to-earnings ratios that
exceeded historic levels were often suppressed.

Resembling fully indoctrinated cult followers, no one seemed

to want to ask questions—especially ones like, “Why is it so easy
to make money?” or “When will it end?” Instead, innate greed
brainwashed the masses, transforming investors into gamblers.

Anyone who threw caution to the wind eventually realized

that there was a reason why many of the experts declared the
markets overvalued and thus recommended looking toward
other investment and diversification techniques. If you were
one of the late players in the game, you know the fall from grace
that started in March of 2000 was a severe one. Across the
board, stocks lost a good part of the gains they made during the
prior five years, and some mutual funds were cut down by 30
percent or more.

Not everyone got caught up in the frenzy, though. There

were still a few on the sidelines, ever fearful of a repeat of the
1930s—but only a few. It was quite an extreme situation and
it was very difficult to resist the temptation to get in on the
action. After all, everyone was doing it.
8 The Disciplined Investor

Perhaps the very best way to explain why this bizarre situ-
ation occurred is with a somewhat real-life illustration. By
considering the experiences of the following couple, we can
identify the many influences that caused investors to fall prey
to the frenzy. You also have the benefit of looking at the situa-
tion in hindsight—always a good perspective for analysis.
From this vantage point, you can begin the process of appro-
priately building your disciplines.

Bob and Julie were making a good living, each working in

their respective jobs for the previous decade or so. Both had
401(k) plans and had been employing the advice of a local
financial planner, who gave them guidance on selecting mutual
funds to help them plan for retirement as well as for college
savings for their children.

One day, Bob was on the golf course with his buddies
when he overheard a discussion about the latest IPO that
two of his friends had invested in. They had both turned
$2,500 into $10,000 within a week. One friend even com-
mented that IPOs were “like taking candy from a baby.”

 IPO (INITIAL PUBLIC OFFERING)

The first stock sold by a company when it becomes a pub-
licly traded entity. IPOs receive much more attention than
they deserve, in part because the hottest IPOs can make
their purchasers a quick profit by soaring soon after trading
begins. This was especially true during the heat of the
1998-1999 bull market, when the acronym “IPO” seemed
to stand for “Instant Profit Opportunity.” For the most part,
though, early gains usually disappear rather quickly. IPOs
are risky investments, as they are usually represented by
newer companies without proven track records.
Chapter 1 Creating a Discipline 9

Bob was intrigued. He asked his friend if he could

speak to his broker and get in on the action. After all, he
had extra monies “lying around.” Bob’s friend graciously
introduced him to his broker, and, after purchasing a cou-
ple of profitable IPOs, Bob realized how easy it was to
make money in the stock market in those days.

Then, after a few more “instant money” IPOs and fast-

profit picks, Bob decided to give it a try on his own. He was
anxious to build his portfolio so that both he and Julie could
retire early. Julie was a little more skeptical, but she went along
with Bob’s idea since it truly was amazing how easy the trans-
actions seemed to be.

Bob and Julie were both feeling great. The euphoria of con-
trolling their own destiny was fantastic. Setting up an account
with an online discount broker was easy for them since they were
both comfortable and experienced with the Internet. Both of
them had regularly used the Internet for shopping online.
Trading seemed no different.

Within a day, Bob had started trading after work, gathering

ideas from online bulletin boards and chat rooms. He also listened
closely to the lunchtime discussions between his coworkers. In the
beginning, it seemed that those people really knew what they were
doing. Virtually everything they invested in made big money.

After about two months, both Bob and Julie remarked that
their brokerage statements were looking very different than
they used to. The percentages of increase were climbing at a
record rate. One night, they talked it over and decided that
since their financial advisor had “only” been providing them
10 The Disciplined Investor

annual returns approaching 12 percent during the past 10

years, he would have to be replaced by the new “online money
tree.”

At the same time, they decided without hesitation to invest

all of their excess income and all of the money they had in sav-
ings accounts into the stocks that had showed such incredible
momentum during the previous few months.

Increasingly, much of Bob’s time during the day was spent

watching the computer screen rather than keeping his focus on
his job and the obligation he had to his employer. Julie even
acquired the online passcodes she needed to sneak a peak at the
portfolio each day and see how it was doing.

After a while, the couple decided to buy what was “hot” with-
out looking any further into the fundamentals of a company’s
products or management. They felt that “old-fashioned” research
was no longer required. It took up a great deal of time and it did
not seem to help anyway.

Bob and Julie were flying high. These new-world invest-

ments surely beat their day jobs. Why bother working so hard,
in an effort to retire in a few years, when assets could be built
up so quickly and easily within a portfolio?

Each time the market dipped, they decided to devote addi-

tional monies, even arranging for a second mortgage on their
house in order to invest more into the markets. At that point,
Bob and Julie learned about margin borrowing as a tool to
leverage their buying power—thereby allowing the couple to
make even more fast money.
Chapter 1 Creating a Discipline 11

Ignoring all advice from their now almost-forgotten finan-

cial advisor and any negative possibilities being painted against
the backdrop of prosperity, they both found new religion in
the process. They proudly and openly proclaimed that this
would be the norm.

 MARGIN BORROWING
Brokerage companies are allowed to lend money to investors
at reasonable rates. These loans are collateralized against
the stocks in the borrower’s account. When an investor uses
margin to buy securities, they are leveraging the purchase,
which can be a great benefit if the investments move up. If,
on the other hand, the investments lose money, the down-
side effect is compounded. Add to that the fact that either
way there is a cost to borrow funds. That cost needs to be
included in the calculation to determine your gain or loss.

The improper use of margin has been credited to the stock

market crash of 1929. Since then, strict regulations have
been implemented to ensure that investors use margin with
more care.

Most recall what happened next, but for for those that do
not, here are the gory details:

It was March 2000 when the first major “dip” began to

take shape. That time, though, things were going to be differ-
ent. At first, Bob and Julie were comfortable with the notion
that this dip, like the others, was going to be temporary. They
thought it would quickly bounce back and were confident it
was nothing to worry about. A month went by. Things were
still not looking so good.
12 The Disciplined Investor

Getting close to a margin call, Bob and Julie agreed to

stop trading for a while, as they were starting to have some
doubt about their holdings. After a few months, they received
their first margin call, requesting that monies be deposited to
their accounts in order to cover the loans that they had used to
buy stocks. Now down by over 30 percent, the only thing for
them to do was to hold...right?

 MARGIN CALL
A requirement for additional capital in order to strengthen
the equity in an investor’s margin account. Let us suppose
that you purchased 500 shares of ABC stock, which cost
you $2,000. Before the buy, your account was worth
$1,000; therefore you borrowed $1,000 from the brokerage
company on margin in order to pay for the transaction. Now,
if the stock were to fall by 10%, there would be a shortfall
in the account minimum margin requirement, and you would
be forced to either sell a part of the position or deposit funds
to bring the amount back to the required level. Since the lend-
ing rate is generally a maximum of 50%, once the value of
ABC stock goes down there will be a “Call” for the money
due.

While there were a few bear market bounces, by the

time the year closed out Bob and Julie’s investment portfolio
had fallen by more than 55 percent. They had no idea of what
to do next. Their friends no longer talked about investments
while playing golf. Conversations were spotted with the salient
confessions of losses suffered.

Portfolios heavy with relatively worthless holdings had

become the common achievement of this wild ride. The tide
had turned, and all those who did not heed the warnings of the
past had thrown up their hands in shamed surrender.
Chapter 1 Creating a Discipline 13

 BEAR MARKET BOUNCE

A temporary recovery by a market after a prolonged decline
or “bear market.” In most cases, the recovery is only tem-
porary. Also known as a Dead Cat Bounce—a term derived
from the rather ugly old saying that “even a dead cat will
bounce if it is dropped from high enough.”

In the end, a growing number of investors who were

financially ruined went back to tried-and-true methods that
were developed over decades. These included risk manage-
ment, asset allocation, and research. In other words, they
began to look for disciplines.

Hopefully we have all learned a valuable lesson from this

catastrophe. It is a message that is asking us to open our eyes,
ears, and minds to the possibilities of a dynamically changing
investment climate.

Let us make something clear from the start: a discipline is

a process that is ever evolving; one that is designed to help
enhance market returns and limit risk. Disciplines can be used
on their own as devices to filter stocks or in conjunction with
each other, to find investments that work in concert within a
portfolio.

A discipline should not be used as an excuse to blindly fol-

low strategies that may have worked over the previous 12
months. It is not a process that is sold to you by a stockbroker
intending to help keep you out of the investment process alto-
gether.

Investment disciplines originate from a myriad of sources

that utilize varied techniques to find investments for different
14 The Disciplined Investor

purposes. While that may seem like a very broad comment, the
idea will become clearer to you as you read on. Together, we
are going to define what strategies work best for your particu-
lar investment style. These will help to further identify your
risk characteristics and eventually lead toward specific invest-
ments in stocks, bonds, mutual funds, and other areas that will
enable you to diversify a portfolio for the long haul.

Some call a diversified portfolio of this type an “All-

Weather Portfolio”; others think of it as a “Balanced Investment
Style.” Whatever the catch-phrase, the combined results will
allow for less worrying on your part and a greater understand-
ing of why your portfolio is performing the way it is.

Perhaps you can personally identify with Bob and Julie.

Maybe you have been so astute as to convert your portfolio
entirely to cash right before the market corrected. Or perhaps
you are somewhere in the middle, looking for an answer to the
question of how to prosper in the long run.

Either way, it is time to make a commitment to open up

your senses to all possibilities and all options. Rid yourself of
any preconceived notions that you have about what a broker
does, how the markets operate, and what your role is in the
process. Pack them up and put them aside just for a moment,
so that you may discover another truth—one in which you are
no longer shackled to a computer screen or a financial news
program; one that will ultimately allow you to create a system
that efficiently promotes wealth accumulation. Once you find
that truth it should become the essence of the disciplines you
will use as a guide on your quest towards prosperity.

The poignant lesson that we should have learned from Bob

and Julie is best highlighted by a famous story. Remember the
Chapter 1 Creating a Discipline 15

Aesop fable about the goose and the golden egg? It is the story
of a poor farmer who one day visited the nest of his prized
goose, finding at her side a glittering, yellow egg. Convinced
that it must have been a trick, he was about to throw it away
before he quickly changed his mind…but he didn’t.

He decided to take the egg home for analysis. To his delight,

he discovered that the egg was pure gold. The farmer became
fabulously rich by gathering one golden egg every day from the
nest of his special goose. As he grew richer, he became greedier
and more impatient. Hoping to secure all the gold at once, he
killed the goose and opened her, only to find nothing inside.

What can be learned from this story is that growth is a daily

grind composed of successes, failures, lost opportunities,
progress, and change. Thinking that wealth can be attained in
one fell swoop is dangerous and often results in losing a fortune.

The next task is to find out about your overall investment

preferences. A risk tolerance assessment is a good place to
start.

 RISK TOLERANCE
Best defined as the amount of psychological pain you are
willing to endure from your investments.

For example, if your risk preference is high, you might feel

fairly comfortable investing in options contracts or other
investments that are very volatile. The preference for lower
risk would lead you toward more conservative investments
that do not tend to have large fluctuations in value. Some
also call this your “sleep factor.”
16 The Disciplined Investor

The best way to go about this is to look at yourself from the

outside in. Take a moment to answer the following questions:

1) What is my age and family status (at what point will I

need this money)?
2) Is the money subject to penalties upon withdrawal?
(IRAs, pensions, annuities, etc.)
3) What are my tax considerations regarding this portfolio?
4) What is the likelihood that I can replace this money if
I lose some or all of it?
5) What is my experience with investing on my own?
6) How much time am I willing to put into this process
on an ongoing basis?
7) Do I have access to the tools that I need in order to
manage and monitor my investments?
8) Who else should be involved in the decision-making
process?

When you have these questions answered, utilize them to

develop a paragraph or two about your investment goals. This
self-assessment statement will help you stay focused and com-
mitted to your investment goals. Yes, this means that you
should take out a pen and paper and actually write them
down. I learned very early on in my career that goals and other
important ideas are not worth the breath they ride on if they
are not committed to paper. Hence, the creation of this book.

A sample self-assessment statement might look like this:

I am 42, and my wife is 40. We have 2 children (ages 11

and 8). For the most part, the funds we have in savings are
going to be used for retirement. Some of the funds will also
be needed to cover college costs. This money is not in an
Chapter 1 Creating a Discipline 17

IRA or pension and will not have a penalty for withdrawal.

That means that the income and gains are taxable. Other
monies are in my company’s pension plan.

Since my spouse and I are both working, we could replace

some of the monies that may be lost in investments—but
only up to a certain point. Our experience with investing is
limited to a few long-term mutual funds and our company
pensions. As we are both busy people, we can only put in a
few hours per week at the most for investment purposes.
We are planning to make the decisions jointly and have the
tools through our broker to track the investments.

The above represents a good starting point for you to begin

crafting your statement in the space provided on Page 27.
After writing your statement you should be well on your way
to better understand just what type of investor you are. For
further clarification, see Figure 1 as it provides a good
sampling of risk styles.

Ultra-Aggressive -
Risk Styles willing to risk it all.

Aggressive - willing to risk as

much as 25 percent in losses
to reach long-term goals.

Moderate - willing to risk

10 percent in any year.

Conservative - not willing

to lose any money.
Figure 1
18 The Disciplined Investor

If you are married or in another otherwise committed rela-

tionship, a great way to further refine your style is to read the
statement aloud to your significant other. He or she may have
additional or conflicting thoughts about how much risk they
are willing to take. You may find out more than you bargained
for when you ask about their thoughts on the subject. In fact,
more often than not, couples find out very late in their rela-
tionships how they really feel about money and finance.

Once you know your particular investment style, it is

time to explore the core ingredients of a discipline. For the
moment, we will stay with the example of the couple in the
sample self-assessment statement. They have a moderate risk
tolerance level.

Realize that even the most tightly wound discipline is not

without its pitfalls. Regardless of the area that you choose to focus
your investment agenda upon, your portfolio will face risks.

First, risks exist well beyond the loss of principal due to

market fluctuations. However, loss of principal is where most
investors stop when they think of risk. Over time, inflation
plays a key part in diminishing the spending power of your
money. Just think about an investment such as a CD that con-
sistently earns 3.5 to 4 percent annually. Over time, the
investment will grow substantially. In fact, at a 3.5 percent
annual rate of return, money doubles in approximately 20.5
years. This also means that when using that same rate for infla-
tion, money loses 50 percent of its value every 20.5 years.

 INFLATION RISK
The risk that our money will not be worth as much in the
future. It is expected that the cost of the things we need to buy
(such as housing, clothing, and medical care) will all increase.
Chapter 1 Creating a Discipline 19

Low-yield investments (such as guaranteed investments and

bank accounts) usually do not keep pace with inflation.

Next is currency risk, though it is usually not a concern for

those investing exclusively in dollar-denominated investments.
Years ago it was not as easy to buy non-dollar-denominated
investments. These days, they can easily be obtained through
investments in mutual funds. This potentially adds an additional
level of risk for those mutual funds that have exposure to the
foreign markets.

 CURRENCY RISK
This term refers to the risk imposed on an investment by
fluctuating worldwide currency exchange rates. When you
invest in the mutual funds or stocks of companies that are
overseas, there is an inherent risk associated with owning
the investment in a foreign currency. Once the investment is
sold and the money is eventually converted back to U.S. dol-
lars, there may be an additional loss or gain depending on
the current exchange rate. Mutual funds face this risk when
investing as well. In order to reduce some of the risk, they
employ “hedging” to reduce the effects that the adverse
exchange rate will have on the portfolio’s performance.

Similarly, political instability risk has been a significant

problem for many investors who have had money in regions
such as Latin America and the Middle East. When govern-
ments are in conflict, it usually causes nervousness amongst
investors, often to the detriment of financial markets.

This can also happen to investments in the U.S. stock mar-

kets. Consider, for example the hotly contested presidential
race of November 2000 that caused chaos within the markets.
20 The Disciplined Investor

Without a clear winner, investors became worried over the

outcome and looked at it as a sign of domestic weakness. The
S&P 500 index lost 7.88 percent in that month alone.

Finally, since taxes are levied upon monies earned by invest-

ments, the net effect is the reduction in overall profits. Even if
there is tax deferral through an annuity or a retirement plan,
there will come a day when the government will collect its due
share. Upwards of 30 to 40 percent of the total value of a port-
folio may be confiscated by taxes over time. If nothing else, that
should make you stand up and take notice, especially when
considering the added effect of inflation and the significant
impact it will have on the long-term value of any investment.

Portfolio Tax Comparison

Tax Efficient Tax Inefficient
Start of Year Portfolio Value $ 100,000.00 $ 100,000.00
Income f rom Funds $ 3,000.00 3.00% $ 6,000.00 6.00%
Income from Stocks $ 2,000.00 2.00% $ 3,250.00 3.25%

Capital G ains from Funds $ 1,250.00 1.25% $ 4,000.00 4.00%

Additional Unrealized
Capital Gains *N/T $ 10,000.00 10.00% $ 3,000.00 3.00%
Gross Gain $ 16,250.00 16.25% $ 16,250.00 16.25%
Tax on Gains $ 1,650.00 1.65% $ 3,390.00 3.39%
After-Tax (net) Portfolio Gain $ 14,600.00 14.60% $ 12,860.00 12.86%

Inflation-Adjusted Return $ 14,162.00 14.16% $ 12,474.20 12.47%

* Example shows fund and stock income taxed at 28%; fund gains taxed at 20% (average); N/T=Non-taxable;
Inflation Assumption of 3% - Dividends may receive preferential
. treatment and tax rates will vary.

Further adding insult to injury is the fact that, when you

die, there are potential estate taxes that can further reduce the
wealth that you have worked so hard to amass. While there was
a significant tax reform act passed in 2001, and more recently,
Chapter 1 Creating a Discipline 21

in 2006, the far-reaching implications of the changes will con-

tinue to tax your beneficiaries down the road.

Given all of these considerations, why in the world would

anyone open themselves up to so many negative possibilities?
Wouldn’t it be better to leave the monies in a safe place at a
lower interest rate to avoid most of this hassle? The answer is
an unequivocal “No.” This is because the opportunity to diver-
sify a position of stocks, bonds, and mutual funds with
differing currency exposures, maturities, sectors, and industries
(along with investment styles and size diversification) can pro-
vide you with the opportunity to increase the probability of
positive returns while at the same time reducing the potential
risk.

Portfolio
Risks

Interest
Rate
22 The Disciplined Investor

The good news is there are several ways in which you can
reduce risk to a point that is manageable and acceptable.
Chapter 9 covers the asset allocation process and points out
how it can work in tandem with a disciplined investment strat-
egy to create the potential for a highly stable and profitable
portfolio. For now, it is safe to stick with the notion that risk
is a topic that needs to be properly approached and defended
against. Remember: there are many different types of risk that
affect portfolios in just as many varying ways.

Now that you have a relatively good idea of what risk really
is, let us go back to our example of Bob and Julie. When focus-
ing closely on their risk assessment, we find that the money is
in an account that is held outside the umbrella of a retirement
plan. Therefore, the tax status of an account needs to be con-
sidered in order to protect the portfolio from erosion due to
taxes.

Since they are relatively young, care needs to be taken in

order to ensure that their investments keep pace with, and
exceed, inflation. College costs are on the near horizon, so for
that block of money safer, non-volatile investments should be
utilized. It is probably accurate to say that they are moderate
risk takers, as they are willing to lose some money in the pur-
suit of their goals.

This now leads directly to the point of actual investment

types. Bob and Julie desire the greatest tax efficiency and low-
est volatility. Therefore, individual equities will play an
important role in this portfolio. In order to properly under-
stand this, it is important to let go of any preprogrammed
ideas you may have about individual stocks.
Chapter 1 Creating a Discipline 23

Over the years, mutual fund companies have attempted to

create a mystique about the investment process. In particular,
they have brilliantly convinced us that there are problems with
investors using individual stocks within their portfolios. Large
brokerage houses have heavily promoted the use of mutual
funds for the average investor, as their number one priority has
been asset gathering rather than investment management.

It has been startlingly easy to convince most consumers

that mutual funds are better for them. Why wouldn’t they be?
There are “professionals” tending to the assets.

A number of years ago, John Bogle, founder of the

Vanguard group of funds, wanted to find out if active manage-
ment of a mutual fund provided returns greater than the index
that they competed against. He discovered a significant under-
performance by active managers as compared to their
benchmark. He then set out to provide investors with a low-
cost alternative to investing in the indices—the same ones that
were beating the managers handily.

Vanguard’s mantra of low expense ratios, low turnover,

and a passive management style turned the industry on its
head. A few years later, Bogle’s mutual fund company grew
into one of the largest fund companies employed by individ-
uals and institutional advisors. This was primarily due to a
clear understanding that there should be no “hiding” of the
fund’s true investment policy and that, above all, it was essen-
tial to put the investor first.

 PASSIVE MANAGEMENT STYLE

A financial strategy in which a fund manager makes as few
portfolio changes as possible in order to reduce transaction
costs and minimize capital gains taxes. A very popular way to
24 The Disciplined Investor

achieve the same return as an index is to buy an index mutual

fund. These types of funds utilize a passive management style
and simply buy the same investments that are held within the
index they are imitating. The managers of index funds do not
have much work to do other than to ensure the fund maintains
their absolute correlation with its benchmark index.

Clearly, mutual funds play an important role in a portfolio.

They are most appropriate for the portfolio of investors with
limited monies available to start a savings program. There is no
better way to begin a systematic investment plan than to
stick to a monthly plan of investment through a fund. Even so,
when it comes to proper diversification, it should be pointed
out that there are many opportunities beyond a simple mutual
fund. This will become much clearer when reading Chapter 6,
where you will find more information about the tax inefficiency
of most mutual funds and the inability of most fund managers
to compete with a non-managed index.

 SYSTEMATIC INVESTMENT PLAN

A way in which an investor saves money for college, retire-
ment, or other major life events by automatically investing
in mutual funds on a monthly basis. Most plans start as low
as $25 per month.

At this point, it is important to realize that one of the best

uses of a mutual fund is for your international stock, domestic
and international bonds as well as small cap stock exposures.

You may be thinking: I am scared of individual stocks, or,

I have never purchased a stock in my life. I do not know the
first thing about them. Not to worry. Armed with the informa-
tion contained within the next few chapters, you will have all
the tools needed to compete with the experts.
Chapter 1 Creating a Discipline 25

As a general rule, you should know that with every 10 per-

cent of exposure to equities/stocks, your portfolio will also
carry a volatility of 1 percent. For example, a portfolio com-
prised of 50 percent stocks and 50 percent bonds should have
a volatility of 5 percent greater than a portfolio that carries
nothing but bonds.

This is just one of many general rules that can be applied

to a successful investment strategy. Until you identify your
own needs, however, it will be impossible to effectively lay the
foundation for your unique portfolio.

If we were to stop right here and lay out a plan to invest

with the information we know up to this point, Bob and Julie’s
portfolio might look like this:

Individual Stocks

Large-cap 20%
Mid-cap 10%

Mutual Funds

Bonds/Fixed Income 30%

Small-cap 10%
International 20%

Cash/Other 10%

This allocation is overly simplistic and

is for illustrative purposes only.
26 The Disciplined Investor

Building a Discipline
Every investor—with his or her many passions, carefully culti-
vated biases, and unique inklings—is vastly different from all
the others. The truly intriguing aspect of this statement is that,
despite all of these separate conditions, there is a unified,
underlying strategy to any successful portfolio. It is a concept
that is based on discipline, analysis, shrewd and careful
investment choices, a dash of independent ingenuity, and a
reasonable tolerance for risk.

The key to understanding how to win in the markets does

not come from a glitzy CD-ROM or an all-encompassing
program with catchy phrases and “trade-secret” stratagems.
While it is true that this journey is best traveled with the
company of a qualified advisor, it can indeed be braved alone.
The trick is to maintain a consistent investment discipline.

So how do you avoid procrastination, stagnation, or just

plain poor decision making? The first step is to remove all
emotion from the investment picture. For many of us, this is
easier said than done. Fortunately, years of research and trial
and error have lead to the development of exactly the kind of
strategy it takes to invest without the bias of feelings or
intuition.

The initial step is to apply a three-headed plan of careful

analysis—the first of which you will find in the next chapter,
Quantitative Analysis.
Chapter 1 Creating a Discipline 27

My Self-Assessment Statement
 Chapter 2

Quantitative Analysis

Emotions play an important role in our everyday lives. People’s

instincts usually “alert” them to avoid certain foods, situations,
and sometimes other people that they believe may be harmful.
Surely you have had those “gut feelings” that seem as real as the
air you breathe. There are even people who rely on their “intu-
ition” to make many important decisions.

Whatever you want to call it—a hunch, an instinct, a pre-

monition, or even a sixth sense—there is no room for this type
of mentality in an investment discipline based on quantitative
analysis.

Have you even been investing in a stock and said to your-

self, “It just does not feel right,” or “I really think that this is
going to be a winner”? That enthusiasm or fear is an emotional
response to information that we, as humans, are processing.
The reaction is filtered through a host of preconceptions and
learned behaviors that have built up throughout our lifetimes.

As people enter into new situations, their brains instantly

call back historical memories, allowing them to access records
that have been neatly stored in the infinitely complex corridors
of the mind. Within a microsecond, a judgement is locked in

29
30 The Disciplined Investor

about new circumstances that is based on these historical files

and thus forms a prediction that is believed to be true. In the
world of psychology, this is termed “classical conditioning.”

Classical conditioning is a type of learning in which an ani-

mal’s natural response to an object or sensory stimulus transfers
to another stimulus. This is how a dog can learn to salivate at
the sound of a tuning fork, an experiment first carried out in
the early 1900s by Russian psychologist Ivan Pavlov.

The human brain has been compared to a machine that

captures, processes, files, and then accesses information when
needed, but not everyone believes that it is that simple. There
is a group of scientists that believe people will look at their
memories in a way that best suits their needs, drawing from
their internal thoughts, desires, requirements, and past experi-
ences. They also believe people use learned behaviors to help
create assumptions and mold their memories to what they pre-
sume to be true.

Sometimes, without any malicious intent, people will even

remember events differently from how they really happened.
When two or more people are asked about an event that they
witness simultaneously, vastly different memories of the situa-
tion are often reported.

Psychologists have studied and been fascinated with this

phenomenon. In one study, “The Misinformation Effect
Experiment,” conducted by Elizabeth Loftus in 1978, subjects
watched a slide show depicting a car accident. Randomly, they
were shown either a “stop” sign or a “yield” sign in the slides.
Immediately after, they were asked a question about the acci-
dent that implied the presence of the other sign that was not
Chapter 2 Quantitative Analysis 31

actually there. Influenced by this suggestion, many subjects

recalled the incorrect traffic sign.

Another study conducted in July of 1995 by Henry L.

Roediger III and Kathleen B. McDermott and reported in The
Journal of Experimental Psychology: Learning, Memory and
Cognition showed how people who listened to a list of sleep-
related words (bed, yawn) or music-related words (jazz,
instrument) were often convinced moments later that they had
also heard the words “sleep” or “music”—words that fit the cat-
egory but were not on the list.

This memory distortion effect was shown once again in

another study where college students were asked to recall their
high school report cards. Researchers checked those memories
against the students’ actual grades. While most of the grades
were recalled correctly, many of the errors reported were exag-
gerations of the quality of the grades, especially when the
actual ones were very low.

These examples are primary reasons why the quantitative

(“quant”) investment process was designed. For the most part,
people will create preconceived notions about a stock based on
its name, industry, sector, and even the location of the com-
pany’s corporate offices. This can often bias the outcome of the
recommendation if the analyst or the investor is not aware of
their mental predisposition.

Quantitative analysis attempts to remove the emotional

side of the process by means of filters, screens, and searches
that are based on historical facts. Quants—those who ascribe
to quantitative stock theory—believe that active management,
technical analyses, fundamental analyses, or any combination
32 The Disciplined Investor

of these three approaches are complete wastes of time. In fact,

hardcore Quants would rather have a computer provide all of
the stock picking recommendations, buying, selling, and
reporting instead of an actual person. For them, human inter-
action adulterates the process and causes degradation of the
byproduct of their efforts.

What is more, they believe that active “thinking” should be

used during the creation of the technique, not after it is put
into action. This is simply because the screen or filter needs to
maintain its integrity by sticking to the original methodology.
Only then can success be realized.

With that in mind, realize a compromise of methodologies

is probably the better model for a Disciplined Investor. As you
know by now, there are a host of tools that you need to possess
in order to achieve success. Quant analysis is the filtering tool
that will help you narrow down the list of potential stocks to
include in your portfolio.

As there are literally tens of thousands of stocks available in

the domestic stock markets, there needs to be a way to navi-
gate through the chaos and find a few opportunities that can
be further analyzed and reviewed. The truth is that no one per-
son can efficiently research hundreds of stocks simultaneously.
To do so would require a team of seasoned professionals to
help gather, examine, and authenticate the data for further
review.

For this reason, your practice of quantitative investing

should be limited to the use of screening tools that will help to
better refine the arduous task of searching through the avail-
able stock universe. These tools may also be used in the
Chapter 2 Quantitative Analysis 33

application of stock selection within a portfolio. This is often

a hard task, as most investors despise taking losses and usually
sell too early. This can help to push out losers without the
emotional overlay.

Further, most investors have propensities toward one sector

or another, as they often have a good deal of knowledge about
their professional fields and the companies within them. This
may helps provide an understanding of the sales cycles and
trends for that stock group, but usually not for others.

So, if you feel that after reviewing all of the possible invest-
ment styles you have a better ability to research and make
decisions on technology and growth-oriented stocks, then you
may want to employ a quantitatively designed process in order
to manage stock outside of these sectors.

Often, when a quantitative process is begun, the designer

will seek out historical evidence on the performance of a basic,
central element that is similar within a group of stocks. For
instance, the Dogs of the Dow is a popular quantitative process
that was introduced by Michael O’Higgins in 1991 in his
book Beating the Dow. He discovered it as he was looking for
a consistent and measurable system of stock selection that out-
performed the Dow Jones Industrial Average (DJIA) annually.
Similarly, an initial search criterion that you construct may be
based on a simple filter.

Screens and criteria may be complex or simple—however,

neither will end up being the ultimate cause of their success or
failure. The Dogs of the Dow is a very simple process that calls
for the buying of an equal dollar amount of the 10 stocks with
the highest yields from the DJIA. They are to be held for a
34 The Disciplined Investor

period of one year, at which time the screen is reevaluated. At

that time, you find the 10 stocks with the highest yields again,
sell any of the stocks that are no longer on the top 10 list, and
replace them with the new “highest-yielders.”

This method is dubbed the Dogs of the Dow because the

high yielding stocks are the ones with prices that are low rela-
tive to the dividends paid, indicating stocks that are potentially
out of favor.

James O’Shaughnessy provides one of the longest back-

tests in the book What Works on Wall Street. From December
1928 through December 2003, the Dogs returned 14.3
percent per year on average (12.2 percent when annualized),
outperforming the S&P 500 which returned 11.7 percent on
average (9.7 percent annualized).

For the 25-year period ending in 2005, this simple

approach has compounded at an annual rate of over 18 per-
cent, beating the DJIA and most professional money managers
decisively. Interestingly, the string of annual wins was abruptly
halted in the late 1990s as the relative performance leadership
changed and returns on technology stocks trounced stocks in
most other sectors.

Performance Comparison
Ending December 2004

2002 2003 2004 1 Year 3 Year 10 Year

Dogs of
the Dow - 8.90% 28.70% 4.40% 4.40% 8.10% 12.90%
Small Dogs
of the Dow - 10.70% 23.50% 12.40% 12.40% 8.40% 12.10%
Dow Jones
Industrial
Average - 15.00% 28.30% 5.30% 5.30% 6.20% 14.40%
S&P 500 - 22.10% 28.70% 10.90% 10.90% 5.80% 14.00%
(Source: Compiled from www.dj.com)
Chapter 2 Quantitative Analysis 35

As an investor, there is an important issue to contend with

when using a repetitive process that may trigger significant
turnover within a portfolio. While deep-discount brokers are
charging relatively low prices for trades, after a while the fees
do add up. Also, tax implications need to be taken into consid-
eration when buying and selling on a regular basis.

If you stick to a strict quantitative process and it triggers a

sale, as a true Quant you will not override the recommenda-
tion simply because of tax implications. For some, this can
represent a high price to pay for investing with this technique.
This is especially true with some of the more complex strate-
gies that can be developed. The more often there is the
requirement for rerunning a screen, the greater the number
of trades that will take place in your portfolio.

The Dogs of the Dow approach requires only an annual

review and, as such, the costs associated with turnover and
taxes are limited. Be careful, though—if you utilize a strategy
and reset the portfolio prior to the expiration of 12 months,
you may be required to pay a higher tax rate on the short-term,
rather than the long-term, gains.

 RERUNNING A SCREEN
Some screens will require daily processing to choose port-
folio positions. Fortunately, computers do most if not all of
the heavy lifting.

One final story related to this type of investing before get-

ting into the nuts and bolts and the actual technique:

Janus, the Roman god of doorways, gates, beginnings, and

endings, reminds us of the importance of seeing the past as well
36 The Disciplined Investor

as the future. The many statues and pictures of Janus portray

him as having eyes, a nose, and a mouth on both the front and
back of his head to show that doorways simultaneously include
both entrances and exits. As he stands in the doorway—the
present—he can look forward and backward at the same time.
The month of January is named after this god, as it indicates
the end of the old year and the beginning of the new one.

Taking Janus’s advice, you can learn from where you have
been while keeping your eyes focused on where you are going.

Understanding market history is an essential part of mak-

ing sound investment decisions. The quantitative investment
process relies solely upon history to validate its worth.

With this bit of information comes many pitfalls that you

need to be able to recognize. First and foremost, quality of data
is probably the most important component for ensuring
worthwhile results. Great care needs to be taken when finding
data sources that will allow us to gain a level of accuracy and
comfort. This point will be addressed frequently because for
this process to work, data integrity is an absolute necessity.

Second, a clear head that is unbiased in implementing the

process will give you the best opportunity for success. Earlier
you read the discussion about the strict Quants and their desire
to have computers run the entire system. As much as possible,
you need to allow technology to take over while you act as the
controller of the inputs. When creating a new screen or recre-
ating an existing one, make sure that you are wide awake, and
take your time.
Chapter 2 Quantitative Analysis 37

Beyond the essential need for data integrity, the time hori-
zon for the testing of results should be as long as possible. The
basic premise of this discipline is to find a recurring theme that
identifies stocks that will outperform.

After the idea for a screen is generated, back-testing is

important. That way you will be able to see how the inputs that
you have chosen have performed over the years. The longer the
time, the better the chances are that a pattern can be discerned
through the noise. There have been studies that have gone back
as far as 40 years just to prove that the design works.

To use four decades of information requires a great deal of

data as well as an enormous amount of time and manpower.
Years ago, the lack of available computer power was the biggest
obstacle when performing a back-test. Today, this is no longer
a problem.

For professionals, historical information is readily avail-

able, yet still expensive. Probably the best source for this
information is the Standard & Poor’s Compustat database.
Unfortunately this service can cost a subscriber several
thousands of dollars per year—surely not the most feasible
option for an individual investor.

Finally, there is an inherent need for most people to find

simple solutions. Everyone wants to win, and enthusiasm often
gets in the way of our better judgment. Sometimes people look
for rationales to justify data instead of looking toward the data
to provide its own answers. This is what is known as data-min-
ing. What ends up happening is novice investors believe they
have the winning solution that will become the next great
38 The Disciplined Investor

investment idea. Do not let this happen to you. Be skeptical.

Assume that each new idea is a bad one until it is proven oth-
erwise.

Over the course of the next few pages you will be presented
with screens that have been thoroughly compiled and back-
tested over a number of years. Each screen will include a
step-by-step instruction set for its creation within Microsoft’s
MSN Money website (http://www.moneycentral.com). This is the
best alternative to many of the high-cost professional data
products.

You will first need to activate an account through

Microsoft’s online Passport or Hotmail system. Once you navi-
gate to the MSN Money website, there will be an area to log in
and create a new account. All of this is free, although you may
receive periodic e-mails from Microsoft and their advertising
affiliates.

Once you are set up, you can log in to the investor site
(http://moneycentral.msn.com/investor). You will find that
Microsoft’s data sources and the overall ease of use is well
suited for the purpose of stock screening.

Realize that there is no guarantee that each piece of data

from this or any other source will be 100 percent accurate.
That is the general rule when it comes to stock analysis and
investigation, particularly when looking at historical informa-
tion. You may be asking yourself, “Why is that?” It is purely
because information is input by people, and sometimes peo-
ple make mistakes. Also, with the ever-growing number of
earnings restatements, dividend corrections, stock splits,
mergers, acquisitions, and secondary offerings, information
Chapter 2 Quantitative Analysis 39

needs to be adjusted constantly—and it is not always done

correctly.

While this is a scary thought, remember that these prob-

lems are present in all databases and therefore, you are still on
a level playing field with even the most seasoned professionals.

There are a few items that you will need to become com-
fortable with as you start to use this excellent screening tool. It
is important that you become familiar with the basic functions
and features available to you, as they are extremely powerful.

For our purposes, it is assumed that you have a basic

knowledge of the MSN Money website. If you don’t, don’t
worry—what follows is a guide that will provide for most of
the processes that you will need to master. As a warm-up, here
is a quick lesson to help you get better acquainted with the
screening system: (Note: This requires installation of the MSN
Money Investment Toolbox for Microsoft Internet Explorer)
Download and install from either:
1) http://www.thedisciplinedinvestor.com or;
2) http://moneycentral.msn.com/investor/controls/FinderPro.asp)
1) Go to http://www.moneycentral.com
2) On the top navigation bar, click INVESTING
3) Next, below, click STOCKS in the sub-menu
4) On the left bar, click STOCK SCREENER and then
click CUSTOM SEARCH
5) Click below Field Name
6) Select COMPANY BASICS and then DOW JONES
MEMBERSHIP
7) Click under OPERATOR, and then click an option
8) Click “ = ”
9) Click under VALUE, and then click an option
40 The Disciplined Investor

10) Use DJ INDUSTRIALS

11) Look for the box that says, “Return Top Matches”
12) Type in “30”
13) After you finish adding criteria, click RUN SEARCH

What you now have is a current list of the 30 stocks that make
up the DJIA. As you see them, they are ranked in alphabetical
order by the name of the company.

Tips
• If you click ASK ME in the Value field, you will be prompted to
pick a value each time you run the search.

• If you click DISPLAY ONLY in the Operator field, the criterion

will appear in the results, but it will not affect the search results.

• To remove a search criterion, right-click the gray box at the far

left of the row, and then click DELETE ROW.

• To quickly reorder your results, click the column heading you

want to sort by. Click the heading again to reverse the sort
order.

• To adjust a column’s width, click, hold down

and drag the dividers between the column headings.

• To adjust the height of the panes, click and drag the split bar.

• To change the position of the columns, click a column heading

and while holding it down drag it to a new location.

Remember, there are three basic components to be input for

each screen: Field Name, Operator, and Value. These are the
components that build the query that provides the results.
Chapter 2 Quantitative Analysis 41

The only other area that you will need to enter anything
into is under “Return Top Matches.” This is a number (up to
100) that limits the query to the quantity of matching stocks
you wish to see, based upon the criteria provided.

One more note: the addition of field names acts as an

AND statement when searching through the available infor-
mation. Translated, this means that all criteria must match in
order to show up in the final result. This is different than an
OR statement, which will bring out information from either
Field Name input.

Above the Search1 title is the VIEW menu item. Click

VIEW and a dropdown menu appears:

Within this submenu, you will find the option to choose

“Column Set Displayed.” Scroll down to “Company Basics”
and select that as the layout.

You will now notice that the results pane has changed to
include the most pertinent information regarding the compa-
nies in the search. Try a few more displays to get accustomed
to the ones that are prepackaged with the system.

There is also a handy option that allows for the creation of

an unlimited number of custom views. For the time being,
stick with the predefined ones. In addition to this, there are
predefined searches available to help get you thinking about
42 The Disciplined Investor

some of your own ideas. Clicking on the “File” menu and

choosing “Open” will display these.

This will then bring you to a screen that allows you to

either open the screens that you have previously saved or open
pre-designed stock and fund screens. To see what one actually
looks like, select the “Dogs of the Dow” and then click “Open
and Run.” The result is the 10 highest dividend-paying stocks
of the DJIA as compared to their prices.

Screens
Dogs of the Dow
The basic premise was discussed previously, so only the crite-
ria and a few comments are provided here. Use the following
table as a guide to inputting your screen. Match the fields,
operators, and values to come up with the current list of
“Dogs.”

Dogs of the Dow

This is a great screen to uncover stocks that are super value-ori-
ented. Because the current dividend yield is requested to be as
high as possible, the price is obviously comparably low to what
it may have been just a short time ago.

Field Name Operator Value

Dow Jones = DJ Industrials

Membership
Current Dividend
High as Possible
Yield
Chapter 2 Quantitative Analysis 43

The problem today is that there are now many stocks

within the DJIA that provide little or no dividend. This means
that they are repeatedly excluded as possible candidates in this
screen.

Case in point: Microsoft and Intel were added to the DJIA

in 2000 because it was believed that a change in the index
composition was important to keep updated with the then-
current investment climate. However, neither of these stocks
had ever paid a dividend that was worth talking about. In fact,
when it was initially included in the DJIA, Microsoft had
never paid a dividend, as management believed that investing
back into the company was a better way to go. At that time,
Intel’s dividend yield was a paltry 0.30 percent.

Even if these two stocks are the worst performers in any

given year, they will most assuredly be excluded from the final
list of “Dogs.” There is virtually no chance that they will ever
be included in this list.

As a matter of fact, 10 out of the 30 stocks that make up

the index maintain a dividend yield of less than 1 percent.
Consequently, screening from this universe will essentially
result in 10 Dogs out of 20, rather than 10 out of 30.

Price-to-Sales for Large-Cap Stocks

In his acclaimed book What Works on Wall Street, Jim
O’Shaughnessy states, “The price-to-sales ratio is the king of
all the value factors.” He goes on to explain that this individ-
ual value ratio has been the best performer throughout history.
In fact, his research shows that using this one criterion helped
investors beat the markets more than with any other value
ratio, and did so more consistently.
44 The Disciplined Investor

The Large-Cap Price-to-Sales screen will provide you with

an excellent list of value stocks that can be combined with
other ideas. For the most part, the outcome of the query will
reveal those companies that have a high level of sales but have
not seen their stock price appreciate commensurately.

The implication is that stocks here have lower downside

potential, as they have a respectable stream of revenue that
may eventually be rewarded. This is a far cry from those go-
go growth stocks with high prices and low sales. While the
upside for those is great, the downside is usually even greater.

Large-Cap Price-to-Sales

Field Name Operator Value

S&P Index = S&P 500

Membership
Market High as
Capitalization Possible
Low as
Price-to-Sales Ratio
Possible

While simple, the results may provide you with an interesting

list of candidates to think about researching further. Most of
the results will represent value-oriented stocks by the very
nature of the criteria used. Some, on the other hand, may actu-
ally be “diamonds in the rough.”

S&P Index Slugs (SAPI Slugs)

According to MSN Money, this simple but effective value
search presents a pure yield play. It is similar but potentially
superior to the better-known “Dogs of the Dow” search we
Chapter 2 Quantitative Analysis 45

just received because it draws from a wider pool of large-cap

stocks and includes a secondary financial-strength overlay.

The search was also developed and tested by money man-

ager and author Jim O’Shaughnessy. The strategy calls for
buying the top 20 stocks from the result set of this search,
ranked by dividend yield. These should be held for 1 year and
then rescreened and rebalanced. It can be combined with
O’Shaughnessy’s Momentum Growth search to create a bal-
anced 30-stock, 1-year portfolio. This search criteria and
others are available in the stock screener section of the MSN
Money website and can also be downloaded from The
Disciplined Investor website (www.thedisciplinedinvestor.com).

The theory of using more than one screen is to allow for

greater diversification within the portfolio. This way, if one
particular screening method is sorely out of favor, the other
may help to avoid massive losses.

In his research, O’Shaughnessy built portfolios for one

year each. Translated, this means that once you buy the result-
ing stocks and effectively hold them for 52 weeks, you can
rerun the screen to find the stocks to include in the next cycle.

For most individual investors, this is a tedious task and can

result in excessive trading fees. Also, as has been discussed, the
tax implications alone could be extremely detrimental to a port-
folio’s performance. This is precisely why these methods are
often used within tax-deferred accounts along with additional
fundamental overlays. Suffice it to say that these screens should
be used as initial idea generators, not as absolute methodologies.
46 The Disciplined Investor

SAPI Slugs

Field Name Operator Value

S&P
S&P Index Membership = Industrials

Current Dividend Yield High as

Possible 1,000,000

Market Capitalization >=

Industry Average
Current Ratio >=
Current Ratio

<= Industry Average

Debt/Equity Ratio
Debt/Equity Ratio
Display
Industry Name
Only

The MSN Money stock-screening tool makes available some

great ways to unearth buried opportunities. One that has been
found to be very profitable in an upward momentum bull
market is The Earnings Momentum and Analyst Upgrades
screen, which searches out the information reported by sea-
soned analysts.

Earnings Momentum and Analyst Upgrades

This particular screen is meant to be used as a brainstorming
tool for those stocks that may be possible short- to mid-term
momentum plays. The very thought that analysts are raising
their assumptions can cause the sentiment surrounding a stock
to quickly change. As has been seen from the bull markets that
occurred during the latter part of the 1990s, earning surprises
both to the upsides and downsides have a habit of creating
either prosperity or poverty.
Chapter 2 Quantitative Analysis 47

When an analyst that closely studies a certain company or

sector changes his or her rating or earnings estimate for that
company or sector, it is a pretty good sign that there is some-
thing more going on than meets the eye. Companies such as
Zacks Investment Research are in the business of following
these analysts and tracking the changes that they make to their
ratings and earnings estimates.

This search focuses on the companies with the highest earn-

ings-per-share growth projected for the next year and for which
the analysts have increased their estimates. It also adds addi-
tional parameters and overlays to find the stocks with the
greatest recent price changes and upward-moving technical
trends.

Momentum and Earnings Up

Field Name Operator Value

Earnings Estimate Since <In the Last Month>

Increased
High as
EPS Growth Next Year
Possible

Previous Day’s Closing Price >= 50-Day

Moving Average

% Price Change Last Display

6 Months Only

You will undoubtedly find many stocks that you have proba-
bly never heard of within these results. Caveat emptor! Try not
to let yourself get sucked into the temptation of following
historic returns. Be sure to keep a cool head and think about
the company and its longer-term prospects.
48 The Disciplined Investor

GARP
Contrarian plays have long been attractive strategies for those
investors who do not have the stomachs for high-ratio stocks.
By their very nature, these types of strategies expose stocks that
have fallen from grace within the eyes of the markets. They
also find ones that have never caught fire while growing at rates
appropriate to their underlying fundamentals.

Somewhere in between the world of growth and value invest-

ing is the GARP (growth at a reasonable price) patron. This
theory, popularized by Acorn Fund manager Ralph Wanger
(also the author of A Zebra in Lion Country), focuses on find-
ing opportunities with a modest risk within the realm of
smaller capitalization stocks. To control risk, Wanger advocates
companies with proven management structures. He also looks
for stocks with sound balance sheets and strong standings in
their industries, while simultaneously avoiding those that are
already overpriced.

Growth at a Reasonable Price (GARP)

Fieldname Operator Value
Market <= 1,000,000,000
Capitalization

Income Per Industry Average

>= Income Per
Employee
Employee

>= Industry Average

Inventory Turnover
Inventory Turnover
Debt/Equity Ratio <= 0.5
5-Year Revenue >= 20
Growth
EPS Growth Next High As
5 Years Possible

<= EPS Growth

P/E Ratio Current
Next 5 Years

PEG Ratio Below 1 True

Now
Chapter 2 Quantitative Analysis 49

The information returned from this hybrid technique, which

employs multiple levels of filters, will help find additional
opportunities for investment. For the most part, looking at
both the income per employee and the inventory turnover
helps to seek out those companies that have an edge over their
industry constituents.

Each of the resulting stocks from this screen likely reflects

the company’s ability to understand the distribution and man-
ufacturing process of the goods they are selling.

When a company consistently shows the ability to be a

leader within these two important areas, there may be some-
thing further to review.

Debt to equity is very important to keep at a minimum,

especially in smaller companies. The impact of large debt loads
are most pronounced with small-cap firms. As this screen
hunts for companies with market capitalization of under $1
billion, this particular overlay provides a better positioning
with companies that have lower than average debt.

Finally, the earnings per share (EPS) and PEG ratio

fields filter for stocks that show reasonable growth. The require-
ment to screen out those companies with PEG ratios above one
and those that have P/E ratios above their projected EPS growth
rates is very important. By doing so, it will be clear that the
results will have analysts showing that they believe in the stock’s
prospect for growth and that most investors have not over exag-
gerated the buying. Therefore, the current price is in line or
lower than it should be, taking into consideration earnings and
earnings growth.
50 The Disciplined Investor

 EARNINGS PER SHARE (EPS)

This ratio is perhaps the most widely used by analysts
because it reveals how much profit was gained on a per-
share basis. On its own, EPS is not particularly useful. When
sizing up the value of a company’s stock using the EPS
ratio, you must compare the current figure to that from the
previous quarter or year. When doing so, you can properly
determine the rate of growth for a company’s earnings.

 PEG RATIO
This ratio represents a hybrid application of the P/E ratio (the
price to earnings ratio—fully defined later in Chapter 4) and
a company’s annual growth rate. If a stock’s PEG falls below
a value of one, it is typically considered underpriced. If it
jumps much higher than one, it is considered overpriced. It
should be noted that when applied on its own, the accuracy
of this formula has been questioned by many reputable econ-
omists.

Momentum Stocks
Trading on a short-term basis has provided both boom and
bust outcomes for many. The theory of investing in stocks
based on technical factors such as volume traded, comparative
price changes, and recent price changes was, and is, the home
for day traders.

Yet, with that said, it has to be understood that there are

those who want hot stocks and lots of trading action for a por-
tion of their portfolio. Still, whether or not you believe that
this is a good investment strategy is another story altogether.

Screening can be used to find information about the

underlying technicals of a stock. A wonderful search that
Chapter 2 Quantitative Analysis 51

can be found directly on the MSN Money website looks for

stocks whose prices have moved rapidly higher during the past
six months. The screen also has requirement of at least a $100
million market cap and an average daily volume of at least
10,000, to help exclude very small companies.

 TECHNICALS
The trading patterns exhibited by a stock. For more informa-
tion, see Chapter 3.

The primary result will be stocks with terrific performance

over the past few weeks. It also searches for companies with
increasing trading volume. Theoretically, the increased volume
will lead us toward stocks that are finding more interest with
investors.

Momentum Stocks
Fieldname Operator Value
>= 100,000,000
Market Capitalization

On Balance Volume >= 80

On Balance Volume <= 300
Average Daily Average Daily
Volume >= Volume
Last 2 Weeks Last Month
Average Daily Average Daily
>=
Volume Volume
Last Month Last Quarter
Average Daily Average Daily
Volume >= Volume
Last Quarter Last Year
Average Daily
Volume >= 10,000
Last Month
6-Month >= 90
Relative Strength
12-Month >= 90
Relative Strength
3-Month >= 6-Month
Relative Strength Relative Strength
% Price Change >= 5
1 Week
52 The Disciplined Investor

As you look at the screening criteria for this search, notice

how the progression starts from the most recent time period
and extends forward. The next time period of volume is com-
pared to the previous to ensure gains during the more recent
period. Momentum is the goal here.

With that in mind, it is time to move on to the next topic

in order to help bring some of this together. It is wise to remem-
ber that none of the disciplines that are presented represent a
black-box answer to investment analysis. Only when combined
with the appropriate investment research and analysis should a
decision be reached to buy or sell a stock.

Use each of the disciplines as building blocks to gain

insight into the future direction for your investments. Then
develop a thorough understanding of the company, and the
answers to the many questions you seek will become clear.

As you have seen, the application of hard numbers—if not

simply the intricate formulas—plays a basic yet valuable role in
a disciplined investment strategy. But, as mentioned near the
end of Chapter 1, the numbers do not stop there. In the next
chapter you will find a detailed account of the second compo-
nent of our approach—technical analysis. It is a discipline that
relies on three key premises to reveal a visual account of market
movement: efficiency, history, and trends.
 Chapter 3

Technical Analysis

There are three basic premises that technical analysis is

predicated upon: 1) markets have trends; 2) markets are effi-
cient; and 3) history repeats itself. The latter is only true
because people are creatures of habit. During your lifetime,
you will tend to react to the same conditions in a similar fash-
ion almost every time. Economist Harry S. Dent, Jr. has
termed this “the human model of forecasting.”

 TECHNICAL ANALYSIS
Technical analysis is the use of historical statistics of invest-
ment supply and demand to discover and exploit stock price
patterns. This technique is not limited to stocks, but can
also can be used to forecast market indices, industries,
sectors, bonds, currencies, and commodities.

These actions and reactions translate to buy-and-sell events

in the investment marketplace. They are then charted by a
technical analyst who looks to uncover potential patterns and
trends. Many patterns can be accurately measured and
ultimately forecasted in order to determine cycle highs and
lows, creating signals that determine when to get in or out of
the market. Note that the previous sentence states that the pat-
terns and not the forecasts can be accurately measured and

53
54 The Disciplined Investor

ultimately forecasted. Forecasting where a particular stock or a

market index is headed is not a clear-cut scientific process.

The technical analyst, also known as a technician, gauges

how investors “feel” about a certain company by watching the
flow of monies in and out of that particular stock. They do not
concern themselves with profitability ratios, growth rates or
product pipelines. That is the job of the fundamental analyst
(see Chapter 4).

The technician believes that all of the known financial

information pertaining to a stock is already priced into the
market in the form of supply and demand (the Efficient
Market Theory).

 EFFICIENT MARKET THEORY

This refers to the extent to which securities prices reflect
what is known and promptly adjust to what becomes
known. Even with the advent of technology, an active press,
and easily accessible online trading, there is still an ongo-
ing debate about market efficiency.

Those that subscribe to the efficient market theory argue

that markets are properly priced, giving consideration to the
point that all information available has been already discounted
in the price. The implication is that there is nothing that will
help an individual or an advisor consistently beat the markets.

Proponents of passive investment management, and specif-

ically advocates of index investing, believe this theory and cling
to any and all evidence they can conjure up. At the same time,
it is difficult to disagree with the fact that most active money
Chapter 3 Technical Analysis 55

managers have a hard time outperforming their benchmark

index on a regular basis.

The counter-group, of course, feels that this is just hog-

wash and contends that an investor, through research, can find
stocks that will outperform the market. Warren Buffett and
Peter Lynch are prime examples.

Since the market is an anticipatory mechanism, techni-

cians can forecast changes in stock prices more quickly by
looking at charts than the fundamentalist can by taking time
to analyze a company’s financial data. To illustrate this fact,
think about how many times you have witnessed a stock rising
or falling for no apparent reason. Then, after a fundamental
change (earnings announcement) or newsworthy item (CEO
retirement) is announced, the stock price starts to rise or fall
once again. By the time you find out the specifics as to why the
stock price has moved, it is usually too late.

This is where technical analysis can prove to be a beneficial

tool. In essence, you can analyze and interpret charts in order to
act on a stock movement without having to wait for the catalyst
to appear. Keep in mind, however, that if there are significant
financial concerns underlying the company, the chart may not
be a particularly helpful tool. In fact, it can be quite harmful.

The most successful professional day-traders are, at the

core, good technical analysts. Day-traders are frowned upon by
many old-school money managers, but given today’s stock
market and its increased volatility, this type of trading has a
tendency to be extremely profitable.
56 The Disciplined Investor

 DAY-TRADERS
A stock trader that falls within the category of “very active.”
The typical day-trader tends to hold stock positions for a
relatively short time, opting instead to make multiple trades
(sometimes dozens) on most days. These investors usually
view stock trading as an independent career rather than a
vehicle for amassing a retirement fund or generating
supplemental income.

Day-traders are just one type of short-term trader. This

group also contains swing-traders, market-timers, and many
short-sellers. In today’s market, a great deal of the daily market
volatility can be attributed to their influences.

Think back. How many times have you seen top blue chip
stocks come out with great earnings reports and subsequently
watched their share prices drop like rocks?

There are two reasons for this. First, investors are always try-
ing to get in or out before everyone else does. The strategy for
trigger-happy investors is to buy on the rumor and then sell on
the fact, or vice versa. Therefore, if the consensus believes that a
certain stock will hit or surpass its expected quarterly earnings,
investors will begin to bid up that stock ahead of the earnings
release. Then, when the good or bad news is announced, the
short-term traders of the world start selling, taking out the prof-
its they made on the way up. If the stock moves against them,
they will also sell in an attempt to limit their losses.

Second, using technical analysis will tip off the day-trader

as to the sentiment surrounding the stock. Money flow into
the stock grows on higher volume, telling the short-term trader
that the fundamentals are looking bullish, signaling a potential
Chapter 3 Technical Analysis 57

buying opportunity. When money flow into the stock drops

off, the amount of buyers and sellers is, in effect, balancing
out. This, in turn, translates into a stock that is only fairly val-
ued to investors. At this point, the short-term trader sees no
further price appreciation and dumps the position, causing the
stock to fall.

The most prudent of the new breed of Disciplined Investors

will not confine his or her investment strategy to charting
alone. The optimal strategy combines both fundamental and
technical analysis skills to create a disciplined investment style
for long-term wealth accumulation. A fundamental (financial)
review should uncover the strengths and weaknesses of a firm.
Then, if the stock is fundamentally sound, technical analysis
can be implemented to make an informed decision on when to
buy into or sell out of the position.

Chart Analysis
A technician needs to be able to analyze many different
types of charts. First though, they need to understand the prin-
ciples of how charts are constructed and what each piece of
information represents.

Price History - IBM (11/24/2005 - 11/22/2006)

11/21/2005 1/2/2006 4/3/2006 7/3/2006 10/2/2006 11/20/2006
$94
$92
$90
$88
$86
$84
$82
$80
$78
$76
$74
$72

(Data Source: Yahoo! Finance)

58 The Disciplined Investor

For our purposes, a bar chart will be used as a starting

point. Below is a sample of a daily bar chart showing the high,
low, and close data points (HLC).

Chart Components
On the left/vertical axis of the chart above, you will find the
stock price of IBM. On the top/horizontal axis is the date
range. For every date, you will find a corresponding data point.
From these points, you can find the opening and closing
prices, the high for the day, and the low for the day. In addi-
tion, for each day, you can easily see the full price range of
executed trades.

An example of a data point:

Take a closer look at the data point:

High for the day

Trading
Range
Closing
Price

Low for the Day

Chapter 3 Technical Analysis 59

The “trading range” refers to the range of prices the stock was
selling at throughout the day. The top of the trading range is the
highest price at which the stock was sold and the bottom of the
range is the lowest price at which the stock was traded. The clos-
ing price is how the stock ended at the end of the trading day.

To determine the opening price, simply refer to the previ-

ous day’s data point and find the closing price. That closing
price is usually the opening price for the next trading day.

There can be much more information included on a stock

chart, some of which will be addressed later in this chapter.
This important additional information includes studies such as
volume, moving averages, oscillator lines, and the MACD
(pronounced Mac-dee) indicator.

Now that you better understand the basic components of

a basic stock chart, the analysis of various price patterns will be
easy to comprehend.

Time Period
Before further exploring the components that make up a tech-
nical chart, one point needs to be made clear: technical
analysts look at price charts constructed over any length of
time, including yearly, monthly, daily, intra-day, and even tick-
by-tick. You will see a data point corresponding to each and
every trading period.

 TRADING PERIOD
The last point in a given time period in which trade prices
are reported. If the chart is made up of daily pricing, the
end-of-day price will be one of the data points. The high or
low may also be included, depending on the chart type.
60 The Disciplined Investor

Price Patterns
First, and perhaps the most obvious, is the fact that stock
prices can only move in three directions: up, down, and side-
ways. Price patterns can get very detailed and complex; so
much so that any number of books could have been (and have
been) written on price patterns alone.

This section will illustrate various price patterns in order to

provide you with a base of knowledge, helping you to recog-
nize the most popular patterns that technical analysts use.
Keep in mind that the overall objective is to help you profit
from stock investments.

Trading in a Range
As discussed previously, stock prices are fueled by human expec-
tations and therefore, recognizable cycles will often emerge.
These usually consist of peaks (highs) and valleys (lows).

The following illustration is a simplified example of a

“cyclical trend.” The assumption is that humans have varying
perspectives. At the same time, they generally predict that
cycles will usually continue to trend in the same manner over
and over. Remember, these cycles can occur over any period of
time, no matter how long or short.

Peak
Peak Peak
k

Valley Valley

The trend, illustrated above, is at a peak as related to its

historical performance or pattern. This does not necessarily
mean that the price will move lower in the future, just because
Chapter 3 Technical Analysis 61

the pattern has done that before. Nor does it mean that the
price will continue climbing higher.

From the viewpoint of an investor and specifically a tech-

nical analyst, this is not the most opportune time to buy.
Rather, this pattern is seen as a bearish indicator (negative sen-
timent) and signals a good time to sell, or could indicate a
short-sale opportunity. The opposite would be true if the trend
line were in or near the valley. At that point, it would proba-
bly represent a buying opportunity. Therefore, cyclical trend
lines are not strong buy or sell indicators.

Consolidation
Consolidation (illustrated below), or “formation of a rectan-
gle” (shown by lines A and B), occurs when pressure is
building up in a stock. A consolidation phase is usually a tem-
porary stall in a pattern. The belief is that if a stock has been
in an uptrend and then begins to consolidate, the prevailing
uptrend should continue and a breakout through the resist-
ance level will soon follow.

This assumption can be made unless the price breaks

through the support level, signaling the confirmation of a
reversal of the previous trend. This consolidation rectangle can
provide strong evidence of future direction:

Resistance

B
Support
62 The Disciplined Investor

Congestion
A stock is in a “congestion phase” (example below) when there
are no obvious patterns emerging. Along with this type of trend
comes indecisiveness with regard to technical direction. This
usually indicates confusion about the underlying direction of
the stock on the part of investors.
No Obvious Pattern

A stock trading in this manner will not attract the techni-

cal analyst, as there are no definitive price patterns signaling
any action.

Upward Trend
An “upward trend” occurs when a stock begins to move higher.
In the situation illustrated below, each successive high becomes
higher than the last and each successive low is also higher than
the last. An upward trend is a bullish indicator that signals a
buying opportunity, as a stock may be breaking out through its
resistance levels and beyond.
Price History - Microsoft (11/30/1998 - 2/2/1999)
$88

$86

$84

$82

$80

$78

$76

$74

$72

$70

$68

$66

$64

$62

$60

11/30/1998 12/14/1998 12/28/1998 1/11/1999 1/18/1999 2/2/99

(Source: MSN Money)

Chapter 3 Technical Analysis 63

Downward Trend
A “downward trend” is the exact opposite of an upward trend.
Each successive high is lower than the last and each successive
low is also lower. This will often signal a sell, as the stock price
may be falling below support levels and may be carrying a neg-
ative sentiment regarding its underlying fundamentals.

Price History - Lucent Technologies (2/29/2000 - 4/5/2000)

$76
$74
$72
$70
$68
$66
$64
$62
$60
$58
$56
$54
2/29/2000 3/6/2000 3/13/2000 3/20/2000 3/27/2000 4/3/2000 4/5/2000
(Source: MSN Money)

Resistance and Support

A “resistance level” can be defined as a ceiling (high-end), per-
haps as the result of purchases made before a decline. The
general thinking is that investors, waiting for a rebound, will
seek to sell when the stock price has recovered enough to wipe
out their losses. Thus, the stock or the market as a whole is pre-
vented from moving higher.

On the other side, the “support level” is the price point at

which investors seem comfortable to buy (the low-end), per-
haps because it is as low as the stock seems to be going, or
because the apparent bargain becomes irresistible. The trading
range between the support level and resistance level is known
as a “channel.” Look at the chart, on the next page, for Texas
Utilities (TXU) and notice the channel between the resistance
level of $42.50 and the support level of $39.00.
64 The Disciplined Investor

Price History TXU Corp. (1/2/1996 - 5/28/1996)

$43
Resistance Level

$42

$41
Channel
$40

$39

Support Level
$38
1/2/1996 2/1/1996 3/1/1996 4/1/1996 5/1/1996 5/28/1996

(Source: MSN Money)

In order to become a significant support or resistance

price, the chart should show several successive and unsuccess-
ful attempts to breach a price level. When you attempt to draw
either, look to a chart that shows a significant number of peri-
ods to allow for an accurate representation of the price activity.

As stated before, stock prices can only go in three direc-

tions: up, down, and sideways. The chart of Texas Utilities
(above) is an illustration of a sideways trend, which usually fol-
lows and precedes an upward or downward trend.

Now, look at the second Texas Utilities chart, located on

the bottom of the following page. Notice the downward trend,
illustrating the market is turning in favor of the sellers—in
other words, the trend is moving toward more sellers of the
stock than buyers.

In the first consolidation phase (number one), there is a

leveling out of the stock price as buyers and sellers begin to
even out. As this sideways trend continues, there is a buildup
Chapter 3 Technical Analysis 65

of pressure in the stock, and eventually there will be either a

reversal or a continuation of the previous downward trend.

You can anticipate this next trend by looking at the resist-

ance and support levels. In the first sideways trend (1), notice
the resistance at about $48.00 per share and the support holds
at around $47.75 per share (a very tight channel). Once the
price dips below support, it indicates a confirmation signal. It
did just that on September 20th of that year and provided the
technical analyst the ability to forecast a continuation of the
previous downward trend. The result would probably be a sale
of a long position or an initiation of a short-sale.

In the example, the trend continues downward to just

under $46 per share and the next or secondary consolidation
phase begins (2). If, instead, the stock price breaks out above
the support level, it could indicate a buying opportunity.

Price History - TXU Corp. (8/26/1993 - 10/14/1993)

$50

$49

1
Resistance
$48

Support
$47
Breakdown 2
through Support

$46

8/26/1993 9/6/1993 9/13/1993 9/20/1993 9/27/1993 10/4/1993 10/11/1993 10/14/1993

(Source: MSN Money)

Discovering these consolidation phases can be very helpful for

taking advantage of swings in stock prices for a daily momentum
trade, or when looking for the optimal price or time to enter a
66 The Disciplined Investor

stock transaction. Bear in mind, though, that many times when a

price breaks out or falls through there is the chance that it repre-
sents a “fake out” and the price may boomerang back. Therefore it
is recommended to wait for the price to surpass at least three per-
cent over the resistance or three percent under the support price
before assuming the confirmation signal is accurate.

Head and Shoulders

Another popular (and perhaps the most reliable) price pattern is
the “head and shoulders distribution” as shown below. The pattern
consists of three separate and distinct rallies. One rally (the head) is
sandwiched between two smaller rallies. The first shoulder is the
initial run in the bull rally and the second shoulder is basically the
start of a bearish decline.
(H )
(S) ) (S)

A very important aspect of any price pattern is the techni-

cal indicators that accompany them. Look at the chart below
and take notice of the daily prices of Sample Stock, Inc. and
the volume illustrated by the vertical bars at the bottom.
Price History - Sample Stock, Inc. (3/1/2006 - 4/21/2006)
$74

$72
(H)
$70

$68

$66 (S)
$64

$62

$60
(S)
$58

$56

$54

100M
e
Volumsing
80M
rea
Inc
60M
40M
20M
0M
3/1/2006 3/5/2006 3/13/2006 3/20/2006 3/27/2006 4/3/2006 4/10/2006 4/17/2006 4/21/2006
(Source: Horowitz & Company)
Chapter 3 Technical Analysis 67

Trading activity is usually heavier during the formation of

the first shoulder, as can be seen by the volume indicator
related to that period. The confirmation (or the development
of a head and shoulders pattern) is signaled during the forma-
tion of the second shoulder.

The head and shoulders pattern does not always need to

have a symmetrical look to it. Rather, it may come in many
different shapes and sizes as shown here:

(H)
(S)

(S)

(H )
(S)

(S)

(S) (H )

(S)

If the pattern is flipped, or the head forms a bottom (see

below), it is known as an inverted head and shoulders pattern,
which is actually a bullish indicator.

(S) (S)
(H)
68 The Disciplined Investor

When presented with a head and shoulders pattern, you

can often measure the expected price movement up or down
during the pattern’s lifecycle. Refer to the chart depicting the
NASDAQ Composite Index during 2000, shown below. By
drawing a straight line connecting the low points (shoulders)
on each side of the head, you have easily created a “neckline.”

Next, draw a line from the highest point on the head to the
neckline. Then, take that distance (sometimes referred to as
the range) and subtract it from the neckline. This is the esti-
mated level to which the price can theoretically fall.
Price History - NASDAQ Composite (7/5/2000 - 8/2/2000)
4,300
(H)
4,250
4,200 R
4,150
a
n
4,100 g
4,050 (S) e (S)
4,000
3,950
3,900 Neckline
3,850

3,800
3,750
3,700

7/5/2000 7/10/2000 7/17/2000 7/24/2000 7/31/2000 8/2/2000

(Source: MSN Money/Horowitz & Company)

In addition, the period of time it takes for the head and

shoulders pattern to develop is usually a good indicator of how
long or short the correction could last. Therefore, if you notice
a head and shoulders pattern that developed over a two-year
period, you could expect a potentially lengthy correction on
the other end of the pattern.

In the summer of 2000, the downside range from this

pattern became a short-term resistance level as investors
were looking for direction. At the end of July 2000, the
Chapter 3 Technical Analysis 69

stock market continued to slide and buyers began to step in,

hoping that the end of the correction was near.

Those buyers assumed that the drop below the neckline

range created an oversold situation. They bid the market up to
the resistance level, which at one time was support. Once they
realized that there was a price ceiling and that the bounce was
not going to move beyond that level, selling ensued once again.
Example of Head and Shoulders Pattern - “Inverted” (6/21/2007 - 7/17/2007)
$40

$39

$38

$37

$36

$35

$34
$33

$32
(S)
$31
(S)
$30
(H)
6/21/2007 6/26/2007 7/3/2007 7/10/2007 7/17/2007

(Source: Horowitz & Company)

Double Top and Double Bottom

The “double top” is a major reversal pattern that usually
emerges after an upward trend has occurred. As you would
expect, the pattern consists of two significant tops or heads. It
usually precedes a bearish move and sometimes even market
corrections as well. One important note about double tops is
that they are typically confirmed if they are separated by 30 or
more periods.

If there is no clear confirmation of the pattern, it may

actually be a normal resistance level that will eventually break.
The time requirement helps to separate the real pattern from
70 The Disciplined Investor

a fake-out. Another signal that will help with confirmation of

this pattern is the occurrence of accelerating volume as the
price declines. If you notice the lowest level between the tops
has been breached on increasing volume, this usually repre-
sents a clear sell signal.

4,300
Price History - NASDAQ Composite Index (6/5/2000 - 10/9/2000)
4,200

4,100

4,000

3,900

3,800

3,700

3,600

3,500
Double Top

3,400

3,300
6/5/2000 7/3/2000 8/1/2000 9/1/2000 10/9/2000
(Source: MSN Money)

The “double bottom” is really the opposite of the double

top in that it usually signals a forthcoming rally. If you think
about it for a moment, both of these indicators are simply
showing technical investors that there is a price level that has
not been breached. It shows either a support or resistance point

$42 Price History - Walt Disney Companies (5/18/1998 - 4/3/2000)

$40
Double Bottom
$38

$36

$34

$32

$30

$28

$26

$24

5/18/1998 7/6/1998 10/5/1998 1/4/1999 4/5/1999 7/5/1999 10/4/1999 1/3/2000 4/3/2000

(Source: MSN Money)
Chapter 3 Technical Analysis 71

that has been well established. In this pattern, there have been
multiple times when key levels have been reached but not bro-
ken. The forecast will usually predict that the trend should hold
the support (bullish) or be limited by the resistance (bearish).

All of the material presented in this chapter merely scrapes

the surface. This tip of the iceberg presentation is intended to
be a primer to introduce you to the valid approaches used in
technical analysis that are at your disposal. By mastering the
forms of research explained within these pages, you will be well
on your way to becoming a self-driven investor with a keen
sense of discipline—and with this newfound knowledge can
come steady and stable growth for your portfolio.

As with anything, history has a great deal to teach us. The

investment markets are often cyclical and usually have a way of
creating repetitive patterns. With a sharp eye to what has
already been revealed, you can shrewdly carve out a path
toward a successful investing experience.

There are times when charting, on its own, falls short as a

means of projecting outcomes for the market. Fortunately
there are other forms of analysis that will allow you to take a
look at a company’s public records in order to gain a clearer
picture of the here-and-now of a stock’s growth potential.

In the following chapter, you will find an overview of this

process—the discipline known as fundamental analysis. It is
much different from what has been discussed so far. What you
will find is that a fundamental analyst tries to anticipate the rate
of growth of a firm’s earnings and uses other ratios to predict a
stock’s price. Essentially, the research is used to determine if a
stock is over- or undervalued and then invest accordingly.
 Chapter 4

Fundamental Analysis

Thousands of people around the world make their livings by

analyzing securities. This is a relatively new vocation, as it was
only around the turn of the last century that buying and sell-
ing stocks became honorable. Once it began to gain a better
reputation, it caused many of the speculators to leave the mar-
ket in search of the next unsavory opportunity. Prior to the
stock market as we know it today, people utilized the markets
as more of a center for legal gambling than a place for long-
term growth.

Many of today’s analysts work for institutional money man-

agers such as mutual funds, pension funds, and insurance
companies. They are often labeled as “buy-side” analysts
because they are looking to buy or sell securities specifically on
behalf of the firms they work for. Their analysis and reviews
need to be unbiased and accurate in order to ensure that the
firms will make well-informed decisions concerning their
expectations for profitable opportunities.

The remainder of the practitioners are considered “sell-

side” since their purpose is to create reports that will entice
investors to purchase a particular stock. This faction works
largely for brokerage houses and securities firms.

73
74 The Disciplined Investor

The average investor can easily obtain the advice pre-

sented by the latter crowd, since they are in the business of
generating fees from transactions. Because of this, hundreds
of reports are authored every day. Consequently, as a
Disciplined Investor, you need to take extra care when review-
ing price targets and recommendations found in reports that
may be overly optimistic.

 FUNDAMENTAL ANALYSIS
A method wherein an investor searches for winning stocks
by researching a company’s earnings history, balance
sheet, management, product line, and other factors that will
affect its profitability and growth. The significant difference
in fundamental analysis versus technical analysis is that the
fundamental analyst will look at information pertaining to a
company’s finances that are obtained from their annual
statements as well as news items. Past trading patterns are
of no concern, as the focus is on the future. They seek out
companies that will have financial and business catalysts to
help improve their shareholder value. This discipline is con-
siderably more “long-term” minded.

The art of creating a stock report is at the center of the fun-

damental analysts’ daily routine. They do this in an effort to
fully understand the current financial health of a company and
to make educated buy, sell, or hold decisions.

As a Disciplined Investor on your way to learning the inner

workings of fundamental analysis, you will need to rely on
information and data that is current and accurate. In addi-
tion, historical data and future projections are vital tools in
this process. Since the market is very efficient, the slightest
Chapter 4 Fundamental Analysis 75

miscalculation or the use of incorrect data could cause

devastating financial results.

History has vividly shown to us many times over that stocks

can literally be crushed by the announcement of an accounting
change or a restatement of earnings. With this in mind, it is a
non-negotiable prerequisite that as you make your analysis you
look for reliable sources of information for the raw data.

Similarly, it is essential that you understand the equations

behind the various ratios that you use. Question and
re-question the information. Is the ratio developed using past or
future earnings? Do you have accurate and up-to-date informa-
tion from the balance sheet and income statements? Are the
figures you are using adjusted for splits and dividends? These
are just some of the questions that will be answered in this
chapter.

Volumes upon volumes have been written on this very sub-

ject, and this chapter will attempt to convey it in only a few
pages. Realize that this is intended to be an overview and guide
on how to properly utilize the most important techniques and
latest systems developed for the disciplined investor. Some will
be taken from investment icons like Benjamin Graham, Jeremy
Siegel, and David Dodd, as well as other well-known and well-
respected experts in the field.

Ultimately, upon completing this chapter, you will have all

the tools necessary to help you understand the inner dynamics
of fundamental analysis. This will provide you with a major
advantage over your neighbors in properly interpreting infor-
mation and financial statements.
76 The Disciplined Investor

When you begin to analyze a company, there are a few

basic items that need to be understood. The “must list” con-
sists of a review of the company in question, its business
proceedings, present and historical earnings, analyst recommen-
dations, financial projections, and price targets. Additionally, a
thorough review of recent research reports should be completed
in order to provide you with a multidimensional picture of the
company. This will eventually assist you during the final process
of an informed buy or sell decision.

Too many times, hearsay and tips are used as “sound finan-
cial investigation” only to turn out to be a big monetary bust
(tax losses are available as a small consolation).

Finally, it needs to be said that the use of this technique is

not rigid. Many derivations of the basic principals have been
used over the years in an attempt to find the magic formula.
You should embrace the idea of working within the frame-
work, but do it with flexibility.

Search outside the box to discover alternative ways of

applying the data. Remember that when it comes to the mar-
ket, there are no absolute answers, so you do not have to
restrict your thoughts to the teachings of others. Rather, use
them for guidance when forming general parameters and in
the creation of your own unique disciplines.

The best way to start off is with a few important defini-

tions. These will be used throughout this and other chapters, so
it is wise to become familiar with them, as they are the “talk of
the street.” When investors chatter, this basic vernacular is the
lingo of money.
Chapter 4 Fundamental Analysis 77

Financial Statement and Ratio Analysis

Income Statements
Income statements reveal how much revenue a company
brings into the business by providing services and/or goods to
its customers over a specific timeframe. It is intended to show
the costs and expenses related to procuring the revenue
acquired during the specified time.

The income statement also shows two main categories of

information for each period covered. First is the revenue from
products and services that the company has sold. Next are the
expenses—the actual costs of doing business. Analysts pay
close attention to this statement and rely upon information
related to revenue, gross profit, operating income, net earn-
ings, and earnings per share when interpreting a company’s
financial position.

Revenue
Revenue can be earned by companies in many ways. They can
sell products and services or possibly lease or rent equipment.
They can also earn dividends and interest on loans they supply
to other companies. Many companies have several sources of
revenue while others rely on a single stream of income. As an
example, a company such as Apple may receive income from
selling products as well as manufacturing. They may also
receive a commission from selling music and books. They
could report revenues from consulting and services, which may
additionally include rentals, financing, and maintenance. In
addition, they may earn dividends and capital gains on various
investments that will also be included as revenue.
78 The Disciplined Investor

Gross Profit
You are undoubtedly familiar with the belief that if you want
to make money, you usually have to spend money. For most
companies, the cost of goods sold (COGS), also know as the
cost of sales, is the greatest cost of generating revenue.

For example, Dell Computers must buy circuit boards and

semiconductors to make its computers. They also have to pay
their workers and management teams as well as spend money
on property expenses, power, and maintenance. All of these
expenses are deducted from the revenue, leaving the company’s
gross profit (net revenue minus cost of sales = gross profit).

As stated above, the cost of goods sold is usually the great-

est cost for any business. A company that manufactures and
sells products will usually have a higher level of expenses related
to COGS, while a company that provides mainly services will
have a higher level of salaries, bonuses, and benefits.

Operating Income
Beyond the expenses directly related to manufacturing a prod-
uct, you will find operating expenses. Spending that falls under
this category could include items such as salaries for office staff,
research and development costs, advertising costs related to the
sale of the product or service, and other administrative costs.
When these are subtracted from the gross profit, the number
that remains is considered the operating income or loss.

Launching a new product or service or attempting a phys-

ical expansion will cause most companies to carry operating
expenses that are much higher than normal. Attention to detail
in this area should be maintained to fully understand why the
Chapter 4 Fundamental Analysis 79

operating expenses have increased on a year-over-year basis in

order to properly project future operating income.

Some firms may incur large expenses as they expand in an

attempt to gain market share. As you look through the income
statement, try to identify and make note of the annual changes
on a separate piece of paper. As you build your list of items to
be reviewed further, you will start to develop a virtual picture
of what has really happened within the company over time.

Additional questions may come up and can be answered

after a further review of the annual report or by calling the
company directly. Shareholder service representatives are usu-
ally more than happy to help with basic requests regarding
reported operations.

It may be a good idea to call the direct line of a company

that you are considering investing in. You can usually call a
company’s investor relations department and speak to a knowl-
edgeable source that should be able to provide accurate
information regarding the company.

Here is a real example of this idea in action: a number of

years ago, an investor was searching for additional information
on Tosco, a company in the oil sector. It was 8:00 a.m., and
there was a need for additional information to clarify a few
discrepancies about their inventories.

The decision was made to call the direct line and ask to
speak to the chief financial officer. Amazingly, he picked up
the phone himself. It was early in the morning and appar-
ently his assistant had not yet arrived to screen his calls. After
80 The Disciplined Investor

a 10-minute conversation, the investor had all of the infor-

mation he needed to make an important financial decision.
The clarification helped to explain the issue and in the end
the transaction was highly profitable.

Net Earnings
The “bottom line” is by far the most important item in any
financial analysis. This often-used phrase may quite possibly
be derived from the fact that there is actually a “last line” on
financial statements.

Once the deductions are subtracted from the gross rev-

enue, the result is considered to be the net earnings (or loss). If
the company had a good year and their expenses were less than
their revenue, they would (or at least should) show a profit. On
the other hand, if the contrary is true, the cash flow statement
will show a loss.

During the latter part of the 90s, many “dot-com” compa-

nies were surviving on money in the bank in an attempt to
capitalize on future technology promised by the new millen-
nium. This is precisely why most now refer to many of those
companies as “dot-bombs.” It was a folly for them to spend
down their primary sources of capitalization rather than
actively seek profitable business models that would provide for
their income needs.

When a company has negative earnings is a good indica-

tion of what lies ahead. There is no possible way that any
business can maintain viability when it is continually showing
a net loss. Case in point: the staggering number of bankrupt-
cies that plagued the business-to-consumer market of the
“dot-com” industry at the turn of the century.
Chapter 4 Fundamental Analysis 81

With that in mind, there is still the potential for a com-

pany to make a turnaround and become highly profitable,
even if it is currently showing a loss. Be certain that there is
substantial evidence that there is or will be a catalyst that will
help to turn the loss into a gain. Otherwise, there will surely
come a time when the company will need to stop the bleeding.
If it gets to that point, you will wish you were never a
shareholder.

Earnings Per Share (EPS)

Earnings per share is the best means of understanding the prof-
itability of a company. It is the net earnings or income of the
company divided by the number of shares outstanding. This
particular number can be used as a base to calculate many
other useful comparative ratios.

EPS = Net Income ÷ Shares Outstanding

Suppose that a company has 2,000,000 shares outstanding

and earns $4,000,000 per year. Since the EPS is a division of
the two, the result will be $2 of EPS per share. This simple
ratio is one of the core principles in analyzing the fundamen-
tals of a stock. It helps to show the relative earnings of a stock
when compared to others in the same industry.

Earnings are by far the most important component when

calculating the true value of the stock. Whether a multiple is
applied or a discounted calculation is used, this is probably the
one instrument that most analysts include in their studies. The
good news is that historical earnings information is easy to
come by. The bad news is that estimates of future earnings are
known to have wide ranges with limited accuracy.
82 The Disciplined Investor

Even companies that make their livings “guesstimating”

future earnings have acknowledged their relative inabilities to
properly forecast the future. Moreover, the greater the distance
from today until the actual earnings report, the more deviated
the estimated earnings are likely to be from the actual result.

Price-to-Earnings Ratio
The most commonly used ratio is probably the price-to-earn-
ings (P/E) ratio. This is sometimes referred to as the “price
multiple” or “earnings multiple.”

To calculate this ratio, you take the closing price and

divide it by the earnings per share (EPS) for the previous 12
months. This ratio helps one to understand whether or not a
stock is over- or under-valued.

Current P/E Ratio = Price ÷ Current Earnings

Forward P/E Ratio = Price ÷ Estimated Earnings
Trailing P/E Ratio = Price ÷ Prior Earnings

When looking at this ratio, it is important not to view it in

a vacuum. This is one of those ratios that should be used in a
comparison, rather than on a stand-alone basis. Every market
sector has a different P/E in which its members can be com-
pared. Make sure to look at this ratio with that in mind. Be
careful not to compare the P/E of significantly different indus-
tries such as a technology company and a bank since it will
have no relevance. Technology, health care, biotech, and some
service companies often trade at P/Es above 40, or about dou-
ble the average of the stocks comprising the S&P 500 index.
Financials, utilities, and certain old economy stocks typi-
cally have below-market P/E ratios.
Chapter 4 Fundamental Analysis 83

 OLD ECONOMY STOCKS

A term used to describe the old “blue chip” industries and
stocks that enjoyed fabulous growth during the early parts of
the 20th century. These companies are usually very
traditional in their ways of doing business. Industries such as
energy, steel, and autos are considered to be members of the
old economy.

Often times, a high P/E ratio is reflective of soaring expec-

tations that investors have for a stock. Think about this: Who
would invest in anything that would require them to wait 20 or
40 years to make back their original money?

Here is a another way of looking at it: When you invest

in high P/E stocks, the expectation is that future earnings
will grow. In other words, if a company has a forward P/E of
40, it means that the stock price is 40 times the earnings per
share. Or, said another way, the company’s value is 40 times
its earnings.

If that were equated to a simple investment, it would show

that for each $100,000 you would earn only $2,500 per year.
Consider the fact that an elevated P/E ratio may also be reflec-
tive of poor earnings. Similarly, a lower ratio may signify
negative investor expectations, an undervalued stock, or both.

Imagine that you had a dime that was brand new. It was
rare, it had a limited-edition stamp on the back, and you
preserved it well. You could say that the raw value of the coin
was $0.10.

Now imagine that someone you knew was willing to buy

it for $1.00. Essentially, they were willing to spend $0.90 more
84 The Disciplined Investor

due to the quality and rarity of the coin. They most likely
wanted to enter into the transaction because they believed that
the dime would be worth more in the future and they would be
able to sell it for a profit. In the language of the markets, the coin
was selling at a price multiple of 10 or a P/E of 10.

Price Multiple of Coin = Trading Value ÷ Coin Value

Hence: Price Multiple of Coin = $1.00 ÷ $0.10 = 10

Apply this example to a publicly traded security using the

same basic math. If you know the earnings of a company and
the current market price per share, you can easily calculate the
P/E ratio.

Here are a few historical examples of stocks and sample

P/E ratio calculations:

Price per P/E

Company Name Share EPS Ratio

Abercrombie & Fitch $ 67.25 $ 4.23 15.90

Apple $ 88.35 $ 2.27 38.92
Boeing $ 89.80 $ 2.12 42.36
Dell $ 26.35 $ 1.23 21.42
Microsoft $ 28.90 $ 1.26 22.94
Proctor & Gamble $ 63.90 $ 2.66 24.02
Wal-Mart $ 46.42 $ 2.62 17.72

To level the field, an excellent derivation of the P/E ratio is

used to see if a stock is valued fairly compared to its own future
growth. This is called the PEG ratio or price-to-earnings-to
growth ratio.
Chapter 4 Fundamental Analysis 85

 PEG RATIO
The calculation: price/earnings (P/E) ratio divided by
expected per-share earnings growth over the next year.
More than likely, a result that is less than one tells us that
we may have a good investment that is undervalued for
the time being. On the other hand, a result of more than
one is usually a sign that the position is valued higher
than it should be.

Originally, the PEG Ratio was developed to look at stock

statistics in more than one dimension. By adding expected
growth to the P/E ratio, it will effectively provide a
comparison tool to level the playing field when valuing stocks.

Small- to mid-cap stocks are well suited to utilize the

PEG Ratio as the initial screening tool since they usually pay
little or no dividends. In effect, it is a good tool for some
stocks that are usually more difficult to value using
traditional methods.

Just as it is true that the ratio is beneficial for smaller

stocks, larger stocks should have an additional requirement to
help create a more useable and appropriate valuation tool. By
simply adding an overlay of dividend yield along with the
earnings a much better outcome can be crafted for large-cap
stocks.

PEG ratios are considered less useful in assessing cyclical

stocks and those in the banking, oil, or real estate industries,
where assets are more accurate indicators of relative value.
With these stocks, the growth rates are low and the company’s
assets are a much better indicator of stock value.
86 The Disciplined Investor

PEG Ratio Signal

.50 or less Strong Buy
.50 to .75 Buy
.75 to 1.00 Hold
1.00 to 1.25 Possible Sell
1.25 to 1.75 Consider Shorting
Over 1.75 Short/Sell

PEG is probably one of the best fundamental tools to

use in assessing the optimal time to enter or exit a stock
position. The discipline will allow you to take some of the
emotion out of the buy-and-sell decision so that you will not
get caught up in the average investor’s predicament of latch-
ing on to a favorite stock and never letting go. As they say,
“It’s not the buy strategy that makes a successful investor; it’s
the sell strategy.” Remember, no one ever went bankrupt by
taking a profit.

Balance Sheet Ratios

There are those stocks for which earnings are of less impor-
tance than their assets. This is a notable distinction, given that
not every company does the same thing. Therefore, you should
use a separate set of valuation techniques, depending on the
exact type of company.

As has been explained via the PEG ratio, it is appropriate

to approach some sectors in a different manner than you might
approach others, depending on the way companies within the
given sector do business. Stocks within the cyclical, financial,
utility, and defense sectors can be better assessed from the val-
ues of the holdings than from the revenues they make from
their ventures.
Chapter 4 Fundamental Analysis 87

Sample Income Statement for IBM

Annual Income
Statement Year 5 Year 4 Year 3 Year 2 Year 1
(in millions)
Net Sales $87,548 $81,667 $78,508 $75,947 $71,940

Cost of Sales 49,034 45,803 42,898 40,396 35,971

Gross Profit 38,514 35,864 35,610 35,551 35,969

Selling, General &
Administrative
Expense 20,002 21,708 21,511 21,943 22,776

EBITDA 18,512 14,156 14,099 13,608 13,193

Depreciation &
Amortization 6,585 4,992 5,001 5,012 5,602
EBIT 11,927 9,164 9,098 8,596 7,591
Other Income, Net 557 589 657 707 947

Income before
Income Expense 12,484 9,753 9,755 9,303 8,538
Interest Expense 727 713 728 716 725

Income before Taxes 11,757 9,040 9,027 8,587 7,813

Income Taxes 4,045 2,712 2,934 3,158 3,635

Special
Income/Charges 0 0 0 0 0

Net Income from

Continuing
Operations 7,712 6,328 6,093 5,429 4,178
Net Income from
Discontinued
Operations 0 0 0 0 0
Net Income from
Total Operations 7,712 6,328 6,093 5,429 4,178

Continued...
88 The Disciplined Investor

Annual Income
Statement Year 5 Year 4 Year 3 Year 2 Year 1
(in millions)
Normalized
Income $7,712 $6,328 $6,093 $5,429 $4,178
Extraordinary
Income 0 0 0 0 0
Income from
Cumulative Effect
of Accounting Changes 0 0 0 0 0

Income from Tax

Loss Carry- forward 0 0 0 0 0
Other Gains
(Losses) 0 0 0 0 0

Total Net Income 7,712 6,328 6,093 5,429 4,178

Dividends Paid per

Share 0.41 0.43 0.39 0.33 0.25
Preferred
Dividends 0.20 0.20 0.20 0.20 0.62

Earnings per Share 2.24 2.12 1.87 1.75 1.59

Sample data for illustrative purposes only.

This does not imply that you should take the income
component and throw it out the window. It simply means
that in the ultimate scheme of things, an analysis that looks
at balance sheet items instead of the components con-
tained in the income statement can be more effective for
these groups.

 BALANCE SHEET
A firm’s balance sheet (sometimes referred to as a
“Statement of Financial Position”) is a snapshot of its
financial picture for a given moment in time. On the left
Chapter 4 Fundamental Analysis 89

side of the statement, companies detail their assets. The

topmost position contains those assets with the greatest
degree of liquidity, and as you move down they become
less liquid.

On the right side are the liabilities (also known as the

company’s debt).The time order when payments are due is
also shown from top to bottom. When liabilities are added to
shareholder’s equity, the result should equal the total value
of assets.

By becoming familiar with the balance sheet, you will be

able to skillfully analyze areas such as current assets and cur-
rent liabilities. You can also compare a company’s
liabilities to its shareholder’s equity to find out more about
the financial strength and amount of leverage a company has.
This should help you decide whether the assets have addi-
tional value beyond what is plainly visible on the statement.

Assets = Liabilities + Shareholder’s Equity

 ASSETS
Simply put, assets are any item of value owned by a busi-
ness. On the balance sheet a firm lists its assets, which are
eventually reduced by its liabilities.

There are several types of assets a company can own. Each

business is different but all will have some combination of
capital stock, land (or some other form of real estate), inven-
tory, trucks, and many other items of value. These assets will
have differing abilities to create profits as well as differing levels
of liquidity. Some assets are characterized as tangible while oth-
ers may be considered use or even current.
90 The Disciplined Investor

As an example, inventory is usually very easy to convert to

cash. Therefore it would be considered liquid. On the other
end of the spectrum would be farmland and any other items
that generally require a longer time to sell and, therefore,
require much more time to liquidate. On the balance sheets,
liquidity is important. It is differentiated by the terms current
assets and non-current assets.

Another distinction is whether they are “real.” Remember

that some assets, such as cash, are easily valued and liquidated.
Then there are those that are much more difficult to pin a
price on, such as farmland and buildings. Regardless, the fact
is that you can actually touch and feel these, and they are
therefore considered “tangible assets.”

Beyond those assets that we can easily see are those that
have significant value but are not quite as apparent. Goodwill,
as an example, may include the value of a name brand or pos-
sibly a well-known company spokesperson. (Think of William
Shatner and Priceline.com.)

It takes a good eye to recognize the hidden values that may

be found on the balance sheet. Consider Sears, for instance. For
years, they were valued according to generally accepted account-
ing principles (GAAP) as well as traditional investment
valuation techniques. It was only recently that the idea of valu-
ing Sears to include their significant real estate holdings was
introduced. This occurred as analysts realized that they have
tremendous unrealized value in their land holdings. During
2004-2006, Sears’ stock shot up as investors wanted to own
them as a real estate play, in addition to their ability to create rev-
enue from the sale of washers and dryers.
Chapter 4 Fundamental Analysis 91

 LIABILITIES
The best way to look at these is to think about a traditional
house that you may live in. The house has value (assets)
and there is often a mortgage (liability). The liability that a
company may have comes in the form of obligations to pay
bills as well as the interest and principal payments on
bonds.

Invariably, companies have liabilities. It is the nature of

business to leverage funds to help with the day-to-day opera-
tions and ongoing expansion of the business. A few examples
of a liability are taxes payable, payroll, rent, employee benefits,
and services.

If a company is unable to make interest payments in a

timely fashion during the repayment of a loan, their alterna-
tives may include bankruptcy, reorganization, or absolute
disbandment. Obviously, any of these would represent a prob-
lem. Therefore, as an investor, it is crucial to review the short-
and long-term liabilities of a company on an ongoing basis.

When looking at the balance sheet, there are a few very

interesting morsels of information that you can collect. First,
you can find out how the company is capitalized. In other
words, do they have more debt than cash, how much treasury
stock do they own, and how much debt is outstanding? These
are all important to uncover because they point to whether the
company in question has sufficient backing to persevere in
difficult times.

Companies that have high debt ratios are more apt to

come under severe pressure in an increasing interest rate envi-
ronment. Others that have a high amount of cash may be in
92 The Disciplined Investor

very good positions to participate in profitable buyouts and

mergers. One particular ratio that gets right to the heart of this
matter is the debt/equity ratio.

 DEBT/EQUITY RATIO
Taking the most recent quarter’s long-term debt and divid-
ing it by the most recent quarter’s common stock equity is
the basic method of calculation. Essentially, the debt/equity
ratio is a calculation of the degree to which a company’s
capital has been used as compared to leverage.

Companies that are on an aggressive expansion plan are

usually more leveraged than those that are stable and mature.
In practice, the more leverage a company employs to help cre-
ate profits, the greater the profit potential to the investor. This
comes with a warning as well: leverage increases risk in propor-
tion to the amount of potential gain.

Investors allow more conservative and stable companies (or

companies that must adhere to stringent debt regulations) to
have a greater level of debt, as it is presumed that their markets
are more dependable. Food makers and oil companies are good
examples of this.

Debt/Equity Ratio = Total Liabilities ÷ Shareholders Equity

Another test for information on the balance sheet is find-

ing out whether the company in question has enough
short-term assets to cover its immediate liabilities. This is
important because as bills come in, the company will be
required to make payment in a timely fashion. The “Quick
Ratio,” sometimes referred to as the “acid test,” is an excellent
method to examine the health of a company’s debt.
Chapter 4 Fundamental Analysis 93

Quick Ratio Calculation

(Cash + Accounts Receivable + Short-term Investments)
Current Liabilities

An excellent tool used by value-oriented investors is the

price-to-book ratio. This helps an investor know if the stock
is trading at a premium or a discount when compared to the
actual worth of the company. It effectively shows how much
the company would be worth if it was forced to close its doors
and liquidate. When the ratio is below one, bargain hunters
find it to be an irresistible opportunity. Since we have seen that
balance sheets will usually err on the side of a more conserva-
tive valuation, the company may be more overvalued than is
reflected by a low price-to-book ratio.

 PRICE-TO-BOOK RATIO
To calculate this ratio, use the latest price of the stock and
divide it by the most recent quarter’s book value per share.
(Remember, book value is simply assets minus liabilities.)
This is also known as the price/equity ratio.

It is a good idea to think about this ratio as the failsafe for

ownership in a stock. The book value is at least the “owner-
ship” value of the company for the stockholder. If the price
moves below this, there is a good chance that investors will still
retain some value. (Although there are those odd cases that will
leave an investor with little more than a piece of paper as the
value of their investment.)

Given all this, a very low price-to-book ratio makes some

fundamental investors feel that a company has the ability to
generate earnings and the opportunity for long-term profits.
94 The Disciplined Investor

This ratio, as with others, will be quite different for each

industry. For some companies the price/book will be very use-
ful (such as banks) and for others (such as biotechs) it will not.

Texas Utilities was chosen as an example of a company that

may be better reviewed by the balance sheet and its related
ratios. MSN Money has all of the latest raw data available—
free—for you to do the same.

Expect most companies to do their best to focus their

attention on assets, rather than liabilities. Be on the lookout
for hidden items in the footnotes, especially with regard to lia-
bilities. Make sure to have all information at hand to calculate
the correct ratios and assumptions in order to create a good
strategy. All of this will once again result in a well-informed
and disciplined investment decision.

Do not worry if you do not master this exercise immedi-

ately. With practice, your eyes will become focused on the
most important areas which will eventually allow for you to
zero in on only the important items.

By looking at an annual comparison for Texas Utilities—

between years 1 and 5—you are able to make a few
observations. At first, it seems that the company has done an
excellent job of increasing current assets. A move from a
level of $848m in Year 1 to over $3,900m in Year 5 is a sub-
stantial increase.
Chapter 4 Fundamental Analysis 95

Sample Balance Sheet for Texas Utilities

Annual Balance Sheet Year 5 Year 4 Year 3 Year 2 Year 1

Assets
Current Assets
Cash and Equivalents $ 560.0 $ 796.0 $ 44.4 $ 15.8 $ 24.9
Receivables 1,492.0 1,887.0 981.1 327.8 321.0
Inventories 622.0 676.0 447.9 322.8 328.1
Other Current Assets 1,226.0 1,228.0 521.4 110.6 174.4

Total Current Assets $ 3,900.0 $ 4,587.0 $ 1,994.8 $ 776.5 $848.4

Non-Currents Assets

Property, Plant & 31,799.0 40,627.0 25,286.7 23,726.1 23,307.9

Equipment, Gross

Accumulated 8,159.0 17,760.0 6,715.7 6,127.6 5,562.2

Depreciation & Depletion

Property, Plant & 23,640.0 22,867.0 18,571.0 17,598.5 17,745.7

Equipment, Net

Intangibles 7,516.0 0.0 0.0 0.0 0.0

Other Non-Current Assets

5,685.0 12,060.0 4,308.2 3,000.7 2,941.7

Total Non-Current Assets 36,841.0 34,927.0 22,879.2 20,599.2 20,687.4

Total Assets 40,741.0 39,514.0 24,874.1 21,375.7 21,535.9

Liabilities & Shareholders Equity

Current Liabilities

Accounts Payables 1,442.0 1,747.0 879.6 336.4 300.7

Short-Term Debt 4,576.0 4,022.0 1,386.4 679.1 658.3
Other Current Liabilities 2,379.0 2,507.0 1,256.0 643.8 753.6

Total Current Liabilities 8,397.0 8,276.0 3,522.0 1,659.3 1,712.6

Non-Current Liabilities
Long Term Debt 16,325.0 15,133.0 8,759.4 8,668.1 9,174.6
Deferred Income Taxes 3,938.0 3,718.0 2,989.3 2,801.6 2,669.8
Other Non-Current 2,197.0 2,737.0 1,560.5 1,129.6 1,112.8
Sample data for illustrative purposes only.

But, as you look at the liability side of the equation, it

shows that current liabilities have gone up well out of propor-
tion to the growth of the assets. In fact, Texas Utilities shows
an increase in its overall liabilities by a greater percentage than
the expansion of its assets. This caused the ratios to change,
and the company seemed to be valued at the higher end of the
spectrum by some, even in relation to its own history. The
96 The Disciplined Investor

debt/equity ratio illustrates the increase very dramatically

and the corresponding price/book suffers as the net assets
are decreased.

In summary, many investors may have punished the com-

pany for utilizing high levels of debt. Of course, this does not
take into account any macroeconomic conditions that may
have played important roles in the actual movement of the
sector or industry.

Another issue is the large increase in accounts receivable.

This shows what monies are outstanding for goods or services
already sold. Receivables have jumped dramatically on a year-
to-year basis. If customers are slower to pay Texas Utilities,
there may be rightful concern that the company might need to
consider creating a higher allowance for bad debt. This means
that the company will virtually give away services for free,
which will undoubtedly cause earnings to decrease.

Inventories are another area to study. Utility companies will

probably see very little increase on goods purchased, since cus-
tomers utilize energy and affiliated services somewhat equally
year to year. Of course, there are cold snaps, heat waves, and
other heavy usage periods that will cause inventories to
decrease. Even so, usage over time is relatively consistent.

Now, if a company is seen to have increasing inventories,

it should sound the alarm that it may not be making the best
use of planning and logistics. The world relies on 24/7, “just
in time” product delivery, and companies had better “just in
time” themselves to the 21st century. Large inventories could
mean outdated product and distribution procedures, and
Chapter 4 Fundamental Analysis 97

therefore an allowance should be made for the real possibility

of eventual inventory write-offs and write-downs. This could
happen when inventories grow to the point where companies
are agreeable to sell excess at a significant discount. This is in
an effort to clear the warehouse shelves and recoup some of
the costs associated with the manufacturing process.

Sample Ratios - Texas Utilities

Book
Price/ Value Debt/Equity Interest
Book per Share Ratio Coverage

Year 5 1.18 $30.15 1.96 2.0

Year 4 1.60 $29.21 1.84 2.0
Year 3 1.49 $27.90 1.28 2.4
Year 2 1.52 $26.86 1.44 2.4
Year 1 1.62 $25.38 1.60 0. 7

Price Targets

Possibly the most overlooked aspect of fundamental analysis

is the setting of appropriate price targets for both purchases
and sales. As a disciplined investor, you can appreciate the
importance of using guidelines in your investment plan to
reduce risk. This will help your portfolio (and your emo-
tions) fluctuate less.

Obviously, the first element in developing an appropriate

price target is to gather information on the company in ques-
tion. You need to understand what its forward-looking
strategy is, as well as the overall economic environment in
which it operates. Take as an example a company in the semi-
conductor industry.
98 The Disciplined Investor

It is a good idea for the owner of the company to under-

stand the competition. Since you are planning on owning a
piece of the company, here are a few sample questions you may
want to think about:

• Who is the competition?

• Who are the suppliers, and who are the buyers?
• What effect do domestic and international economic
events have on their products?
• Will a weakening currency cause a change in the
demand for their products?
• Will they purchase supplies from international vendors
that can be affected by the dollar or any other
cross-currency exchange issues?
• Do their competitors have similar pricing structures?
• Is the product-set outdated?
• What costs are associated with new research and
development?
• Is there any concentration risk?
• Are they reliant on one supplier or buyer?
• Is there a particular industry, region or country that is
important to the company?
• If a competitor drops the price on a main product,
does the action affect the companies in question?
• Will they continue to have earnings momentum similar
to their historical periods?
• Is their inventory up to date?
• Is management geared to distribute at the levels
necessary?
Chapter 4 Fundamental Analysis 99

Most of these questions can only be answered through sig-

nificant amounts of research. Fortunately, services such as
Thompson First Call, Zacks, Standard & Poor’s, and others
through individual brokerage houses can do this for you.

Actually, employing a service is a great way for you to

receive earnings estimates for a company. It helps to stream-
line the process and give quality estimates of forward
earnings from professionals that are studying them daily. Of
course you could purchase subscriptions directly from these
companies, but the costs are quite prohibitive for the average
investor. A better idea would be to register with either MSN
Money or Quicken.com. Both of these sites provide adequate
earnings data—for free.

Once you have these tools in hand, you can begin the
forecasting process by combining the range of estimates
given with the answers you have gathered to the questions
about the company.

So, if you have a range of analysts’ estimates for stocks such

as Bank of America that fall between $0.30 and $0.42, you can
use your understanding of the markets to choose the estimate
you feel most comfortable with. If you are not confident
choosing a number, use the average of all of the available
analysts’ predictions. Then a formula that includes the earn-
ings and projected growth rate can be used with any
spreadsheet program. The result will provide you with a 12-
month price target to use for both the purchase and the
eventual sale of a security.
100 The Disciplined Investor

Price Target Examples:

Stock ABC

EPS $4.00 Current

$4.50 Forward (1 Year)
$6.00 Forward (2 Year)
$7.50 Forward (3 Year)

5-Year Earnings Growth Estimate = 15%

Current P/E Ratio = 10

PEG Ratio (5yr) = 0.66

12-Month Price Target

(Current P/E X Expected Earnings = Target)
10 x $4.50 = $45.00

24-Month Price Target (Conservative)

Forward P/E X Expected Earnings = Price Target

1) Forward P/E=$40 (current price)/$4.50 (forward EPS)

2) Expected Earnings = EPS (+2 Years)
8.8 X $6.00 = $53.00
24-Month Price Target (Aggressive)
Current P/E X Expected Earnings = Price Target
10 X $6.00 = $60.00
Chapter 4 Fundamental Analysis 101

This chapter has elaborated on the fact that researching

a company is no easy task. With so many different con-
structs and metrics at the disposal of the average investor, it
is not surprising that many people are fearful of making a
severe mistake. With so much to analyze, there is much
room for failure or misinterpretation.

Fortunately, for the cautious investor there is a solution.

In the industry it is known as risk management, and it was
born out of the market’s sometimes-rocky past. With a nod
to its application, however, any investor can rest comfort-
ably knowing that his or her assets are just as safe as they
want them to be.

Just as no two investment approaches are alike, no two

risk management plans are identical. There are many inno-
vative solutions to choose from. The chapter that follows
outlines the most significant of the bunch.
 Chapter 5

Risk Management

As we discussed in Chapter 1, understanding your risk toler-

ance is a big step toward obtaining financial security.
Understanding the emotions that you may go through during
market instability will allow you to set up appropriate “insur-
ance policies,” helping to save your portfolio from the
devastating effects of a crash.

 RISK MANAGEMENT
Analysis of possible loss: the profession or technique of
determining, minimizing, and preventing accidental loss. For
example, this could be accomplished when a business
takes specific safety measures or buys liability insurance.

The above may be a suitable definition for the financial

professional, but what exactly is risk management and for the
individual investor, how does it fit into the scheme of things?

The exact definition of a “market crash” is unclear. Is it

more than a bear market? Is it a sudden or prolonged down-
ward spiral? Is it a 10 percent, 15 percent, or 20 percent
correction? Studying the phenomenon of market crashes will
help to better explain the effects. As an example, let’s look at
what occurred in 1987.

103
104 The Disciplined Investor

The headline and story in the Wall Street Journal for

October 20, 1987 read:

Stocks Plunge 508.32 Amid Panicky Selling

For Houston secretary Julie Ianotti, a hard-won retirement
nest egg suddenly looked very much in peril. “I’m scared,”
she told a reporter. “Should I sell? Tell me, should I sell?”

There were a lot of people who felt that way on “Black

Monday,” as it is called. It sent a wave of dread through a nation
intoxicated on its own prosperity. During Reagan’s presidency
the trickle-down effect supported a loose monetary policy that
spawned an “easy money” culture. Between January of 1980
and late summer of 1987, stocks had skyrocketed more than
225 percent. When they plunged 30 percent in a matter of
weeks—mostly on that hard-to-forget, 508-point day—the
nation was dumbfounded and left wondering what went
wrong.

Forbes magazine ran a similar piece:

Black Monday and Red Faces

OCT. 19, 1987 was a stomach-twisting day for Wall
Street and the nation. In a single trading session the Dow
Jones Industrials dropped 508 points, and $480 billion in
market value was expunged. The euphoria of a five-year
bull market was shattered.

That crash was a terrifying event for the American people,

but with hindsight we know that it provided one of the greatest
buying opportunities of all time. Had you purchased $10,000
worth of a simple S&P 500 stock index fund after the crash and
reinvested the dividends, you would have almost $50,000 today.
That is a compounded annual return of 17 percent!
Chapter 5 Risk Management 105

However, that was not what people were thinking about in

late October 1987. They were looking back, not forward. The
question that was going through everyone’s mind was: “Is it
going to be Black Tuesday 1929 all over again?”

A market free-fall is about the scariest thing imaginable for

anyone who has invested their faith and hard earned money
into stocks. That emotion has more to do with fear of the
unknown than actual financial damage.

Sure, if you put your money to work at the top of the mar-
ket in 1987 and did nothing else, even through the crash, you
would have recouped all of the losses as early as the summer of
1989. Yet most people do not just sit back and let the market
do its work. Instead they prefer to dollar cost average money
into the market from their paycheck into pension plans and
other savings accounts. Moreover, they often attempt to time
the market and usually end up being wrong.

Prior to 1987, you would have had to go back almost six

decades—way back to 1929—to find a time when Wall Street
was so vulnerable. The difference between the two corrections
was primarily the depth and breadth of the occurrence. The
infamous crash of 1929 lasted longer and had a far greater
effect on the populace. In fact, many people were financially
wiped out permanently and plenty of others never fully recov-
ered mentally. On the other hand, the 1987 correction was
short-lived and the recovery was rather quick.

Looking back at the events that led up to the 1929 crash, his-
tory shows the U.S. stock market had peaked on the first Tuesday
of September 1929. The DJIA stood at a record of 381 and
started a smooth, seemingly innocent downturn throughout the
106 The Disciplined Investor

rest of the month. By the end of the September, the index was
down 10 percent.

During the first 19 days of October, the index had lost

another 8 percent and was now hovering at 15 percent below
its recent peak.

Margin calls started to go out by brokerage houses and

investors were very anxious. Then, on Monday, October 19,
1929, the heavy selling began. Within two days, the market
dropped another six percent.

Over the next few days, the markets seemed to have settled
down and there was talk that the worst was over. The daily
volatility moderated and many investors were elated as they
believed the correction had run its course. It was time to
reassess, think about what had happened, and put some funds
back into the market at these lower prices. What they didn’t
know was that they were smack in the middle of the eye of the
storm. It was not over by any means.

Now remembered as Black Thursday, October 24 was the

day when six New York banks needed to step in to intervene in
an attempt to stabilize the markets. By day’s end, the Wall Street
roller coaster had seen enormous peaks and valleys. Amazingly
though, the market closed off only 2 percent off for the day.

Nonetheless, the sell-off, with its many interruptions, con-

tinued. The 1929 low came on November 13 at a level of
199—almost half the value of the previous market’s peak.

It was not until July 2, 1932 that the index reached a dra-
matic low of 41. In the end, more than three tortuous years
Chapter 5 Risk Management 107

had passed from the time the DJIA had reached its highest peak
to when it dipped to its lowest valley—almost a 90 percent loss.

Most of the world’s stock markets crashed right along with

Wall Street in both 1929 and 1987. Once again the distinct
difference was that the 1929 crash was much more sustained
and deep. Also, the 1987 crash was shown to be quick and
abrupt. In 1987, most investors recognized that it was a “con-
tained” American catastrophe, not a world crisis.

Another differentiation is that after the 1929 crash there

was a grave blunder by the government regarding monetary
policy. Essentially, it zigged when it should have zagged. This
is what eventually led to the Depression of the 1930s.

This is not to say that the 1987 crash was not without its
governmental faux pas. That time, however, the mistake was
made to the other extreme—creating a loose monetary policy.
In time this mistake led to the explosive inflation that
Americans experienced during the late 1980s.

While there are several definitions available for the term

“Market Crash,” let us agree that a market crash is represented
by a substantial drop the in value of stocks and stock markets.
The truth is that a stock market never goes up in a straight
line, so there are bound to be crashes and/or corrections along
the way. It can take a few days, months, or even years for a
market to recover after a crash or correction.

For example, think back to March of 2000 to revisit the

highest high of both the NASDAQ and DJIA. If only there
could have been an insurance policy to stop the losses… If only
108 The Disciplined Investor

we had seen it coming… If only we had gotten out sooner… If

only we had…

Fortunately, there are steps that can be taken to help pre-

vent your portfolio from being decimated by a market
correction. By following risk management disciplines, the type
of excruciating pain and mental anguish that most investors
endured during 2000-2002 can be avoided. Now you have the
tools enabling you to be much more consistent and ultimately
more successful. In Chapter 9 you will earn how to organize
your portfolio to allow differing asset classes to work harmo-
niously. The science of diversification will be introduced and
explored as one type of risk management.

Intuitively, we all know that we should have some forms of

insurance on our lives, our homes, and our automobiles. It is
truly unfortunate that only a small percentage of individual
investors have ever considered buying some type of insurance for
their portfolios. The only possible explanation is that brokers
and financial advisors do not believe that individuals have the
capacity to understand these techniques—after all, they are
more difficult concepts to learn than simply investing in a
mutual fund. Yet given a little patience (along with user-friendly
information) you can learn to understand them.

If the market crash discussions did not persuade you to

give this topic serious thought, maybe some quick points will
help to drive home how a portfolio should react and why port-
folio insurance is so important. While you may actually be able
to buy “portfolio insurance” through an annuity or possibly
from specialized insurance companies, what you will learn here
mainly deals with protection and risk reduction rather than an
actual insurance policy.
Chapter 5 Risk Management 109

Quite often, questions regarding portfolio volatility and

performance expectations are on the minds of investors.
Usually they want to know the risk of loss and the opportunity
for gain. More importantly though, a Disciplined Investor is
looking to take on the risk associated with upside gain yet
wants to limit the potential for loss. The following analogy
effectively explains this important concept.

Sit back and relax for a moment. Now, picture yourself

walking down the street of a busy metropolis with buildings as
tall as 100 floors. You enter a building and walk through the
lobby and arrive at the elevators. The doors slowly open and
you step inside. As you look at the panel of potential floor
selections, you quickly notice that there are 100 buttons for
the floors above you and four for the floors below.

This is exactly how a portfolio should operate on a long-term

basis. It should have good upside potential while limiting the
downside. The “skyscraper approach” to investing can be done
quite effectively through disciplines of diversification, protective
puts, covered calls, and a few other strategies that you will soon
learn how to master.

Now, picture of a flower garden. To have a gorgeous gar-

den with flowers in bloom throughout the year, you would
not want to simply plant annuals. Sure, they would look gor-
geous for the few months that they were in bloom, but they
would eventually die. Only stems would remain as a depress-
ing reminder of the beauty that once was.

Most gardens, like most portfolios, have far better plans in

place. Perennials, annuals, and even evergreens create an
assortment that will have something in bloom at any given
110 The Disciplined Investor

time of the year. Even during the harsh winter, the evergreens
remain fully colored and full of life.

Now, try to bridge these concepts as they relate to your

portfolio. How many of us had cash positions (garden-speak:
evergreens) during a significant market downturn? Did we
overdo it a “bit” in the technology area (garden-speak: were we
only planting impatiens and flowering plants)? What about
those investors who had a large percentage of their holdings in
only a few stocks that, at the time, they were completely head
over heals, madly in love with (garden-speak: that big tree that
Grandpa loved and would never trim which fell on the house
when the big storm came)?

Any of these analogies can be all too real. You need to be

aware of your personal influence(s) when constructing a solid,
disciplined portfolio.

No worthy discussion of risk management would be complete

without touching on the topic of market timing. There are
many different forms of market timing, but for our purposes, we
will focus on simply buying in and selling out of equity markets.

These strategies represent attempts to either create profits

or reduce losses. If you have the time, the desire, or both, try
an Internet search for market-timing strategies. You will find
that there are plenty of websites that will fill you in on all the
details of, and provide you with incredible claims of fortunes
made by, market timing programs.

While researching information for this book, websites were

uncovered that claimed to have developed methods for making
thousands of percents in profits on an annual basis. All it took for
Chapter 5 Risk Management 111

you to have the same experience was a paid subscription to

their secret and “exclusive” market timing programs. Oddly,
most of these claims ended in either 1999 or 2000. Not
much more information was available, and it was painfully
obvious that substantial upside results were not recorded dur-
ing those periods anyway.

 MARKET TIMING
Trying to buy or sell investments and/or enter or exit the
market at the right time by anticipating when prices are
going to rise or fall.

The important word to focus on in the above definition is

“trying.” It describes the process of market timing rather well. In
this definition, “trying” has a dual meaning. First, it refers to
trying to find the optimal time to buy and/or sell a stock. Second,
it refers to the realization of how trying an experience it is.

For years, investors have hoped that market timing would be

the miraculous solution to the problem of limiting losses during
periodic market corrections. Unfortunately, it rarely seems to
work out that way. The art of market timing has never really
been proven as a scientific strategy that could be adopted by the
majority within the investment community—though there have
been some revered prognosticators who were elevated to
Investment Gods after certain very timely predictions.

Elaine Garzarelli, probably the best known market timer,

accurately predicted the market crash of 1987. It has been
reported that since then, she has called market tops, only to
find that the markets were headed much higher.

With this fine example, what they say about the practice of
market timing seems to be true: “Eventually, a market timer
112 The Disciplined Investor

will be right, just the same as a broken clock is right two times
every day.” Be wary of predictions, substantial and overstated
claims, and incredible fortunes made by market timers. Look
closely and you will find that quite often they are merely offer-
ing you historical returns based on one particular stock or one
particular mutual fund style.

Rather than an exhaustive diatribe on the disadvantages of

authentic market timing, we will take a peek into how market
timers have fared. To fairly illustrate the results of the predictors,
we have gathered information from the pages of SmartMoney (a
joint publishing venture from Dow Jones & Company, Inc. and
Hearst Communications—see www.smartmoney.com).

SmartMoney has done a terrific job of researching and review-

ing the predictions of high-profile market prognosticators. Some
are economists, while others are analysts. SmartMoney acquires its
pundits’ predictions from two major sources: Dow Jones News
Retrieval (which gives them stories from all major business pub-
lications, newspapers, and newswires) and all of the
market-strategy reports that their experts send directly to their
clients (for example, David Jones’s “Monthly Market
Commentary” or Ed Hyman’s “Money and Markets Summary”).

After receiving the Dow Jones News Retrieval predictions

electronically, the researchers at SmartMoney disregard, “pithy
quotes from pundits who comment on yesterday’s markets and
therefore do not discuss the markets’ future.” Then, at the end
of each month, they keep only the cleanest predictions—clear
and decisive calls about one of the several important market
indicators such as:
Chapter 5 Risk Management 113

• The DJIA and S&P 500 Index

• The Fed
• Interest Rates
• The Economy
• The 30-Year Treasury Bond Yield
• Individual Stocks or Sectors

Their research only dates back to January 1, 1995, yet the

markets have thrown many curves along the way to help trip
up the experts. Therefore, the outcome could be considered a
good showing of their accuracy.

Smart Money’s “Pundit Scorecard”

Pundit/Analyst Score/Rating
Abby J osep h Cohe n 66 .20%
Ed war d Ke rschner 62 .50%
Byron W ien 58 .70%
D avid Jone s 56 .50%
Ed ward H y man 56 .50%
R alph Ac ampo ra 55 .90%
El aine G arz arelli 55 .70%
Ed war d Y ar deni 54 .80%
Barton Biggs 50 .90%
Jeff A pplegate 48 .90%
Joe Ba ttipaglia 48 .50%
Thoma s G alvin 47 .00%
*Ending June, 2001 Historical Example
(Source: Smart Money)

To calculate their pundits’ batting averages, they take the

predictions made by each of them since the beginning date and
then figure in each successive call. Then they see if it was accu-
rate or not. For example, in June 2001 they used all the
pundits’ calls from January 1, 1995 through May 31, 2001.
114 The Disciplined Investor

Are you surprised to learn that the group was generally less
than average at predicting the markets? These are the people
making headlines daily. Despite that fact, it seems pretty obvi-
ous that good and enduring investment disciplines should not
be built around types of individual predictions—as on average
they only have a 50/50 possibility of being correct.

One final point on market timing, and then we will move

on. There are four possible outcomes for a market prediction.
If the prediction is correct, you win…right? Well, maybe. Take
a look at the table below to find out more about the possible
outcomes of predictions made by market timers.

Action If Prediction Is Correct If Prediction Is Incorrect

-You Will Receive-
Buy Stocks Market Performance Significant Loss
Sell Stocks Money Market Returns Money Market Returns

Only two of the four possibilities will yield market

returns. Explained another way, you have a 50 percent
chance of participating in the growth or loss of the market
with a good market timer. If you add that to the 50 percent
batting average that the “cream of the crop” scored, you are
now down to a 25 percent probability of positive participa-
tion in the market. Those are not the odds that you should
want for your portfolio.

At this point, you are undoubtedly stuffed with informa-

tion about the advantages and/or disadvantages of market
timing. Hopefully, you agree that removing this strategy from
the list of risk management ideas to help manage risk within a
portfolio is wise. So, with that gone, what is left? Only the two
best ways to keep your profits: covered call options and
protective puts.
Chapter 5 Risk Management 115

Each of these methods can be used in such ways as to allow

you to keep maximum gains while at the same time reducing
losses. Does that sound like the Holy Grail of investing?

Let us start by outlining the background of (and introduc-

tion to) a topic known simply as “options.” According to their
own published history, the Chicago Board Options Exchange
(CBOE) was founded in 1973. It is an initiative that systemat-
ically revolutionized options trading by creating standardized,
listed stock options. Prior to the year of its foundation, options
were traded on an unregulated basis and were not required to
adhere to the principle of “fair and orderly markets.”

Investors quickly accepted these new options, propelling

the CBOE to the status of second-largest securities exchange in
the country and the world’s largest options exchange. Today,
CBOE accounts for more than half of all U.S. options trading
and an amazing 91 percent of all index options trading.

Even though the CBOE was originally created by the

Chicago Board of Trade (CBOT), it has always been managed
and regulated as an independent entity. This is important to
note because it means that there are layers of checks and bal-
ances in place to provide for oversight.

On April 26, 1973, after four years of solid planning, the

doors of the CBOE were finally opened for business. In the
beginning, it was limited to trading call options on only 16
underlying stocks. It was not until 1977, however, that put
options were introduced. Only two years thereafter additional
securities exchanges began entering the business. Today,
options are traded on four U.S. exchanges, including the
CBOE. Even with these additions, the CBOE is still consid-
ered the busiest options exchange in the world.
116 The Disciplined Investor

History out of the way, you are about to learn all you ever
may want to know about the investment known as “options.”

Simply put, an option is a contract giving the buyer the

right, but not the obligation, to buy or sell an underlying asset
(a stock or index) at a specific price on or before a certain date.
Listed options are contracts for 100 shares of the particular
underlying asset.

Options are securities, similar to bonds and stocks. The

difference is that they are not actually ownership in the com-
pany. Rather, they are a contract to buy or sell the underlying
shares of a company.

Options contracts contain very strict provisions and have

many fine details that need to be reviewed before an investment
is made. Even though there are essentially only two types of
options (calls and puts) there are several dozen different invest-
ment techniques used by options investors. Some only include
the use of a call or put, while more complicated strategies may
involve several puts, calls, or even shares of an underlying stock.
The bread and butter of these is the covered call strategy.

 COVERED CALLS
A covered call is the process of both owning a stock and
selling a call option against that stock. It can also be the
purchase of a stock and the synchronized sale of a call
against that stock purchase. For the most part, these
transactions are often paired in 100 share lots.

By “writing” or “selling” the call, the investor receives a pre-

mium and in return will be obligated to sell the stock to the
buyer at a predetermined price. Said another way, the
Chapter 5 Risk Management 117

investor/writer is paid money in return for a contract to sell the

stock to another party at a predetermined price for a specific
period of time. The writer of the covered call, in return for the
premium paid, will essentially give up his rights to the profit of
the stock above a certain price, also known as the strike price.

The use of covered calls works well in most types of

portfolios, but it may not be permitted in some accounts such
as IRA’s and certain pension plans. While this is a risk reduc-
tion strategy and is available to most investors, it may not be
suitable for all. Since there is a much greater degree of experi-
ence required, care should be taken to understand the basic
components of options before entering into any transaction.

Who should consider covered call options?

• An investor who is desirous of protecting the risk

associated with the downside losses in his portfolio.
• An investor who is looking to trade some upside
opportunity for risk reduction.
• An investor who would like to receive income
payments in addition to the regular dividends paid
from a stock he or she is holding.

One of the benefits of the covered call strategy is that the

premium received can be calculated into the cost structure
of a stock purchase, effectively reducing the price paid. Also,
the holder of the stock will collect dividends from his or her
holding (if any) until the position is sold. Even so, while the
investor has reduced the cost and thereby helped to reduce
risk, if the price of the stock surpasses the strike price of the
option the investor will not participate in any additional gains.
118 The Disciplined Investor

 PREMIUM
The amount that a buyer needs to pay for a call or put option.
This grants them the right to buy or sell a stock or index at
a predetermined price at some time in the future.

Currently, stock ZYX is priced at $41.75 and the investor

thinks that this might be a good purchase. Three-month 45
calls can be sold for $1.25. Historically, ZYX has paid a quar-
terly dividend of $0.25. By selling the three-month 45 call, the
investor is agreeing to sell ZYX at $45 should the owner of the
call decide to exercise his or her right to buy the stock.

 EXERCISE (OPTION)
The act of implementing the right to either buy or sell a
security (as with a call option). Exercising an option is basi-
cally another term for taking action on an owned security.

Remember that the owner of the call option has the right
to exercise the option at any time. Until it reaches $45 that
would not make much financial sense. Once it moves past the
strike price, the owner will be able to buy the stock at a price
lower than it is currently trading in the open markets.

Take a look at what happens to a covered call position as

the underlying stock moves up or down. Commissions have
not been taken into consideration in these examples; however,
they can have a significant impact on returns.

Transaction: 1) Buying 100 ZYX at $41.75 and

2) Selling 1 Three-Month 45 Call at $1.25
Chapter 5 Risk Management 119

Below are three possible scenarios provided by the CBOE.

Note that all discussions assume option expiration.

Scenario 1: ZYX remains below $45 between now and

expiration—call not assigned.
The call option will expire, worthless. The premium of $1.25
and the stock position will be retained. In effect, you have paid
$40.50 (which is also the breakeven price) for ZYX ($41.75
purchase cost minus $1.25 premium received for sale of the
call). This would be offset by any dividends that were received,
which, in this example, were $0.25.

When the ZYX call expires worthless, the covered call

writer can sell another call going further out in time, taking in
additional premiums. Once again, this produces an even lower
purchase cost or breakeven point.

If ZYX remains below $45 for an entire year, the

investor can sell these calls four times. For this example, we
will make the hypothetical assumption that the price of the
stock and option premiums remain constant throughout the
year.
$1.25 (Call Premium Received) x 4 = $5 in Premium;
Premiums Received + Dividends Received = Total Income

Scenario 2: ZYX rises above $45 between now and

expiration—call assigned.
The call buyer can exercise his right to buy the stock, and the
call seller will have to sell ZYX at $45, even though ZYX has
risen above $45. But remember, the call seller has taken in the
premium of the call and has been earning dividends (if any) on
the stock.
120 The Disciplined Investor

If ZYX stock is called away at expiration:

$ 45.00 per share

1) Receive (from stock sale/exercise) $ 4,500.00
2) Add $ 1.25 per share (premium) $ 125.00
(Total Proceeds from Strategy) $ 4,625.00
3) Subtract $ 41.75 (cost per share) $ 4,175.00
GAIN* $ 450.00
* In three months, plus dividends (if any) received.

Scenario 3: ZYX is right at $45 at expiration.

At expiration, the seller of a call may be in a scenario similar to
either one or two as discussed above. There is also the chance
that the stock is right at the strike price when it expires. The
option buyer may require the stock to be called away, and the
call writer will be obligated to sell ZYX at $45.

Alternatively, the stock may not be called away and the

option will expire worthless. The writer can then use the
strategy of selling another call, going further out in time,
bringing in additional premium, and further reducing the
breakeven point.

Covered Calls Summary

When an investor writes a covered call, it meets a good deal
of investment needs by helping to reduce risk while still
keeping some of the upside opportunity in play. The actual
strategy can be used in many different types of accounts for a
defensive position on a stock that the investor is considering,
or one that the investor currently owns. Amazingly, there are
more than 1,700 listed options for stocks and more that 200
that are considered LEAPS® (Long-term Equity AnticiPation
Securities).
Chapter 5 Risk Management 121

LEAPS® are for a longer term than the standard equity

related options and are often linked to stock indices’. There are
also numerous choices of options types available today and a
very active market for investors to trade. This is primarily due
to the fact that options as an investment choice have come
back into “vogue.”

The strategy of utilizing covered calls is actually considered

less aggressive than just owning the stock on its own. Since
premiums are received in return for the obligation to sell at a
specific price at a later date, the breakeven point for the
position has been lowered, thus allowing for a greater margin
of error in the buy discipline.

Protective Puts as a Hedge

Think of purchasing a protective put against stock as you
might think of purchasing insurance: the premium is paid in
order to insure against the potential loss inherent in stock own-
ership. Regardless of which direction the stock’s price moves,
the holder of the protective put can automatically sell as soon
as it reaches the strike price.

First, before getting into the specifics of protective puts,

consider who should think about investing in them.

• If you already hold a stock that you think may rise in

value, but you do not wish to take part in the risk of
a fall, you may be interested in protecting your interests
with a put.
• If you are considering purchasing a stock but are
concerned that it could take a dive, a protective put
may be right for you.
122 The Disciplined Investor

The stock market remains a volatile investment avenue.

During bullish periods, investors often find themselves anxious
about market corrections. During bear markets, they typically
are worried about continuing declines.

The first reaction of most people is to avoid the situation

altogether. But, considering the extraordinary potential for
profit in the markets, this is not always the most appropriate
course of action. Missing a strong upward move in the market
would be an unfortunate circumstance.

Fortunately, puts protect against any reluctance you may

have toward investing. It is strange to think that for centuries
people did not blink an eye when it came to the concept of
insuring a tangible asset, but it has taken so long for the
strategy of insuring a commodity such as a stock position to
become popular.

A protective put requires the purchase of what is known as

a put contract. Each put contract covers 100 shares of stock
that the investor is either buying or already owns. This put
contract grants the owner the right to sell the covered security
at a pre-established price. There is never any obligation
involved in a protective put.

The contracts can be made to carry expiration dates of up

to eight months in the future. As many as 1,700 stocks may
be covered under this strategy. For a contract that stretches
out as far as three years, only 200 stocks may be protected.
The latter category is referred to as LEAPS®, which was
mentioned earlier.

Knowing what protective puts are allows you to examine

the effects they have on an otherwise unpredictable stock
Chapter 5 Risk Management 123

position. Take note: these examples do not take commissions

into consideration.

How to Use a Protective Put

Now we will discuss the three possible scenarios at the expira-
tion of a put contract as provided by the CBOE.

Scenario 1: Buy ZYX at $50.

First, let us look at buying a stock without owning a put for
protection. If stock is bought at $50 per share, as soon as it
drops below the purchase price the investor begins to lose
money. The entire $50 purchase price is at risk. Of course, if the
price increases, the investor benefits from the entire increase
without incurring the cost of the put premium or insurance.

When you buy a stock, there is no protection or insurance.

Therefore, you are at risk of losing the total investment.

Scenario 2: Buy ZYX at $50, Buy ZYX 50 Put.

Let us look at a scenario in which ZYX is bought with a pro-
tective put. In this example, ZYX is still at $50 per share. A
6-month put with a strike price of $50 can be bought for
$2.25 or $225 per contract ($2.25 x $100).

This scenario of utilizing a put “at-the-money” can be

thought of as insurance without a deductible. Since the stock
is bought at $50 and the put has the same strike price, a drop
in the share price of the stock will have little effect on the net
portfolio value for the investor. This allows for an investor to
effectively reduce the risk on a stock or a portfolio during
volatile market conditions.
124 The Disciplined Investor

Buy ZYX and

Buy ZYX Only
6-mont h 50 put option

Stock Cost $ 50.00 $ 50.00

Put Cost $ - $ 2.25
Total Cost $ 50.00 $ 52.25

Risk $ 50.00 $ 2.25

Even if the price of ZYX falls, the investor that bought the
six-month put option with a strike price of $50 has the right
to sell it at $50 through the expiration date. The savvy option
investor has limited the risk of that position to only $2.25,
which is the premium paid for the put.

Since a “near-the-money” put was purchased, this invest-

ment strategy provides benefits of limited downside protection
and does not limit the upside as we have seen with other
option approaches. The limitation is that the investor will need
to see the stock rise above $52.25 in order to achieve a profit
from this trade. If the stock maintains its price without mov-
ing up, the put will eventually expire with no value and the
premium will vanish.

In contrast, if the stock were bought without an option

strategy, the investor would profit as soon as the stock price
moved beyond $50. Yet there would not be protection
afforded against the risk of the stock’s price falling. By utilizing
a put option along with a stock purchase, the investor benefits.
Risk is reduced and the potential for gain is maintained.

Scenario 3: Buy ZYX at $50, Buy ZYX 45 Put.

Perhaps an investor would rather have some downside protec-
tion with a small deductible. This strategy will reduce the cost
Chapter 5 Risk Management 125

of portfolio insurance by purchasing an “out-of-the-money”

put option along with the stock purchase.

If the put has a $45 strike price and the underlying stock
is at $50, it can be said that you have effectively purchased
insurance with a $5 deductible (per share). The put will pro-
vide a counterbalance if the stock moves below $45 per share.
At that point the investor can make the choice of exercising the
put—thereby selling the stock or selling the put. The basis for
the decision will depend on where the investor believes the
bottom will be. If he or she believes the stock is at its base, they
will probably sell the put.

If the stock is under $45, the put will be valued at least

somewhere between where the stock price is trading in the
open markets and the strike price of the put option. The profit
from the sale of the put can be used to offset the losses from
the stock’s position. If there is no more hope for the stock, the
stock can be sold. If, on the other hand, the stock has the
opportunity to move up again, the profits from the put can be
realized and the stock’s rise will further enhance the investor’s
portfolio performance.

The problem with this strategy is the investor will have to

see a rise in the stock above $51 before a profit is realized
since in the example there is a $1-per-share cost to buy the
option. If the investor did not use the option plan and only
bought the stock at $50, he would begin to profit from the
investment above his share cost. However, the lack of a
defensive position will leave the investor open to the risk of
losing the full value of the initial purchase.
126 The Disciplined Investor

Buy ZYX Buy ZYX Buy ZYX

and buy and buy
No Options 6-month 6-month
50 put 45 put
Stock Cost $ 50.00 $ 50.00 $ 50.00
Put Cost $ - $ 2.25 $ 1.00
Total Cost $ 50.00 $ 52.25 $ 51.00

Risk $ 50.00 $ 2.25 $ 6.00

Applying the correct strategies when buying an “at-the-

money” or an “out-of–the-money” put helps to reduce risk in a
portfolio. At the same time, each has advantages and disadvan-
tages. Either way, the intent is to provide a touch of portfolio
insurance while maintaining a degree of upside potential.

Protective Puts Give You Options

In the past, options have been given a bad name. Maybe it was
because of the lack of understanding or possibly the known
abuses within the industry. Today, with a new sense of what
certain options can do for a portfolio, the benefits can be bet-
ter recognized. The choices available are many when using puts
as a protective mechanism within a portfolio. For example, a
put with a strike price of $55 might cost $1.25 per share or
$125 per contract. This 55 put gives the investor the right to
sell ZYX at $55. With this position, he can continue to hold
the stock, hoping it will rise further while knowing that he can
always sell it for a profit of $3.75 (sell at the $55 strike price
minus the $50 stock purchase price minus the $1.25 put cost)
no matter how far the stock falls.

When investors are buying the same type of puts over and
over, it is considered “rolling.” This will provide a good deal of
Chapter 5 Risk Management 127

flexibility so that the investor can adjust the strike price as the
price of the underlying stock moves, but it will also create
higher costs due to commissions. This needs to be considered
carefully to ensure that there can be profitable transactions, net
of fees.

Protective Puts Summary

Investors are always looking to find ways to reduce risk in a
portfolio. As investors are inherently “risk adverse,” the pur-
chase of a protective put is a good way to supply an ample
amount of relief from the fear of losing money.

$300
Graph At Expiration
$200

$100
Profit
Stock Price
or $0
Loss
-$100
Protective Put
(Strike Price = $50)
-$200

-$300

By now, you will hopefully agree that the use of a pro-

tective put and other options strategies will actually create a
layer of support and protection which can help to reduce
risk within a portfolio. While the advantages clearly out-
weigh the disadvantages, there is an important fact you need
to remember: profits can only be realized after the costs of
the options purchase are subtracted and the stock moves past
a certain calculated level. Additionally, the put option has a
finite lifespan. This last point will require accurate tracking
128 The Disciplined Investor

to ensure that once the option expires, another protective

put strategy will be implemented.

Several key protective strategies have been outlined in this

chapter. While it is good to consider each of these risk man-
agement factors, the critical point to remember is that no
portfolio—regardless of its level of protection—is completely
safe from all potential risks, even if it is properly diversified. As
a result of this fundamental concept, the idea of the mutual
fund was conceived.

While the mutual fund can be viewed as a form of invest-

ment strategy with diversification built right in, it is not in
itself a complete portfolio. You cannot simply dump all of your
investable assets into one mutual fund and call it a day.

This is not to say that this tool does not have value, how-
ever. In fact, quite the contrary. Mutual funds are the core
component of any balanced portfolio and disciplined invest-
ment strategy. In the next chapter you will learn why.
 Chapter 6

Why Mutual Funds?

Mutual funds help to create a well-diversified portfolio. Using

them not only helps you broaden your investment base, but it
also provides you with assistance when researching investment
sectors that are difficult to understand. They are also beneficial
because:
• There are only so many hours in a day you can commit
to research.
• The disciplines for mutual fund investing are not the
same as those for stocks. The truth is funds need to
be researched with an entirely different skill set.
• There are potential language barriers when investing
internationally.
• Currency conversion/hedging may be difficult to
implement for an individual investor.
• Information and research within certain sectors may be
difficult to access.

Fortunately, this is a solution readily available to help

investors find suitable investments in countries, sectors, and
industries that they may not be able to research. This will allow
you to focus your research within the areas you are strongest, and
at the same time confidently handing off the remaining portfolio
management responsibilities to a qualified fund manager.

129
130 The Disciplined Investor

The process of finding the best fund choice can be daunt-

ing as there are over 10,000 funds available today. Right now,
there are more sectors covered than ever before. Looking for-
ward, it seems likely that more specialty funds will be created
rather than those that will simply invest according to an index.
This is primarily due to the public’s desire to have some con-
trol and involvement over its investments.

Looking back, mutual funds have a history dating back as

far as the 19th century. At that time, labor groups and trade
guilds within Europe often used the pooling of monies to pur-
chase investments. Yet it was not until 1924 that the first true
open-ended mutual fund was established. That fund, the
Massachusetts Investors Trust, was the brainchild of Edward
G. Leffler. Within the first year of operation, it successfully
amassed over $392,000 from 200 excited investors.

Prior to the crash of 1929, there had been less than ade-
quate financial disclosure; a prospectus had yet to be
required. At that time, there existed only 21 funds with just
$134 million of invested assets. In 1933, a sweeping change
jolted the industry as congress adopted the Securities Act of
1933, requiring full disclosure by prospectus.

 PROSPECTUS
A prospectus is a formal notice filed with the SEC that outlines
a company’s intent to sell securities. This notice is required to
contain every bit of information that might be valuable for an
investor attempting to make an informed decision about
whether to buy or sell a stock in that company.

At that time, funds did not gain much popularity, as they

were a mystery to most. The fund industry’s growth was also
Chapter 6 Why Mutual Funds? 131

hampered by the fact that investing in the stock market did not
come back into fashion again until the 1950s. Up until then,
most investors still suffered a bad hangover from the great crash
of the 1930s and were terrified of stocks. Bonds were therefore
safer bets, since they were easily understood, and ultimately
became the investment of choice for the average Jane and Joe.

Fast forward to the 1950s and the days of sock-hops and

hot-rods. This period eventually gave birth to over 100 new
funds for investors. This popularity continued to intensify as
time passed into the 1960s. New funds came on strong and
investors started to invest money at record rates. Unfortunately,
just as soon as funds were becoming a popular investment vehi-
cle, the stock market went through one of the worst corrections
in over two decades.

From 1971 to 1973, the Dow Jones lost an average of 16.1

percent per year. With their investors furious, money flew out
of equity funds and into the safety of CDs. It was not until the
latter part of the 1970s and into the 1980s that the “me first”
attitude was back in full swing again. This sounded the charge
to investors wanting to catch the “profit wave.” At the time,
stocks were difficult to research and commission rates were
outrageous. (During the early 1980s, buying 100 shares of a
stock could have cost you $150 in fees alone.)

As such, the most obvious choice was to either give your

broker full discretion (not a good idea) or buy a mutual fund.

Mutual fund sales soared again, further enhanced because

of the fact that they paid a whopping commission to the selling
broker. Fund companies saw their assets increase geometrically.
132 The Disciplined Investor

Jump forward to the latter part of the 90s, when there

were more funds than anyone knew what to do with. Today,
over 80 million Americans own mutual funds, with assets
totaling more than $6 trillion. Investment styles range from
value to growth, quantitative to fundamental, market corre-
lated to neutral, and everything in between.

Even so, there are still some problems inherent to mutual

fund investing, like window dressing and high fees. The good
news is that if you carefully follow a regimented discipline to
uncover the true strategy of the fund and research a few key
statistics, you can probably avoid these pitfalls.

Mutual Funds Defined

A mutual fund is an investment company that allows share-
holders to pool money with the intent to invest in a
diversified portfolio of securities. Funds usually accept a min-
imum initial deposit of $250 or sometimes less by creating a
systematic investment plan for only $25 per month. The
benefit to investors is professional management and diversifi-
cation. Whether investing $1,000 or $1,000,000, the investor
will have an exact proportional percentage of the total fund
holdings within their portfolio.

Suppose that Jeff and Sarah invest $10,000 into the

Superior Stock Mutual Fund. Their respective holdings will be:

Percent Jeff and Sarah’s

Of Fund Holding Percentage
10% Microsoft 10%
15% Pfizer 15%
20% General Electric 20%
25% FNMA 25%
15% Oracle 15%
15% General Motors 15%
Chapter 6 Why Mutual Funds? 133

This is the case for all investors in this fund, since it is an

open-end mutual fund. This means that as more money is
deposited, additional fund shares are created. On the reverse
side, as money is withdrawn, fund shares are redeemed. The
end product amounts to unlimited shares with total liquidity.
Ultimately, the process dictates daily pricing of the fund at 4:00
p.m. and more importantly, equality for all fund investors.

Fund Types
As previously mentioned, funds come in all shapes, sizes, and
flavors. In order to get even more acquainted, a good starting
point would be to break down the fund universe into four
basic groups: Money Market Funds, Hybrid Funds, Equity
Funds, and Bond Funds.
Total Net Assets of Mutual Funds (billions of dollars)

Sept 06 Aug 06 % chg Dec 05

Equity/Stock Funds $5,455.5 $5,361.5 1.8 $4,939.8

Hybrid Funds 613.0 602.8 1.7 567.3
Taxable Bond Funds 1,086.4 1,077.2 0.9 1,018.5
Municipal Bond Funds 357.0 353.7 0.9 338.8
Taxable Money Market Funds 1,861.2 1,837.7 1.3 1,706.5
Tax-Free Money Market Funds 349.1 351.8 -0.8 334.0
Total $9,722.2 $9,584.7 1.4 $8,904.8

(Source: Investment Company Institute)

From here, you can further define subcategories to help

discover the appropriate fund for your portfolio.

Now that you know what broad categories are available, it

is important to understand the more specific fund classifica-
tions. This will be especially useful when you start the
screening process outlined later in this chapter.
134 The Disciplined Investor

According to the Investment Company Institute, funds can

be further divided into many unique objective categories.
Below are the common definitions.

MUTUAL FUND INVESTMENT OBJECTIVES

EQUITY FUNDS
Equity Funds primarily invest in common stocks with the
objective of capital appreciation.

• Capital Appreciation Funds, as their name would suggest,

seek capital appreciation; dividends are not a primary
consideration.

• Aggressive Growth Funds invest primarily in common

stocks of small growth companies.

• Growth Funds invest primarily in common stocks of

well-established companies.

• Sector Funds invest primarily in companies within

related fields.

• Total Return Funds seek a combination of current

income and capital appreciation.

• Growth-And-Income Funds invest primarily in common

stocks of established companies with the potential for
growth and a consistent record of dividend payments.

• Equity/Income Funds invest primarily in equity securities

of companies with consistent records of dividend
payments. They seek income more than capital
appreciation.
Chapter 6 Why Mutual Funds? 135

• World Equity Funds invest primarily in stocks of

foreign companies.

• Emerging Market Funds invest primarily in companies

based in developing regions of the world.

• Global Equity Funds invest primarily in equity securities

traded worldwide, including those of U.S. companies.

• International Equity Funds must invest in equity

securities of companies located outside the United
States and cannot invest in U.S. company stocks.

• Regional Equity Funds invest in companies based in a

specific part of the world.

HYBRID FUNDS
Hybrid Funds may invest in a mix of equities, fixed-income
securities, and derivative instruments.
• Asset Allocation Funds invest in various asset classes
including, but not limited to, equities, fixed-income
securities, and money market instruments. They seek
high total return by maintaining precise weightings in
asset classes.

• Global Asset Allocation Funds invest in a mix of

equity and debt securities issued worldwide.

• Balanced Funds invest in a mix of equity securities and

bonds with the three-part objective of conserving
principal, providing income, and achieving long-term
growth of both principal and income. These funds
maintain target percentages in asset classes.
136 The Disciplined Investor

• Flexible Portfolio Funds invest in common stocks,

bonds, debt securities, and money market securities to
provide high total return. These funds may invest up to
100 percent in any one type of security.

• Income-Mixed Funds invest in a variety of income-pro-

ducing securities, including equities and fixed-income
instruments. These funds seek a high level of current
income without regard to capital appreciation.

TAXABLE BOND FUNDS

These are corporate bond funds that seek current income by
investing in high-quality debt securities issued by U.S.
corporations.
• Corporate Bond Funds (General) invest two-thirds or
more of their portfolios in U.S. corporate bonds with
no explicit restrictions on average maturity.

• Corporate Bond Funds (Intermediate-Term) invest

two-thirds or more of their portfolios in U.S. corporate
bonds with an average maturity of 5 to 10 years. These
funds seek a high level of income with less price volatil-
ity than longer-term bond funds.

• Corporate Bond Funds (Short-Term) invest two-

thirds or more of their portfolios in U.S. corporate
bonds with an average maturity of one to five years.
These funds seek a high level of income with less price
volatility than intermediate-term bond funds.

• High-Yield Bond Funds invest two-thirds or more of

their portfolios in lower-rated U.S. corporate bonds
(BAA or lower by Moody’s and BBB or lower by
Standard and Poor’s rating services).
Chapter 6 Why Mutual Funds? 137

• World Bond Funds invest in debt securities offered by

foreign companies and governments. They seek the
highest level of current income available worldwide.

• Global Bond Funds (General) invest in worldwide

debt securities with no stated average maturity or an
average maturity of five years or more. These funds
may invest up to 25 percent of assets in companies
located in the United States.

• Global Bond Funds (Short-Term) invest in debt secu-

rities worldwide with an average maturity of one to five
years. These funds may invest up to 25 percent of
assets in companies located in the United States.

• Other World Bond Funds, such as international bond

and emerging market debt funds, invest in foreign
government and corporate debt instruments. Two-
thirds of an international bond fund’s portfolio must
be invested outside the United States.

• Emerging Market Debt Funds invest primarily in debt

from underdeveloped regions of the world.

• Government Bond Funds invest in U.S. government

bonds of varying maturities. They seek high current
income.

• Government Bond Funds (General) invest two-thirds

or more of their portfolios in U.S. government securi-
ties of no stated average maturity. Securities utilized by
investment managers may change with market
conditions.
138 The Disciplined Investor

• Government Bond Funds (Intermediate-Term) invest

two-thirds or more of their portfolios in U.S. govern-
ment securities with an average maturity of five to ten
years. Securities utilized by investment managers may
change with market conditions.

• Government Bond Funds (Short-Term) invest two-

thirds or more of their portfolios in U.S. government
securities with an average maturity of one to five years.
Securities utilized by investment managers may change
with market conditions.

• Mortgage-Backed Funds invest two-thirds or more of

their portfolios in pooled mortgage-backed securities.

• Strategic Income Funds invest in a combination of

U.S. fixed-income securities to provide a high level of
current income.

TAX-FREE BOND FUNDS

State municipal bond funds invest primarily in municipal
bonds issued by a particular state. These funds seek high after-
tax income for residents within their individual states.

• State Municipal Bond Funds (General) invest primarily

in single-state municipal bonds with an average maturity
of greater than five years or no specific stated maturity.
The income from these funds is largely exempt from fed-
eral as well as state income tax for residents of the state.

• State Municipal Bond Funds (Short-Term) invest pri-

marily in single-state municipal bonds with an average
maturity of one to five years. The income of these
Chapter 6 Why Mutual Funds? 139

funds is largely exempt from federal as well as state

income tax for residents of the state.

• National Municipal Bond Funds invest primarily in

the bonds of various municipal issuers in the United
States. These funds seek high current income free from
federal tax.

• National Municipal Bond Funds (General) invest pri-

marily in municipal bonds with an average maturity of
more than five years or no specific stated maturity.

• National Municipal Bond Funds (Short-Term) invest

primarily in municipal bonds with an average maturity
of one to five years.

MONEY MARKET FUNDS

Taxable money market funds invest in short-term, high-grade
money market securities and must have average maturities of
90 days or less. These funds seek the highest level of income
consistent with preservation of capital. Maintaining a stable
share price is a primary objective

• Taxable Money Market Funds (Government) invest

primarily in U.S. Treasury obligations and other
financial instruments issued or guaranteed by the U.S.
government, its agencies, or its instrumentalities.

• Taxable Money Market Funds (Non-Government)

invest primarily in a variety of money market instru-
ments, including certificates of deposit from large
banks, commercial paper, and bankers acceptances.
140 The Disciplined Investor

• Tax-Exempt Money Market Funds invest in short-

term municipal securities and must have average
maturities of 90 days or less. These funds seek the high-
est level of income free from federal (and, in some cases,
state and local) taxes, consistent with preservation of
capital.

• National Tax-Exempt Money Market Funds invest in

short-term securities from various U.S. municipal
issuers.

• State Tax-Exempt Money Market Funds invest pri-

marily in short-term securities of municipal issuers in
a single state to achieve the highest level of tax-free
income for residents of that state.

Now that you are an “expert” on what types of mutual

funds are available, the next thing you need to decide on is
what you want a fund to do for you.

Take as an example John and Debbie. After spending some

time assessing their risk tolerance and investment goals, they
have designed an asset allocation that shows the need for a 10
percent position in high-yield bonds. Realizing that they have
little experience in this area, they want to find a good mutual
fund to help manage this portion of their plan.

Initially, they utilized Morningstar, the “source” for mutual

fund information. They found it online and obtained a three-
month trial subscription. They are now thinking about
subscribing to the hard copy version to see what it may have
that is different from the online version. Debbie also discov-
ered a great deal of information about mutual funds at the
MSN Money website—www.moneycentral.com. To her
Chapter 6 Why Mutual Funds? 141

delight, everything there was available at no cost, so they

decided to use both services until they have a better feel for
what may be most appropriate for them.

To the surprise of John and Debbie, they find that there

are 279 funds that are characterized as high-yield. What
should they do now? They could easily look at the past
performance and find the hottest funds over the past few years.
Yet when they do this, they quickly realize that the underlying
investments vary greatly. Some of the top-performing funds
have bonds that are of questionable quality.

What John and Debbie need to do is use a discipline to

uncover higher-costing underperformers. This can save a lot of
aggravation and financial pain. For a number of years, some
advisory firms have been working at refining their filtering and
scoring systems. A good example of this is a system that aids in
the search for funds to meet investment objectives that are
included in portfolio allocations.

Here is some great news: You are about to gain access to a

finely honed process that seeks out funds that both historically
and presently have:
• Below average costs
• Limited style drift
• Low capital gain/dividend exposure
• Low risk factors
• High management tenure
• Consistency of returns/limited losses
• Statistically relevant characteristics

This may seem like an overwhelming list at first, but

looking at each item one at a time may help.
142 The Disciplined Investor

Cost Factors
It may seem obvious to you, but it bears mentioning anyway:
remember that the more it costs you to hold or invest in a
fund, the lower your potential return. So if there are two index
funds investing in the same sector, the one with the lower costs
should have better long-term performance.

The 0.10 percent higher fee that Fund B charges comes

directly out of your pocket. With this in mind, it is essential to
find funds with below-average fees.

Annual 5-Year 10-Year

Expense Annualized Annualized
Factor Return Return
Index Fund “A” 1.00% 15.00% 12.25%
Index Fund “B” 1.10% 14.42% 11.05%

To help you with some of the research, here are guidelines

by fund sector/style:
Maximum Total Fee

Domestic Large Capitalization Funds 1.20%

Domestic Mid Capitalization Funds 1.30%
Domestic Small Capitalization Funds 1.35%
High-Yield Bond Funds 1.10%
International Stock Funds 1.50%
International Bond Funds 1.00%
Domestic Bond Funds 0.75%
Sector Funds less than 2.00%

For the most part, newer funds will have higher expense
ratios because they have fewer assets to spread their costs over.
Sometimes the management and board of directors will decide
to temporarily subsidize the annual costs until the fund has
reached a size that will support these fees.
Chapter 6 Why Mutual Funds? 143

Watch out, though. You may be in for a hidden surprise a

few years down the road when your annual expense ratio goes
from 1.00 percent to 1.90 percent. Adding insult to injury is
the fact that the only way you will find out is by conducting
thorough research—the fund will not send you a friendly
announcement about the rate change.

This is precisely why you want to stay away from new

equity funds. New bond funds are even more problematic.
When you invest in these, you have no idea what the ultimate
portfolio will look like. Usually, the prospectus will allow for a
wide range of investments available to the manager. You never
know what you may get by blindly investing this way. Stick
with bond funds that have fully invested portfolios with at
least three years of historical performance statistics available.

Style Drift
This is a big no-no. Style drift, or changing the investment
characteristics in the fund, is hard to pin down but it can be
very destructive to your well-thought-out allocation.

This is the reason that index funds have gained such

explosive popularity. An index fund is an investment vehicle
that is designed to produce investment returns similar or
identical to a specified index. These can be the DJIA, the
Standard & Poor’s 500, the Russell 3000, or any combina-
tion of these imaginable.

The fund manager accomplishes this either by replicating

stocks held within the index in the same proportions or by
buying other securities, such as futures and options contracts.
The former is a much safer way to invest, however, since you
hold stocks within the fund’s portfolio rather than difficult to
understand derivatives.
144 The Disciplined Investor

 DERIVATIVES
The word derivative has been used loosely to describe any
investment that has been derived from another. An example
is an option, which is a derivative of a stock. So, we can
further refine the definition to state; “an investment which
has its price based on the price of another investment is a
derivative of that investment”.

Over the past several years, the term “derivative” has been
used in conjunction with a few very complicated investments
that were newsworthy due to the significant losses that
investors, businesses, and governments had to endure. The
massive losses came about precisely because of the complexity
of the offering and the fact that several factors (not to mention
a few unscrupulous brokers) synchronously collided, causing
major financial ruin.

Sometimes even index funds are not what they seem. In

other words, do not judge a book by its cover. A classic exam-
ple of this was seen in 2000. At that time, the Legg Mason
Value Fund fund had the following top holdings:

% Net Assets
America Online 7.29%
Gateway, Inc. 6.44%
UnitedHealth Group 4.80%
WorldCom 4.64%
Waste Mgmt. 4.39%
Nextel Comms Cl A 3.62%
Eastman Kodak 3.43%
WPP Group 3.40%
Citigroup 3.28%
Aetna 3.23%
Chapter 6 Why Mutual Funds? 145

Note that the word “value” appeared in the fund’s name.

This was very deceiving, since the top holdings were clearly
weighted quite heavily toward the growth style.

Drawing another example from 2000—an odd year it

seems, the Franklin Small Cap Growth Fund had over a $3 bil-
lion median market capitalization at that time. The limit for a
small cap fund is usually $1 billion.
Franklin Small Cap Growth Fund - Top Holdings as of of September, 2000
Name % Net Assets Market Cap
JDS Uniphase 5.53% $ 80 bill
PMC Sierra 4.17% $ 33 bill
BEA Sys 2.44% $ 26 bill
I2 Tech 2.27% $ 35 bill
Veritas Software 1.90% $ 54 bill
Micromuse 1.68% $ 6 bill
BroadVision 1.52% $ 8 bill
Voicestream Wireless 1.47% $ 21 bill

Investment professionals have gone to great lengths to

uncover style drift. Since it can be a tedious task, we will break
it down into bite-size pieces.

First and foremost, you will need to find the most appropri-
ate benchmark to compare the fund to. The choices are
numerous, but traditional indices work best. This is because
they are the standard competitors for the fund’s management.

With this information in hand, you are about to become an

immediate statistician. Do not panic. It is a lot easier than it
seems. There are basically two different ways to do this. One is
to go to www.morningstar.com or www.moneycentral.com and
search for the fund that you are interested in. Then, look at the
MPT statistics page and locate the R-squared calculation. If
146 The Disciplined Investor

it is 80 or above, it is a good indication that it tracks its index

fairly well. It is that easy!

 MPT (Modern Portfolio Theory)

A comprehensive investment strategy that attempts to opti-
mize a portfolio by measuring the relationship between risk
and return. The risk of any investment, according to this the-
ory, should not be viewed on its own. Rather, it should be
considered in relation to the investment’s price and the vari-
ation of that price within the portfolio itself.

If you need more detail or if you prefer a more accurate

account of the subject, you can use a spreadsheet program such
as Microsoft’s Excel or Google’s Spreadsheets to find out if a
fund is deviating from its objective. All you need to do is
obtain its monthly price performance and compare it to the
appropriate benchmark.

Here is the process: Navigate to the advanced charting fea-

ture on MSN Money. Choose the fund and then chart the daily
performance for five years. Choose File>Download data, and
paste the returns of the fund into a new spreadsheet in column
“A.” Then, do the same with the returns of the index that best
matches your fund. Make certain that the data points match
up. The date for the fund’s return should match the index you
are comparing.

Most spreadsheet programs have statistical analysis tool

packs that allow you to compare two such sets of returns.
Choose the correlation feature and compare the two columns
of information, making sure that each uses the exact date
range.
Chapter 6 Why Mutual Funds? 147

For example, in Google’s Spreadsheet program, first add

the data as described above. Move to a new field and then,
click on the FORMULAS tab. On the far right of the browser
window, there are choices. Click on MORE>>, a dropdown
will appear on the screen, which has several more choices.
Scroll down on the left and find STATISTICAL. Click it and
now locate CORREL (correlation) and follow the online
instructions. (Note: there is also an R-squared formula avail-
able; follow the same instructions to see if that will provide a
better analysis for your data.)

If the resulting correlation is a high number (above 0.7),

then your fund has accurately invested according to its charter.
If, on the other hand, the correlation is lower or negative, you
need to find out why. This is telling you that the manager is
not sticking to his written style, as the fund’s performance is
not tracking its benchmark.

Tax Efficiency
It is important to understand that it is not how much you
make but rather how much you keep when you invest. With
that in mind, realize that mutual funds are required to pay out
90 percent of all of their earnings and gains to shareholders on
an annual basis in order to keep their tax status. This status
allows for the income and gains to be taxed at the shareholder
level only. While traditional corporations must pay tax on
earnings and then the resulting dividend is taxed to the
investor (effectively doubling taxation), a mutual fund avoids
this trap.

The downside for you is that you may be taxed on gains

you never received. Here is how it works:
148 The Disciplined Investor

When a dividend is paid by a fund, enough shares are

redeemed to cover the distribution.

 DISTRIBUTION
A process where monies are paid out to shareholders.
Distributions can come in the form of dividends (income
from sources within the fund) or capital gains. The capital
gain is either considered short- or long-term. A short-term
gain is applied to sales of securities held less than 12
months, while long-term is for those held longer. The fund
manager is continually buying and selling stocks or other
investments within your fund, and this creates capital gains
or losses. As the rule states, most of these are required to
be passed on directly to shareholders.

As an investor, you may choose to either take these in cash

or reinvest. If you reinvest, new shares are created and you
effectively own that much more. The actual value of your
holdings does not increase or decrease because of the distribu-
tion. The only thing that happens is the realization of a taxable
event and the fund reduces the net asset value of its shares in
direct proportion to the distribution.

Of course, the tax issue is only pertinent to non-qualified

plans. In other words, you need not worry about this in IRAs,
pensions, 40(k)s, and other tax-favored plans.

Therefore, since a high-yield bond fund provides income,

it will obviously not be the most tax efficient. Equity funds, on
the other hand, need to be more sensitive since they have the
opportunity (and the obligation) to micromanage the tax
implications of their portfolio actions.
Chapter 6 Why Mutual Funds? 149

Morningstar uses a calculation aptly named the Morningstar

Tax Efficiency Ratio, which looks at past performance com-
pared to total taxable distributions. It is a simple yet effective ratio.

 MORNINGSTAR TAX EFFICIENCY RATIO

This statistic, which excludes additional gains, taxes, or tax
losses incurred upon selling the fund, is derived by dividing
after-tax returns by pretax returns. The highest possible
score would be 100 percent, which would apply to a fund
that had no taxable distributions whatsoever; many munici-
pal bond funds meet this criterion.

While it may seem that the lowest possible score would be

100 percent minus the average tax rate (roughly 60 percent),
in actuality, if we assume that a fund pays out all of its total
returns in distributions, a fund that pays out high income at
the expense of capital gains can score even lower. This is
because its taxable income distributions may actually exceed
its total returns.

An equity fund with a ratio under 50 percent needs to be

looked at as a possible tax nightmare. If it has more than 70 per-
cent, it is a tax efficient fund, and it shows either a portfolio with
low turnover or a manager with a good eye toward tax efficiency.

Risk Factors
Simply put, you want to pick the fund with the best return and
the least risk. But how do you define risk and reward?

At first, you could use volatility as a guide. You could easily

look at a long-term price chart to see the “ups” and “downs.”
150 The Disciplined Investor

(Source: MSN Money)

Price History of the Alger Small Cap Fund A

The problem with this method is that it is somewhat two-

dimensional. It only shows the historical prices over time. You
need a more accurate tool—one in which you can compare
returns over time against appropriate benchmarks. This will
give you a much better understanding of management’s ability
to perform and the risk they took to get there.

Morningstar uses a calculation that results in a star rating.

 THE MORNINGSTAR STAR RATING

The Morningstar risk-adjusted rating, commonly called the
star rating, brings both performance and risk together into
one evaluation. To determine a fund’s star rating for a given
period (3, 5, or 10 years), the fund’s Morningstar risk score
is subtracted from its Morningstar return score. The resulting
number is plotted along a bell curve to determine the fund’s
rating for each time period.

If the fund scores in the top 10 percent of its broad

investment class (domestic stock, international stock, tax-
able bond, or municipal bond), it receives 5 stars
(highest). If it falls in the next 22.5 percent, it receives 4
stars (above average). A place in the middle 35 percent
Chapter 6 Why Mutual Funds? 151

earns 3 stars (average). Those in the next 22.5 percent

receive 2 stars (below average) and the bottom 10 percent
get 1 star (lowest). The star ratings are recalculated monthly.

Finally, Standard & Poor’s uses a three-year overall

rank to assess risk/reward factors and then assigns a rank.

 THE S&P THREE-YEAR OVERALL RANK

A measure of a fund’s overall risk and return characteristics.
The rank is calculated using the Sharpe Ratio. Those
funds with the highest Sharpe Ratios exhibit the best com-
binations of risk and return (unit of return per unit of risk)
versus their peers. The rank ranges from one (lowest) to
five (highest).

 Sharpe Ratio
A portfolio performance measure used to evaluate the
return of a fund with respect to risk. The calculation is the
return of the fund minus the “risk-free” rate divided by the
fund’s standard deviation. The Sharpe Ratio provides you
with a return for unit of risk measure.

For example, assume Equity Fund 1 returned 20 percent

over the past five years with a standard deviation of 2 percent.
The risk-free rate is generally the interest rate on a government
security. Further assume that the average return of a risk-free
government bond fund over this period was 6 percent. The
Sharpe Ratio would be:

(Return of the Portfolio minus Risk-Free Rate)

Standard Deviation of the Portfolio
152 The Disciplined Investor

In the case of Equity Fund 1, the Sharpe Ratio is

(20% minus 6%) ÷ 2%, which equals 7%. Therefore, for each
unit of risk, the fund returned 7% over the risk-free rate.

Generally, investors evaluating the performance of the fund

would compare its Sharpe Ratio to a benchmark. This could
include, but is not limited to, the average performance of similar
funds or an equity index. For example, assume the S&P 500 was
used as a benchmark. Further assume that the return of an S&P
500 index fund over the past five years was 10 percent with a
standard deviation of 2 percent. The Sharpe Ratio for this index
fund is (10% minus 6%) ÷ 2, which equals 2%.

An investor doing a side-by-side comparison between

Equity Fund 1 and the S&P 500 index fund would clearly pre-
fer Equity Fund 1, which provides a higher level of excess
return for each unit of risk.

To make the fund selection process user-friendly, use the

Morningstar Star System as a starting point to find quality
funds. To begin with, you should look for funds with four or
five stars. After your initial screen has been run, you can use
other factors to refine the list of potential fund candidates.

The web address for the mutual fund screening tool is:
http://moneycentral.msn.com/investor/finder/customfunds.asp.

Management Tenure
Just as it is important to stay away from relatively new funds
(in existence less than three years), it makes good sense to find
funds with managers that have been at the helm for a good
amount of time. A minimum of four years’ experience is
important. This gives a good indication of how the manager
has performed over time.
Chapter 6 Why Mutual Funds? 153

Since The Disciplined Investor’s portfolio needs predictive

results that can be measured over time, the management of the
fund should be relatively stable. Surprisingly, you will find that
this is not always the case. Attention to detail should help to
confirm that there are deep roots within the fund.

Long-Term Consistency
A one-hit wonder is fine if you know precisely when to enter
and exit, but the truth is that this is next to impossible. Over
the years, market timers have provided us with enough bad
calls to teach us this basic fact.

A better move is to look for funds and managers that have

seen both good and bad markets and have performed well over
time. Since historical information is a tool not to be used as a
projection device, the best use you can make of it is to under-
stand the management’s basic methods and skills.

After the basic management screens have been completed,

check the fund against both its peers and its assigned bench-
mark. By finding those managers who have outperformed over
the long haul, you are apt to gain the benefit of their wisdom.
Look especially closely at the years in which their benchmark
was down. How did this fund perform? Was it hurt just as
badly? During those periods of decline, did the manager pro-
vide a value-added benefit and in so doing, save his investors
significant financial losses?

Both 5 and 10 years of history should be sufficient to help

you discern a manager’s strengths and weaknesses. The more
history a fund has, the better.
154 The Disciplined Investor

Relevance
Taking all of the reports provided by both Morningstar and
MSN Money into consideration, it is easy to see that there are
many statistics available. But beware. Not all of the numbers
presented are applicable to every fund.

For example, some funds have low correlation, or similar-

ity of historical returns, to their benchmark. If this is true, you
should find that the R-squared is usually low. In this case,
when pondering the statistical information, it may look ini-
tially as if the fund measures up, but you must realize that the
statistics may bear no relevance. In other words, it may quite
possibly be unusable information.

Sometimes, the information can be confounding. Sizing

up a fund that carries a low R-squared is something like
answering the question, “Would you rather take your lunch or
walk to school?” There are two items presented with no com-
parative significance. Exactly for that reason, look to other
items such as raw volatility, associated fees, and relative versus
actual performance.

If the R-squared is higher than 80, many of the MPT risk

tools can be of real benefit in trying to understand the fund.
Sharpe ratios as well as other MPT (modern portfolio theory)
analytics can be invaluable in the research process.

In summary, using the MSN Money fund screening and

finder tool is an excellent way for you to narrow the universe
of funds. By doing so, you use a powerful mechanism with
data updated on a regular basis. This in itself is important, as
funds can change management and overall style with regular-
ity. As a Disciplined Investor, you can stay ahead of the curve by
Chapter 6 Why Mutual Funds? 155

creating tested and reusable systems in an attempt to gain

superior overall returns with less overall risk.

The funds chosen should be monitored regularly, with an

eye toward relative performance against appropriate peers and
benchmarks. Keep in mind that a significant market event can
temporarily undermine any portfolio. This is the main reason
why adherence to a plan is so important when investing.
Unless there has been a significant change in management style
or other important issues pertaining to the fund structure, be
patient and stay with your well-researched choices.

Summarizing the points made above, you could say that

you are on a hunt for excellence. You should seek out funds
with superior results that have less risk and limited cost. The
good news is that there are so many fine choices available that
finding the right fund to meet your investment objectives
should be easier with these freely available tools and adher-
ence to the system standards. It will take practice and
patience, and it will involve a little bit of work on your part.
But yes, you can do it yourself.

The end result should allow for maintained consistency;

the essential byproduct of a discipline. By staying close to the
disciplines outlined, you will be able to make better choices
about mutual funds and have a good idea of the exact perform-
ance expectations once they are implemented.
156 The Disciplined Investor

Additional Considerations:

Fund Value/Growth Indicator:

Price/Earnings Style Price/Book

Ratio Ratio
Over 19 Growth Over 4.5
Under 19 Value Under 4.5

Fund Capitalization Indicator:

Size Median
Indicator Market Cap
Large-cap $5 billion+
Mid-cap $1 – $5 billion
Small-cap $500 million –
$1 billion
Micro-cap Under
$500 million

Now that the significance of mutual funds has been established,

it would best serve the cause to move on to another avenue of
disciplined investing. In any comprehensive approach to build-
ing a balanced portfolio, a discussion of annuities and
guaranteed investment contracts is certainly warranted.

While mutual funds represent a much easier and steadier

method of diversification—and are relatively new in form
and function—annuities and guaranteed investment con-
tracts have been around for centuries. Some investors may
view such methods as perhaps a little outdated, but annuities
and guaranteed investment contracts have been around so
long for a reason: they work.
Chapter 6 Why Mutual Funds? 157

Throughout a long and tumultuous financial history that

saw the rise and fall of empires and the Dow Jones Industrial
Average, annuities and GICs have remained steadfast, offering
a heightened sense of security and safety for all those saving for
their future.

And what of retirement? Even if it may seem like a distant

condition—something that is still too far off in your life to
even consider—an annuity or GICs may have its valuable
applications in your own portfolio. They may not be as versa-
tile as they are old, but you would still do well to take a good
long look. The following chapter does just that.
 Chapter 7

Annuities and GICs

Annuities and guaranteed investment contracts (GICs) have

long been tools used by savvy investors to help reduce risk
within their portfolios. Before there was the S&P 500 or
theories based on the Dow Jones Industrials, guaranteed
investment contracts were a large part of most individuals’
long-term retirement plans. They offered safety, guarantees,
and freedom from the fear of running out of money.

These programs have a long history, tracing their roots as

far back as the Roman Empire in the 700s. Unfortunately,
though, with the lack of in-depth knowledge on the part of
many agents (along with a significant amount of bad press)
most good annuities have not seen the benefit of reaching the
investment masses. Add to that the fact that the lack of an
appealing interest rate does nothing to inspire investors to
seek out annuities as core components within their portfo-
lios, and what you are left with is a thoroughly underrated
investment strategy.

If you jump ahead to the final chapter and its section on

asset allocation, you may begin to realize that much of that was
essentially developed to reduce risk and, at the same time,

159
160 The Disciplined Investor

increase return. Annuities, it may be said, represent just one

more method to help you gain control over the risk associated
with your portfolio.

On the complete opposite side of the traditional risk spec-

trum, guaranteed investment contracts (GICs) also referred to
as “fixed annuities,” allow for absolute guarantees—along with
an understanding about and the expectation of the future
value of the investment in question.

Annuities have seen many changes over time, and in 1995

there was a major shift in policy design that allowed for
insurance companies to compete with more traditional invest-
ments. Fixed annuities were now not only based on a static
interest rate declared by the insurance company; their per-
formance would also be dynamically affected by the returns of
the stock markets. The idea of an “Equity Index Annuity” was
born out of the need for companies to become more competi-
tive with the rapidly changing investment climate.

Yet it was only after the year 2000 that annuities once
again started to gain popularity. As investment portfolios
continued to hemorrhage due to a market that seemed to move
lower daily, investors became more and more open to new
ideas about how to recapture their money. Those new ideas
carried a natural bend toward conservatism.

Unfortunately, most investors in this country failed to take

action until much of their wealth had already been stripped
away by the volatility of the economy at the turn of the 21st
century. By the time they became receptive to the alternatives,
it was almost too late.
Chapter 7 Annuities and GICs 161

Perhaps a dash of historical perspective will shed some

light on this often confusing topic. Records show that the first
reported annuities date back to Roman times, when contracts
known as “annua” were first offered. They consisted of a prom-
ise of income payments for a fixed term—possibly even a life
term—to an individual investor in return for the deposit of a
sum of money. Back then, speculators were the main source of
offerings for these types of contracts when they provided insur-
ance to marine and other risky enterprises.

The first person to understand calculations and tables that

recorded life expectancies was a Roman named Domitius
Ulpianus. His main objective was to use it for the purpose of
calculating income rights for his descendants.

It was not until the middle ages, however, that annuities

were first made available to individuals who wished to deposit
large sums of money. Later still, during the 17th century, spe-
cial annuity programs that pooled the assets of many people
had begun operation in France and Europe. These programs
were known as Tontines.

 TONTINE
An investment plan in which participants buy shares in a
common fund and receive an annuity that increases every
time a participant dies—with the entire fund going to the
final survivor or to those who survive after a specified period
of time.

In return for the promise of an initial lump sum payment,

purchasers of tontines received life annuities. Annuity pay-
ments would increase annually for the survivors who
162 The Disciplined Investor

remained. They would then claim the payouts which would

have gone to those who had died. When only one survivor of
the tontine pool was left, he or she would get the entire prin-
cipal in a lump sum.

The tontine had elements of both gambling and insurance

tied together in a neat package. It also caused a great deal of
legal and social concern as the financial gain of one participant
was so closely tied to the life and death of others.

During the same period, there were many nations that

turned to selling annuities in lieu of government bonds.
History shows that it was initially England and Holland that
had programs in which annuity companies received invest-
ment funds in return for the promise to pay annuitants a
lifetime income.

By the year 1759, the United States entered the fray, seeing
for the first time the initial availability of annuities for individ-
uals. The first annuity has been credited to the design of The
Corporation for the Relief of Poor and Distressed Presbyterian
Ministers and Distressed Widows and Children’s Ministers, a com-
pany that was chartered by the state of Pennsylvania. This
organization provided survivorship annuities for families as well
as ministers. As an exclusive organization that took care of its
members, it was credited with creating one of the first forms of
guaranteed income. In fact, it eventually paved the way for
other companies that later devised programs for anyone who
wished to receive such guarantees.

A half century later another company, The Pennsylvania

Company for Insurance on Lives and Granting Annuities, was
founded. The annuity market was not in high demand at the
Chapter 7 Annuities and GICs 163

time since life expectancies were not very long. Therefore

growth of the company was slow, but this company can be said
to have founded what is today the modern stock insurance
company. More importantly, they were one of the first compa-
nies to ever sell annuities and life insurance directly to the
public without a membership requirement.

Over the course of the past century, there has been a dra-
matic shift on the part of the public toward annuities as an
alternative to guaranteed investment contracts. For a long
time, this movement was dominated by investments in sover-
eign bonds and programs from banking-related institutions.
As investments became more diverse, so did the plans offered
by annuity companies.

Today the product range has changed in such a way that

the offerings can provide more than just guaranteed incomes.
They also represent opportunities for deferral of income taxa-
tion until the individual decides to withdraw the money.

Within this chapter, you will learn about the advantages of

some of the more “modern” annuities that provide an investor
with a better mix of allocation options, thereby reducing risk
and minimizing the long-term volatility within a portfolio.
Taxation and the details regarding some of the more obscure
types of annuities (two topics which would fill a book by
themselves) will not be discussed in any significant length
within these pages.

Realize that annuities come in many sizes and shapes, but

for the most part, they can be broken down into two separate
subdivisions. Within the subdivisions, there are also many dif-
ferent categories that can be further refined along the lines of
164 The Disciplined Investor

how the annuity in question relates to and may benefit a port-

folio, the length of time required to hold the contract, and
whether you plan to postpone the investment return or wish to
receive it immediately.

For the purposes of this chapter, think about the universe

of annuities as though it were split into two distinct sections:
the galaxy of fixed annuities and the galaxy of variable annu-
ities. These two distinct areas are differentiated by the
underlying investments within their respective annuities. The
level of guarantee that is offered to the purchaser of the plan is
also considered a dividing factor.

With a fixed annuity, you will have the guarantee of prin-

cipal and usually some stated return for a specified period of
time. On the opposite side of this is the variable annuity,
which offers a wide array of investment choices within an
insurance/annuity wrapper. There are traditionally no specific
guarantees within the investment accounts, and the owner
must be willing to accept the risk of principal fluctuation as
well as the potential for loss.

To make this distinction crystal clear: a fixed annuity

allows you to completely eliminate the risk of investment loss
within the plan and transfer it to the insurance company. With
a variable annuity, the risk of loss is passed on to the contract
holder. The latter is the reason why variable annuities are often
favorably compared to investments in mutual funds, as they
have the added features of tax deferral and death benefits.

Variable Annuities
Since the stated goal of this chapter is to help you further
diversify and reduce risk, discussions of variable annuities will
Chapter 7 Annuities and GICs 165

be purposely limited to a few comparisons and a cursory

review of the programs available.

Variable annuities can be said to be the marriage of invest-

ments and insurance. During the annuity accumulation phase
it is quite similar to any investment. Funds are deposited into
accounts that closely resemble mutual funds. The units within
the variable annuity accounts are calculated similar to shares of
mutual funds.

That is where the similarities between variable annuities

and investments end, and the differences begin. One major
differentiation is that there are no dividends, capital gains dis-
tributions, or interest payments within the variable annuity
sub-accounts. Even though the investments within these
accounts will have distributions, the variable annuity will rein-
vest them internally. In fact, it will be unnoticeable to the
annuity holder, as it occurs automatically. The only thing that
may happen is the account shares may move in proportion to
the reinvestment. This will only be seen if you compare the
variable annuity sub-account to the mutual fund it is patterned
after on the day of the distribution.

Even with this advanced knowledge, it will be very difficult

to detect. Why bother anyway? Remember that a deferred vari-
able annuity is often purchased as a tax-advantaged investment
vehicle for which the lack of immediate income distributions
is of no consequence to most investors.

Drawing from the textbook definition of a variable annuity,

when the accumulation phase of the annuity ends, the cumula-
tive value of the investment units are transformed or converted
into “annuity units.” This occurs as if the underlying unit
166 The Disciplined Investor

values were distributed and the funds would have bought a

hypothetical fixed annuity.

While there is no actual payment to the annuitant, the val-

ues are important when calculating income for the future. The
calculated amount is used to provide the actual annuity with
the appropriate number of annuity units. This, in turn, is used
to provide the annuitant with realistic projections of future
values; that way, the investor can choose which option is most
appropriate for his or her particular situation.

Many variable annuities also allow the annuitant the

option of choosing a fixed annuity stream or some combina-
tion of a fixed and variable stream of payouts. In practice, most
people seem to choose a variable annuity for growth, and when
they are ready for income, they move to a fixed style to ensure
that they will never run out of money.

To confuse the situation just a bit more, the variable annu-

ity payout depends on the number of annuity units with which
the annuitant is credited due to net deposits. Over time, the
actual returns on the assets in the portfolio underlying variable
annuities also affect the total payout.

For that reason, a variable payout is a double-edged sword.

It can provide a wonderful hedge against inflation, but it may
also bring uncertainty to a retiree’s annual budget. This is due
to the fact that as the value of the underlying portfolio rises,
the income will also rise during the payout phase. Thus it can
be said that a variable annuity is a great tool to keep the
purchasing power of a portfolio stable.
Chapter 7 Annuities and GICs 167

Unfortunately, though, the converse is also true. The value

of the annuity portfolio will dictate the amount of income
generated. If the annuity value declines, future payments will
decline as well. The opportunity to earn money is beneficial
but at the same time can lead to problems. Therefore a variable
annuity has the potential for fluctuating payments.

Over time, many product incarnations have been devised.

There are now a plethora of options available, as the market for
this type of annuities has become more competitive. The
biggest change has been in the number of investment alterna-
tives that are available within a variable annuity. While the first
variable annuities focused primarily on diversified common
stock portfolios, many of the plans today offer more special-
ized portfolios of stocks and indices (as well as bonds and other
non-traditional securities).

By their nature, variable annuities allow policyholders to

switch between sub-accounts in order to change investment
allocations (usually with different investment options and
objectives). Therefore it is possible to move from one “fund
family” or “style” to another without the traditional expense
and delay. This is usually done without fees or penalties,
although there may be a limit on the number of annual
transfers allowed by contract.

These features make it possible to choose variable annuities

as a viable accumulation vehicle without necessarily requiring
you to purchase annuity-like payouts until the accumulation
phase is over. Add to that the fact that many contracts contain
purchase rate guarantees, and therein lies a terrific avenue for
investing without risk.
168 The Disciplined Investor

Without risk? What does that mean?

The insurance component of a variable annuity states that

upon the death of the annuitant, the contract will equal at least
the net deposits (deposits minus withdrawals). Therefore, if an
investor deposits $100,000 into a variable annuity and the
value of its underlying investments falls below the original
amount deposited, the value of the “death benefit” will be
equal to the net deposits.

This particular component is obviously very attractive to

many investors, especially older individuals who want to
protect their assets without handcuffing themselves to CDs
and money markets.

Since, in this scenario, the beneficiaries will never receive

less than the net deposit, an investor could theoretically create
an aggressive portfolio attempting to maximize gain. At the
same time, he could rest easy knowing that upon his death, his
heirs are assured that the value of the annuity would never be
less than the sum of the deposits, less any withdrawals.

Insurers offer a range of different annuity products that

compete in turn with a range of financial products offered by
other financial institutions. The variable annuity is the insur-
ance company’s closest relative to the traditional mutual fund,
with a few distinct differences. The first is an increased annual
cost. The second is the potential penalty on early withdrawals
that will be assessed by the annuity company. Finally, there is
traditionally a minimum age requirement of 59 1?2 set by the
IRS for withdrawing money without a penalty.

These are the trade-offs required to obtain the death benefit

Chapter 7 Annuities and GICs 169

and built-in tax deferral. So, you may find yourself asking,
“How much will these actually cost?” The total cost of owner-
ship of the annuity includes the underlying investment
manager fees as well as mortality and expense charges. These
may total anywhere from two to four percent per year, depend-
ing on the company.

Unlike other financial products, annuities usually contain

a surrender charge. This is found in many deferred annuity
contracts as part of the initial agreement between the buyer
and the annuity company. Basically, if an annuitant decides to
cancel his policy before the end of the stated surrender
period, he will be required to forfeit some of his account
value to the insurer in the form of a surrender charge.

This concept is quite similar to the contingent deferred

sales charges associated with mutual funds. The justification by
the insurer is that these charges are required in order to recover
the commission and other production and distribution costs
associated with the annuity. Their profit model states that the
longer the money is held within the annuity policy, the more
expenses the insurance company can recoup. This is all part of
the annual administration and mortality fees assessed.

However, if the annuity is terminated prematurely, the

amount collected will be insufficient to allow for the recaptur-
ing of these fees. Therefore, the insurer deems it appropriate to
collect the surrender charge in order to be repaid for the loss.

 SURRENDER CHARGE
A fee imposed upon an investor who decides to prematurely
terminate an annuity contract. The charge is usually higher
during the early years of the surrender period (see below)
170 The Disciplined Investor

and then gradually declines by a certain percentage each

year. Some companies offer annuities without these
charges and are considered “no-load” annuities.

 SURRENDER PERIOD
The period of time under which a surrender charge applies
to the sale of, or withdrawal from, an annuity. Typically, this
period is somewhere between seven to nine years. If an
investor decides to sell all or part of an annuity early (such
as during this pre-established period of time), he is subject
to the surrender charge—based on the percentage associ-
ated with the specific year of the surrender period in which
the sell or withdrawal is enacted.

The IRS has a hand in this as well. As annuities are created

as tax deferred vehicles, the IRS can impose a tax penalty on
early distributions. When this is added to the potential surren-
der charges on early withdrawals, one quickly realizes that
annuities are not for the short-term investor who has not yet
reached the age of 59½. Still, the tax treatment of annuities is
an attractive feature that seems to have been a significant cata-
lyst for their recent growth in popularity. This is because growth
on the investments held within a deferred annuity account is
not subject to taxation until it is withdrawn from the plan. As
we know, when monies are allowed to compound over long
periods of time unhindered by income or capital gains taxes,
there is a wonderful opportunity for exponential growth.

The significant opportunity to defer taxes on the invest-

ments held within an annuity has already been discussed at
length, but here is a final illustration of the points discussed to
hammer this home:
Chapter 7 Annuities and GICs 171

Assume that a 45-year-old with a projected retirement age

of 70 is looking at various investment opportunities in order to
fund his eventual retirement. He and his financial planner use
a return expectation of 7 percent year over year and a 28 per-
cent marginal tax rate for his $25,000 initial investment.

Under these assumptions, the $25,000 investment outside

of an annuity would grow to a bit over $85,000 by the time
the investor reached 70. This is assuming that each year 28
percent of the income generated is deducted for taxes and the
remainder is reinvested.

Now, look at the same $25,000 invested inside of an annu-

ity. The assumptions are all the same except that the annuity
gains are tax deferred. Here, the principal would accumulate to
more than $135,000 by the time the investor turned 70. The
marginal 28 percent tax rate has been assumed in this case as
well. Once he decided to withdraw the funds from his annu-
ity, he would find that the remaining after-tax value would
equal $97,693.

The amount above represents a 15 percent increase in

profit over the amount within the non-annuity investment.
Suffice it to say that a variable annuity is an extremely efficient
way to save for retirement and works nicely as a compliment
to standard retirement programs such as IRAs, pension plans,
and 401(k) plans. But, there is one more hidden expense that
needs to be discussed again before we all rejoice and buy up the
entire supply of annuity contracts. Earlier, we explored the cost
factors of an annuity and found that the variable annuity has
an additional annual cost related to mortality and administra-
tion expenses. If that is included in the same equation, the
annuity may not perform as well as first thought.
172 The Disciplined Investor

All assumptions being equal, the additional annual

expenses (1% assumed) would bring the final after-tax value of
the annuity closer to $84,253. This particular point is one that
is often overlooked when purchasing a variable annuity. The
lesson to be learned, once again, is that all costs should be
taken into consideration when researching any investment. If,
after a thorough review of this chapter, it still makes sense to
invest in a variable annuity, look for a plan with a low-cost
structure or the tax benefits you receive will only offset the
additional costs you will pay.

This poignant discussion is leading toward the reason that,

in the mid-1990s, an annuity design was introduced which
gained tremendous popularity: the index annuity. Up until
then, individuals had only two choices when it came to annu-
ities: fixed annuities offering a guaranteed rate and variable
annuities with “mutual-fund-like” sub-accounts. As more
investors became disillusioned with the performance results of
their variable annuities, annuity companies looked to provide
more guarantees. At the same time, investors were still desirous
of investing in the markets. The blending of these helped to
give birth to an annuity that would have characteristics of both
variable and fixed annuities.

One component of this new type of annuity was to provide

a low-cost structure in order to compete with variable annu-
ities. The mortality and administration expenses were removed
and replaced with caps, spreads, and participation rates. These
had the ability to ensure profits to the annuity company while
allowing the investor to capture some of the market’s gains.

The basic premise of an index annuity is to provide returns

that are similar to many common equity and fixed-income
Chapter 7 Annuities and GICs 173

indices such as S&P 500, NASDAQ 100, Lehman Bond, or

the DJIA. The attraction to this type of plan is that investors
can have returns tied to the changes in the general markets
while still maintaining a degree of safety. Unfortunately
though, the calculation of the returns is not always straightfor-
ward, as they usually contain a few confusing statistical
measures. For example, issuers of index annuities always specify
the level at which index annuity owners will be “in the market.”
This level is called the participation rate, and it reflects how
closely the annuity follows the index’s performance.

 PARTICIPATION RATE
This rate is quoted in terms of a percentage. Suppose an
index annuity has a defined participation rate of 70 percent.
When the index it follows goes up by 10 percent, the annu-
ity’s accumulated value increases by 7 percent. In a market
downturn, an insurance company mitigates the risk.
Participation rates of 80, 90, or 100 percent are typical, and
it is important to ensure this rate is guaranteed throughout
the term of the annuity.

In order to mitigate the risk of excessive interest payments

due on an annuity, some annuity policies may utilize a
spread. The main reason for this is to ensure profitability for
the insurance company.

 SPREAD
The spread is the difference between what an annuity fund
actually earns and the amount that is credited to the investor.

Spreads or fees are not a new idea. In fact, they are not
restricted to annuities either. Whenever you open a savings
174 The Disciplined Investor

account, for example, you are subject to a spread. The bank

may be earning five percent on your money, but in a savings
account, they are only paying you two percent. In this exam-
ple, the three percent difference is the spread.

In the case of index annuities, the annual spread can range

anywhere from zero to five percent and is clearly reflected both
in the initial contract and on the annual statements issued by the
insurer. Some contracts do not have a spread at all, which will
usually be guaranteed in the contract terms.

As with any annuity, index annuities are subject to a 10

percent penalty by the IRS for any premature withdrawal of
earnings made by an annuitant under the age of 59½. Also,
excessive withdrawals made before the index annuity
matures will sometimes incur penalties imposed by the
annuity company.

Most insurers, though, will allow a certain amount to be

withdrawn every year without penalty. Some even allow free
withdrawals for qualifying events such as a nursing home
emergency.

With the surge in popularity of index annuities, more

insurance companies have designed programs with wide-rang-
ing options. As a result, picking and choosing the right index
annuity can sometimes be a difficult decision.

To help you sort through the confusion surrounding index

and variable annuities, the next two pages provide a checklist
to help assist when selecting the annuity that is right for you.
Chapter 7 Annuities and GICs 175

Strong Ratings
What kind of assurances and guarantees does the company
make? Ensure that it will be around when you need it most.
Look for insurance company ratings of “A” (excellent) or better.

Spreads or Fees vs. Caps

A spread is a fee that is subtracted from an index return after
applying the participation rate. It is usually declared and guar-
anteed for a period of one year or more. A cap, on the other
hand, is a limit put on an index return after applying the par-
ticipation rate. It is also usually set and guaranteed for a period
of one year or more.

Participation Rates
Higher participation rates are usually better. However, higher
spreads or lower caps can reduce the benefits of a higher par-
ticipation rate. Make sure you read the fine print.

Surrender Period
Index annuities typically have longer maturities than other
annuities. Make sure that the surrender period lasts no longer
than 10 to 12 years. Shorter surrender periods are available.

Free Withdrawals
Most companies offer withdrawal of 10 percent of your origi-
nal annuity’s value every year, free of penalty. However, you
should look for a company that offers a 10 percent withdrawal
on the accumulated value, not the invested amount.

Nursing Home Waivers

Some index annuities allow you to pull out additional money,
penalty free, if you are confined to a hospital or nursing home.
The usual standard is 90 days of confinement to qualify for the
176 The Disciplined Investor

free withdrawal. If you do not own long-term care protection,

this could be an important factor.

Death Benefits
Some contracts provide instant liquidity should the annuity
owner or annuitant die before the contract has matured. Make
sure your contract provides either the accumulated value (pre-
ferred value) or the surrender value, and that the contract does
not need to continue to the completion of the annuity term in
order to withdraw your entire lump sum value.

Indexing Period
Does your annuity track index changes annually on a monthly
average basis or on a point-to-point basis?

Annuitization Options
What options does the index annuity provide for withdrawing
money? Make sure you have good options to choose from,
including the option not to annuitize in order to access your
money when the term is complete. Annuitization is often not
recommended.

High-powered though they may seem, certain variable and

index annuities should not be mistaken for the only necessary
answer to your portfolio needs. They are merely general ways
to help reduce risk. In no way should they be considered any-
thing more than small parts of a Disciplined Investor’s portfolio.

Since this chapter (and the chapter that precedes it) merely
outlines a supplemental investment strategy, you may find a
great deal more advice to help round things out in Chapter 9.
Chapter 7 Annuities and GICs 177

Now that you have been exposed to several underlying

methods of achieving a disciplined investment portfolio, it is
prudent to study how to go about the act of investing.

There are many levels of action that you can take. From
the intrepid investor who feels no need to seek outside advice
to the casual investor who would rather have a financial advi-
sor or certified financial planner handle his or her portfolio,
there is something out there for everyone. Thanks to this
Internet-powered world of communication that we now live
in, there are plenty of options at hand to help you to discover
how to invest. Regardless of what your situation is, the next
two chapters aim to help you find your niche.
 Chapter 8

Tools of the Trade

How about the do-it-yourself investor inside all of us? Perhaps

you cannot imagine finding anyone more capable of handling
your money than you are. Maybe you are a retiree with more
extra time on your hands than you would care to think about.
Or, it could be that you do not feel that financial advisors are
trustworthy enough to manage your portfolio.

If your feelings are similar to any of these descriptions, take

heart in the fact that there is a whole host of consumer-driven
toolsets available to the hands-on user such as yourself.
Whether you prefer to get your information in the more tradi-
tional vein (via periodicals, magazines, or books) or focus on
the cutting edge of market technology (user-friendly websites,
self-directed trading firms, and up-to-the-second news and
trend updates), there is something out there for you.

In this chapter, you will be provided with a semi-compre-

hensive guide to navigating the treacherous and sometimes
costly waters of investment-oriented tools on the market.

The key to finding success in personal investing is to

employ a well-balanced attack. With so many options, aids,

179
180 The Disciplined Investor

and sources of information to choose from, this is no simple

task. The prospect of absorbing the many ins-and-outs of the
investment industry on a daily basis can be an incredibly over-
whelming undertaking.

Because of this, it is easy to get sucked into a narrow-

minded approach to personal investing. Make no mistake: if
your goal is to see higher, steadier, and quicker returns on your
money, you will need to get your information from the widest
array of sources possible.

The marketplace has a tremendous number of investment

strategy tools available. Some are worth your time and some
are not. Fortunately, there are many that are high quality,
which will make your task of well-informed investing much
simpler. The goal is to separate the good from the bad. In this
chapter, you will find that it has been done for you. The list
below sums up six different categories of personal investment
tools that will be discussed:

The Six Essential Tools for The Disciplined Investor:

• “Easy” Stock-Selection Programs
• Online and Print News Forums
• Online Personal Finance Services
• Web- and Desktop-Based Informational Tools
• Self-Directed Brokerage Firms
• Money-Management Software

“Easy” Stock-Selection Programs

The word “easy” in this subject header is in quotations for a
good reason. Stock-selection tools and red-green, buy-sell
engines that you may have seen on TV are usually not as easy
to use as the advertisements would lead you to believe. These
Chapter 8 Tools of the Trade 181

are sometimes referred to as “black box” systems, as their inner

workings are usually a mystery.

Some of these tools may be moderately effective guides for

when to buy and sell, though they are less effective at explaining
how to buy and sell. This is an important distinction to make
because, as has been stressed again and again, action without rea-
son very rarely leads to a healthy return on an investment.

It is possible that these programs may work for some

investors. There are a great many success stories that come with
the territory, but there are also many horror stories that suggest
a level of difficulty and frustration that is less than appealing
to most users. Nothing is easy in investing. Thinking otherwise
can be more damaging than you realize.

The other point to remember about “black box” programs

is that there are often substantial risks involved with putting all
your stock (no pun intended) in a supposedly standalone prod-
uct. If it were really so easy that anyone could do it, everyone
would be doing it.

These tools may be perfectly acceptable if you plan to use

them to enhance a few of the more traditional trading and
investment disciplines. Their ease-of-use claims however,
should rarely be taken at face value. Remember, if it seems too
good to be true, it probably is.

The final downfall of these programs comes with the fee

structure. While they may carry an attractive up-front price tag,
in the long run they almost always wind up costing the end-
user a great deal more than they bargained for. With all the
paper-trading training, highly recommended seminars, for-fee
182 The Disciplined Investor

stock-tips, and other add-ons peddled by these programs, by

day’s end you will be amazed at just how much money you
have spent on making “easy” money.

Online and Print News Forums

If you are a self-directed investor in search of a supposedly
unbiased news source for market trends, stock tips, and penny-
edition advisory strategies, you probably know that there is
certainly no shortage of material available both online and in
print. The trouble with so much quantity, however, is that it so
often dilutes quality. It is like trying to take a sip of water from
an open fire hydrant.

The most important thing to consider when sizing up the

many sources for investment-related news is where the infor-
mation is coming from.

For instance, while it is crucial to read some kind of

morning-edition newspaper—they provide an excellent foun-
dation for the knowledgeable investor—some small-market
papers may not be the most appropriate sources for financial
news. It’s not that they attempt to mislead their readers. In
some cases it may be that they do not employ a large enough
staff to offer the variety of opinions that it takes to provide a
comprehensive look at the markets.

If you are the kind of investor who fears turning over your
money to the control of a financial advisor, you have something
to consider. If you have been basing your buy-and-sell decisions
on the advice from your local paper’s business section, realize
you may have been putting your trust in only one person’s
opinion. The second issue that should be considered is the
potential biases that the source in question may carry.
Chapter 8 Tools of the Trade 183

If you are a dedicated reader of any of the money-related

magazines, then you must pass everything you read through an
“advertising filter.” In other words, ask yourself how much of
the content of each story is dedicated to lauding the same
companies that advertise within the periodical. How many of
their “Top Lists,” such as the ones for stocks or mutual funds,
include at least one or two of their most prominent advertising
clients? Remember, magazines have to make money too, and
there is a lot of money to be made in selling ad space.

None of this is intended to scare you away from online and

print news in general. If you want to find success as a self-
driven investor, you absolutely must dedicate a sensible
portion of your time to learning all you can about the market
and its trends. Find a thorough and reliable source for daily
news and read it each morning; spend some time on the week-
end catching up on the trends highlighted in a reliable
periodical or magazine. Later in this chapter, you will find top
picks for the most unbiased sources of market news.

Online Personal Finance Services

There are many online services out there—supposedly com-
prehensive websites that supply all the materials needed to
make well-informed investment decisions—but only a select
few stack up to The Disciplined Investor’s standards.

There are many sites to help research and track stocks and
bonds, manage personal savings, plan for retirement, balance
the checkbook, and boost a waning credit score, all in one
place. Does that seem too good to be true? Surprisingly, you
can find all of these services and more on a few key websites as
long as you are willing to spend a good portion of your day in
front of the computer. For many, these tools are more than
184 The Disciplined Investor

enough to provide a solid foundation for managing their own

portfolio.

There are a few items to examine about an online personal

finance service before taking the time to set up a user account.
The first thing you should do is explore the website’s interface
and features. While there are several qualified services out
there, some of them are a bit more user-friendly and sensibly
designed than others. There is really nothing more annoying
and (sometimes) time-consuming than having to struggle
through the confusing navigation of a poorly designed website.
It would really be a shame to get in on an investment a
moment too late just because you could not gain access to the
information you needed quickly enough.

The second thing you should consider is how much each

service costs. While the majority of these providers boast free
access to their all-encompassing online software, not many of
them follow through on that claim. More often than not, you
will find yourself signing up for a rather bareboned product
and then regularly subjected to up-selling strategies. If an
online personal finance provider advertises a tiered service
structure, avoid it at all costs.

Lastly, you must consider how and where the service

provider in question gets its information. Typically, it will be
allied with one of the more prominent news sources available,
but how does it go about gathering information and how quick
is it to update it? If you have all the tools to make your invest-
ment decisions but have outdated information on which to
base those decisions, what good are the tools in the first place?
Chapter 8 Tools of the Trade 185

It should also be noted here that when the term “outdated

information” is mentioned these days, it refers to any data that
is more than 10 seconds old.

Fortunately there are at least a few qualified online per-

sonal finance services floating around in the ocean known as
the web. Later in the chapter you will find a list of those that
provide excellent services to Disciplined Investors.

Web- and Desktop-Based Informational Tools

Which of these do you need? How much is too much? What
is it all about, anyway?

The answer to the last question is simple: apart from those

offered within the online personal finance services discussed
above, it is plainly about the many standalone market and
investment-related tools available to the savvy investor.

There are services that provide up-to-date charts on mar-

ket trends and tendencies. There are always-on tools to track
your favorite stocks without even opening your web browser.
There are programs that alert you when, for example, your
stocks are approaching their sell stops or 52-week highs. If you
are looking for no-hassle, easily accessible information, there is
certainly no shortage of sources on which to report.

How much is too much? There is a happy medium, to be

certain. While it is important to maintain exactly the kind of
information you need, it is also important to avoid bogging
yourself down with informational-tool overload. Many of the
stats, charts, and graphs are little more than bells and whistles
anyway. Again, with all of the options available, an important
factor to consider is the cost of each service in question.
186 The Disciplined Investor

Which tools do you need? If your goal is to light up your

computer’s desktop like a Christmas tree, then go ahead and
Google the phrase, “investment tools” and start downloading.
If, on the other hand, you are looking for value-added tools to
assist in the implementation of your investment strategy, then
there are only a few that you should consider.

Self-Directed Brokerage Firms

Like all of the toolsets listed above, there are many qualified
providers within this arena listed at the end of this chapter.
The truly interesting thing about these companies is that
their concept, in itself, is a bit of a paradox. As an online
investment firm, it is difficult to advertise that your cus-
tomers are truly self-directed while still touting (and charging
for) advisory services.

In addition, firms that fall under this category often tend

to quote low per-trade fees. The trouble with this concept is
that the trading fees are often just the tip of the iceberg. Even
so, at their core is something quite valuable, even for the most
independent-minded investor.

As online money-management tools, they function much

like Internet bank accounts. In other words, they facilitate
comprehensive access to all of your funds and assets, which, at
the very least, should make your life that much easier. Also, it
should be noted that if something were to happen to you,
gathering and managing your portfolio on the part of your
trust manager, attorney, or heirs would be greatly simplified.

As with most products and services, not all self-directed

brokerage firms are created equally. Some may have excellent
customer service but poor presentation and clunky navigation.
Chapter 8 Tools of the Trade 187

Others may boast a completely user-friendly interface while

silently providing completely inaccurate information. Still oth-
ers may ignore the self-directed aspect of the company mission
and try to up-sell you at every turn.

While all of these scenarios can occur, there are still many
benefits to adding a firm from this category to your balanced
investment approach. There is no service on the Internet
better equipped to help you manage and track the brokerage
aspect of your portfolio than an online brokerage firm. For a
variety of reasons, however, some of these companies are better
than others. Actors like Sam Waterston may be charismatic,
but not everything he says on TV should be taken as pure
gospel. In response, several of the biggest companies are
reviewed toward the end of this chapter and the pros and cons
of each are summarized.

Money-Management Software
There was a time, not too long ago, when you could find soft-
ware for just about anything. These days, though, the software
section in the nearest electronics store seems to shrink by a
shelf or two every month.

There are a few reasons for this. First, it’s a lot more cost-
effective for a software company to provide their product
online, rather than “out of the box.” Second, more and more
people are turning to the web to meet their everyday service
needs. And, finally, the Internet is simply a much safer place in
which to do business than it was 10 years ago.

Once upon a time, desktop-based software was more attrac-

tive to the discerning user because of fears over Internet
security. It simply was not safe to keep or transmit your
188 The Disciplined Investor

personal information on a network. Things are changing quickly,

however. Gone are the days when the Internet was little more
than a thief-laden jungle where no transaction was truly secure.

In short, traditional software platforms are becoming obso-

lete. Why put Quicken on your desktop and spend the time to
sync it to your online account when you can just access every-
thing at the Quicken website anyway?

While the future of the industry may see these platforms

headed out the door, since they are still available today they are
worth mentioning. The fact is that they will continue to form
an integral part of the balanced investment attack. There are
few things easier than graphing your profits and losses or bal-
ancing your checkbook on the computer anyway.

The Balanced Plan

Before outlining the basic tenets of the recommended tools for
supplementing your investment strategies, it might be benefi-
cial to provide a cautionary tale of computer-based investing
failure—a kind of “what not to do” for the self-driven investor.

Take as an example a fine fellow named Steve. To begin

with, Steve’s first mistake was taking an all-too-narrow
approach to his stock trading.

Steve, like so many self-driven investors, was drawn in by the

allure of an easy-to-use, get-rich-quick kind of system. He was
sold on the red and green flashing lights of what will be called the
StockLights.com program (a fictitious company/system). This
software vendor suggests that all one needs to do in order to beat
the markets is have a visual aid that indicates buying and selling
points. It comes with a sorely lacking and probably overly biased
Chapter 8 Tools of the Trade 189

support structure consisting of user groups and so-called experts.

Many of these systems have only a rudimentary understanding of
the many facets of the stock trading process.

What’s more, StockLights.com boasted that it was so con-

fident in its program it was even willing to offer Steve (like all
unsuspecting customers) the opportunity to try it out before
he committed to paying for it.

So, in the beginning, Steve decided to play it safe. He

researched the software, kicked its tires a little, and signed up
for the trial program. He plugged in a few of his favorite stocks
and watched as the red, green, and yellow signals dictated his
would-be actions. StockLights.com provided him with message
boards, stock “calls,” and tips of the day, and he felt confident
that it equipped him with an insider’s knowledge of how to buy
and sell his way into riches. The program seemed to be work-
ing—and working well.

What little doubt Steve had was quickly melted away when
he made thousands of pretend dollars per month in paper
trading. He paid to learn how to use the so-called brilliant soft-
ware to manipulate the markets to his advantage and literally
rake in the money along the way.

The only trouble is that trading with Monopoly money is

very different than trading with real money. When faced with
the prospect of losing something substantial, and when gam-
bling on real companies that make rather less-predictable
moves, people tend to behave quite differently than when trad-
ing in a consequence-free bubble. They sell too early. They buy
too big. They just do not carry the kind of patience and lim-
ited emotion it takes to play the markets on carefully
calculated information rather than gut feelings.
190 The Disciplined Investor

When Steve made the move from paper trading to real-

world, live trading, he lost his shirt. He went from making
$30,000 pretend dollars per month to losing close to $60,000
almost immediately. To add insult, he had not only wasted all
that money buying the program, but there were also the fees
associated with all of the add-ons and considerable hidden
costs that came along with the service.

What Steve failed to realize was that when approaching

investing on one’s own, the best plan of attack is a versatile
one. In this case, the StockLights.com “package” was simply
too narrow. While the essential elements of a successful plan
may have been there—the program offered a low-cost track-
ing tool, charting services, and supposedly unbiased
information to supplement a user’s market knowledge—in the
end Steve’s approach was just too shallow and one-dimen-
sional. All of his information and support came from a single
source that, as it turned out, was not the most reliable one
available to him.

A better strategy for Steve would have been threefold. First,

he should have more appropriately assessed his comfort level in
taking on the responsibility of managing his own investing.
Steve, being the kind of person who would rather buy into a
program that offered an easy way to make money than put in
the time and effort it would take to truly invest in the markets
well, probably would have been better served to seek the advice
of an advisor in the first place.

Second, he should have done his homework—in other

words, sought alternative sources from which to gather infor-
mation. Considering the fact that he had no idea just where
the StockLights.com tips were coming from, there was no way
Chapter 8 Tools of the Trade 191

for him to tell the difference between sound advice and that
designed to benefit the interests of the tipsters themselves.

Third, Steve should have worked to build a balanced plan

that did not rely so heavily on one specific investing tool. He
dropped everything into StockLights.com and in the end, he
was sunk.

Among the many flaws in Steve’s approach was that he

allowed himself to get too comfortable with his prospective
investing tool. The best thing that he could have done would
have been to first assess his comfort level and then evaluate the
logistics of the situation that he allowed himself to fall into.

Assessing comfort level is fairly easy. The first step is to

determine how many hours of free time you have in a given
week. Next, figure out what percentage of those hours you can
reasonably spend on managing your portfolio—without detri-
ment to your family or work-life, of course.

Finally, determine your tolerance for loss. Every investor, no

matter how well informed, sees a lag in the performance of his
or her portfolio once in a while. If you hope to navigate the pas-
sage of self-driven investing, you must first reconcile yourself to
the fact that you are going to see some setbacks and that in the
end, you will have only yourself to blame.

Seeking out reliable sources of information seems like such

an elementary concept when it comes to thinking about your
investment strategy. It is amazing to see how little research peo-
ple do for the moves they intend to make. There is no shortage
of self-proclaimed experts willing to pontificate on their tips
and tricks via the Internet, print media, radio, and television
192 The Disciplined Investor

(at all hours of the day and night, no less). Just because they
speak loudly or can turn a clever phrase does not mean that
they have any idea what they are talking about.

Remember, if somebody is willing to offer an “insider’s

tip,” your first question should be: “Where does his or her
motivation come from?” If the many thousands of people read-
ing the column or tuning into the program each day are
receiving the same sure-fire tip, at what point does it water
down the strategy so much that it becomes useless anyway?

The final note on the subject has already been made. You
cannot expect to win for the long-term in the markets without
a carefully calculated, well-balanced plan of action. You should
not put too much stock in one charting program, just as you
should not put too much emphasis in a single news source.

The market and the philosophies that come with it are so

incredibly vast that it seems fairly ridiculous to suggest that
anyone could find a specific path to its understanding or mas-
tery. Without information drawn from multiple reliable
sources and in multiple forms, it is almost impossible to get a
clear enough picture of the whole to make sound decisions.

For sure, not every investor is the same. Indeed there are
people who have used systems similar to the StockLights.com
program to reach some measure of success. It does, in fact,
have the potential to be a valuable supplement to a sound
investment plan. It is just hard to believe in an effective long-
term tool that insists that you put all of your eggs in one
basket. Instead, you should peruse the many tools that have
been listed in this chapter, pick one of each set, and adjust
their ranges of information and services to best suit your needs.
Chapter 8 Tools of the Trade 193

The Disciplined Investor’s Toolbox

Online and Print News

With the benefits and drawbacks of some of the “easy” stock
selection programs, we can dive into the true foundation of the
balanced plan. Information is simply key in the quest for knowl-
edge. In order to keep you well informed, the most important
task is choosing reliable and trustworthy news sources.

The Daily Read: Investor’s Business Daily

Why it is necessary: If you hope to be a well-informed and
therefore successful investor, you absolutely need to stay up to
date with market news. Investor’s Business Daily focuses entirely
on this topic. It also has an excellent online version packed
with many value-added services. The bottom line…it is an
essential read.

What it offers: Investment tips, stock lists, daily analysis,

newsletters, economics, webcasts, a host of valuable investing
tools, a learning center, and the best, most unflinchingly hon-
est market news anywhere. All of these are in the pages of the
www.investors.com website as well as the print edition of IBD.

Profile of a typical user: IBD is a daily paper offering an

excellent source of market news for the investor. It is probably
more appropriate for the longer-term investor rather than
someone who is actively trading. IBD is most appropriately
suited for those who want to understand the markets, and why
and how they are moving. The daily stock ratings and rankings
are also very highly regarded.

Options: The basic sections of the IBD website offer a great

deal of information absolutely free. If you are looking to save
194 The Disciplined Investor

money, you may be able to receive the majority of the informa-

tion you need online, rather than from the print edition. You
can also access the entire version of IBD online if you purchase
an e-subscription.

If you want your news in full and do not want to wait until
the next business day (if your IBD info would best serve you
before the markets open or close), you should consider signing
up for the e-package. If you are more of a traditionalist, daily
print versions can be delivered directly to your door early each
business day. If you would prefer to research and read only one
day a week, IBD also offers a “Monday special” package
wherein you receive only one paper per week.

Weekend Reading: Barron’s

Why it is necessary: If you are an avid trader or a self-driven
investor, you already know that just because it is the weekend,
your job is not over. If a daily news source is important to keep
you up to date on market movement, a good weekend read is
essential to keep you in the know when it comes to market trends
and the bigger picture. There is no better way to get a sense of
where the markets are going than by reading a kind of week- or
month-in-review piece like those that are offered in Barron’s.

What it offers: In-depth articles, featured business and

investor profiles, interviews, opinion pieces, commentary, and
specific market-related themes can be found in the pages of
Barron’s magazine. Its analysis of the market’s impact on daily
life and future trends is second to none. Catering to the finan-
cial advisor, businessperson, self-driven investor, and casual
consumer alike, its articles comprehensively cover the market’s
influence on key topics of the week such as corporate shifts,
political influences, and investment strategies. As an added
Chapter 8 Tools of the Trade 195

bonus, it also offers a incredibly extensive listing of economic

indicators and weekly stock results.

Profile of a typical reader: Anyone interested in the markets

and their movement can find something valuable to read about
within Barron’s pages. However, it qualifies as an essential read
only for the passionate investor. Some of the topics are
advanced and may be beyond the needs of the novice investor.

Options: The print version of the magazine can be pur-

chased with an annual, quarterly, or even monthly subscription.
Subscribers can also get the e-version for a nominal additional
fee. Both versions are quite good and well worth the price.

Final Word on Barron’s: The greatest thing about this mag-

azine is that it seems to be completely unbiased. As mentioned,
some publications of this type provide good information;
Barron’s is fresh and original. Often this periodical will be the
first to break a story and is usually right on the mark. If you
are looking for weekend news and advice without an agenda,
look no further than Barron’s.

Sunday reading: The Wall Street Journal is considered the

veritable bible of money management matters. The problem is
that it has so much in-depth information that it may be diffi-
cult to filter out only the information you need. This might
seem like a travesty to some of the more traditional thinkers in
the crowd. It is not that the WSJ is a bad paper; the truth is it
is excellent. One problem with it, though, is that it has three
parts, only one of which is specifically dedicated to the markets.
While all of the material is superb, some may not be considered
required reading. This should be considered a catch-up to be
savored on weekends. It will help to fill in, and compliment
many of the areas that are not covered in either IBD or Barron’s.
196 The Disciplined Investor

Top Read: How to Make Money in Stocks: A Winning System

in Good Times or Bad by William O’Neil.

Why it is necessary: For the sake of clarity and thorough-

ness, sitting down with a good book before beginning to craft
an approach to investing should be considered a priority.
While magazines and (sometimes) newspapers rarely have
shortages of advice about how to invest, their opinions cannot
touch the wisdom contained within a good book on the sub-
ject. Of course, the word “good” is the operative word here.

In short, this particular book is a good one. First of all, it is

a wonderfully easy read that provides a basic look at investment
strategies and time-tested market indicators. It also represents a
no-emotion, no-nonsense, level-headed approach to investing.
If a primer is what you need before beginning to invest, then
look no further than this classic by William O’Neil.

What it offers: The strategy that this book offers is one of

sensibility. As a Disciplined Investor, the terms “market capital-
ization,” “daily indexes,” and “quarterly earnings” are
hopefully not new to you. That is precisely the beauty of this
book. It does not try to sell you on gimmicks, it simply pro-
vides a proven strategy that employs the use of many of the
most common market tools available to an investor.

O’Neil lays out his strategies through extensive examples.

Individual stock studies for which some of the data employed
stretch back for several decades and appear throughout his
chapters. The author uses these studies to shed light on mat-
ters such as how to identify a healthy stock, when to cut and
run, and how to get out before your investment starts to
decline.
Chapter 8 Tools of the Trade 197

Profile of a typical reader: This book would best serve those

investors who are just beginning to take their investment mat-
ters into their own hands. While people who have been
investing for a long time may find the material a little basic,
simplicity, rather than hyped-up, flashy strategies, is exactly
what The Disciplined Investor should be looking for.

Final Word on How to Make Money In Stocks: For one, this

book was written by the man who went on to create
Investor’s Business Daily. Also, it is a relatively quick read.
Most readers will not have any trouble getting through it in
a day or two. If limiting losses is one of your goals, you
would do well to add this book to your library and its strate-
gies to your financial approach.

Online Personal Finance Services

If you are looking for one-stop shopping for all your personal
finance needs, it would be wise to sign up for an online per-
sonal finance service (OPFS). While there are many of these
services available, only a few of them meet the standards of The
Disciplined Investor. The following providers are presented in
the order of preference.

MSN Money
Why it is necessary: As mentioned, every good investment strat-
egy must be balanced. With that in mind, it is unmistakably
apparent that this service is the essential foundation to that bal-
anced strategy. Reliable news? Check. Professional-grade
tracking tools? Check. Sensible layout? Check. Seamless integra-
tion with other applications? Check. Valuable vendor alliances?
Check. Security? Check. If you hope to gain an advantage in the
markets as well as manage your money effectively, this should be
the website in which you spend the majority of your time. MSN
Money is the definition of a comprehensive online tool.
198 The Disciplined Investor

What it offers: It offers unbelievably sophisticated banking

and investing services, and easy-to-use money tracking tools.
There are also earnings calculators, planning strategies, and
worksheets for retirement. It has a wide range of tools for sav-
ings and family, insurance management, estate planning, and
tax preparation. In addition, you will find comprehensive
research on stocks and funds that includes ratings, charts, and
screening systems. It really is a remarkable website. It can be
said that not all of these services are “industry best” in their
respective categories. Even so you really cannot beat the con-
venience on the whole.

Profile of a typical user: This is for smart, savvy investors

who want to take greater control of their own money but do
not want to spend a lot time surfing the Internet. People who
enjoy this service tend to point to its user-friendly, cost-effec-
tive, and all-encompassing approach to money management.

Options: In researching this book, online and print media

were scoured in search of the best value. Without question, this
is it. Nothing on the Internet or in print offers so much for so
little. Generally there is no cost for this beyond the requirement
of providing your email and personal information to Microsoft.

Final Word on MSN Money: Fortunately for the invest-now-

and-ask-questions-later kind of consumer, MSN Money has gone
and gathered all of the essential tools in one place. This is a way
to get your news, chart your earnings, track your stocks, plan
your retirement, manage your personal bank and credit accounts,
and even file your taxes, all on one site. What is more, you can
do all of this without being subjected to up-selling or overly
obtrusive advertising. It all seems too good to be true, yet it is not.
If there were the option of only choosing one of the recom-
mended tools listed, it would have to be this one.
Chapter 8 Tools of the Trade 199

Briefing.com
What it offers: This truly objective resource represents an
exceptionally wide range of products and services. Among
them are instant market alerts, briefings (hence the name),
updates, advice, analysis, and tips.

Where it falls short: For one thing, it carries three distinc-

tive levels of service, all of which carry their own separate fees.
You must be wary of this whenever you search for a provider
of any kind. For example, Briefing.com’s lowest service pack
only offers market updates every half hour. To get live, to-the-
second stock information, you have to pay for the third tier
(the priciest package).

Profile of a typical user: The experienced investor would be

more apt to use this site. With the highest service pack, it is
easy for the minute-to-minute trader to track and manage an
average portfolio.

Options: With the basic subscription, you get a stripped-

down version of market analysis, calendars, stock analysis,
perspectives, tools, and email services and you pay nothing.

For the Platinum Pack—the mid-range solution, you

receive live trading reports, live headlines, daily trading ideas,
watch list and page alert emails, live coverage of bond markets,
and in-depth Federal Reserve and economic analysis. This is
available for a monthly fee.

For the Trader Pack—the highest level, you get every-

thing included in the Platinum Pack plus technical trading
recommendations with entry/exit points, breakout alerts,
live information from trading desks, and candid opinions on
200 The Disciplined Investor

intra-day events that combine trading instincts with funda-

mental and technical analysis. Additionally, you have access
to “under the radar” investment trading ideas. This is a more
expensive option and is more appropriate for the profes-
sional trader.

Final Word on Briefing.com: The services offered by this

company certainly do represent a great bang for the buck for
news, in-depth strategies, and alerts. You get what you pay for
on Briefing.com, and what you pay for is exceptional quality.
The trouble is that there is a cost and the top package is cer-
tainly not cheap. Almost everything offered through this site is
available for free on the MSN Money site. In fact, some of the
news on MSN Money is provided by Briefing.com.

Dismal.com
What it offers: High quality and a wide range of market cover-
age. This tool seems to be aimed at the globally conscious
investor, having segregated the major markets of each conti-
nent. With this service, you will receive many of the same
benefits offered by Briefing.com. It provides a broad, top-down
overview of the world and the pulse of its economy. First and
foremost, this is an economic reporting and commentary site.

Where it falls short: Again, much of the meat of this serv-

ice is found in the paid subscription level. To be sure, there is
a good amount of information to be found on the basic site.
There is a subscription price for what they call “editions”
(corners of the globe covered by their market research). The
editions include Asia/Pacific, Europe, Latin America, the
U.S., and Canada, and each comes with its own separate,
additional fee.
Chapter 8 Tools of the Trade 201

Profile of a typical user: This service is best employed by an

investor who utilizes a top-down approach to investment
research and strategy. Typically, this person is looking for a
(relatively) inexpensive method of researching the global mar-
kets. Do not, however, confuse inexpensive with a lack of
quality. This site offers a tremendous amount of idea-generat-
ing tools and commentary.

Options: Some of the site is free. Otherwise the cost

depends on the number of editions you want. Each has its own
fee and is available on a monthly or annual basis.

Final Word on Dismal.com: If you are a global thinker, you

really cannot beat Dismal.com. It is highly recommended by
both Forbes and Barron’s, so you know you are getting quality
when you sign up for this service. In addition, it is an adjunct site
to Economy.com, one of the best of breed for economic research.

Web- and Desktop-Based Informational Tools

It has been shown that thorough research is at the core of any
well-designed investment plan. Yet who says it has to be time-
consuming and mentally draining? Rather than spending half
of your day searching for statistics and trends, why not simply
download them or sign up for a piece of software that does all
the searching and compiling for you?

StockCharts.com
What it offers: This is essentially an online tool for creating and
researching charts. The service is quite valuable and will help pro-
vide you with an array of technical analysis tools. In fact, some of
the companies and sites listed previously utilize charts created by
StockCharts.com for their sites. This company offers everything
202 The Disciplined Investor

from chart tracking and creation tools to educational materials

that include anything you could ever want to know about read-
ing or building an effective chart. They also employ an impressive
and reliable support structure headed by the company’s guru,
John Murphy. They even offer an informative newsletter.

Profile of a typical user: Anyone who feels that an accurate

chart may help him or her visualize the most appropriate
strategies for investing.

Options: This tool is also divided into various subscription

levels. There is a pretty good cross-section of charts and charting
services available for free, but a user who wants all the bells and
whistles will have to pay a modest subscription fee. There are also
advanced packages that include additional charting and analysis.

Final Word on StockCharts.com: Much of the site is free. If

you choose to subscribe, you will notice that for what you pay,
you really get a lot. This product is probably best suited for
those who wish to gain an advantage from having a sophisti-
cated charting tool. For the most part, the charts and the
technical analysis features are the best out there. Even so, with
all of the online materials that are offered free, this may repre-
sent an avoidable expense.

MarketBrowser.com
What it offers: This is an exceptionally flashy and user-friendly
tool that allows you to track investments at a glance via a
whole range of simultaneously running charts and graphs. It
provides one-click access to more detailed information on a
stock. In its most expanded view, this product reveals a range
of colorful charts that are dynamically updated and fill your
entire computer screen. Other views provide a less-intrusive
Chapter 8 Tools of the Trade 203

look and take up less desktop real estate. Using this as a hub to
organize your investments will prove beneficial. The program
has an unbelievable depth of options built right in.

Profile of a typical user: Anyone who is looking for a good

charting and quoting service for a low cost.

Cost: Free.

Final Word on MarketBrowser: This is an excellent point-

and-click service that could well serve as the hub to track your
investment plan. It is most beneficial for those who are visually
inclined, however, as its overall look and feel can be a bit
intense and chart-heavy. Be aware that there is no cost for this
service, and as such the quotes are delayed 20 minutes.

Self-Directed Brokerage Firms

The following companies offer many essential services for the

true do-it-yourselfer. Each has its own benefits and drawbacks,
though, so it is important to read as much as you can on the
backgrounds of each company before you take the plunge and
use them to invest.

When researching an online brokerage firm, be sure to

read between the lines about their products, services and gen-
eral account terms. Remember, what you see is not always
what you get.

Charles Schwab
What it offers: In addition to the obvious “for-fee” trading serv-
ices and passive financial advice that you might find at any of
these self-directed brokerage firms, Schwab offers a specialized
204 The Disciplined Investor

trading platform—CyberTrader. This software program is one

of the best available for the day trader. This incredibly
advanced platform presents a substantial amount of informa-
tion and is a powerhouse for serious day traders.

Profile of a typical user: A serious trader, a day trader, or any-

one who wants to have a deeper sense of control over his or her
own investing. It is a good idea to have an advanced understand-
ing of trading and the Level II markets. It is also a prerequisite
to understand advanced charting and the order entry process.

Options: Trading will have costs associated with each trans-

action depending on the amount of activity and the size of the
trade. The CyberTrader software may also have fees depending
on your personal trading profile.

Of course, there may be other fees associated with getting

advice, trading, asset custody, and so on. Frankly there are too
many to list here, though they are all sensible and fully dis-
closed. To view a comprehensive list of fees, visit
www.schwab.com and navigate to the commissions and fees
area.

Final Word on Schwab: In addition to its excellent trading

software and reputation for superior customer service,
Schwab offers a huge inventory of mutual funds. Some may
have transaction fees and some may not. The company also
has more service centers around the country than any of the
other firms that fall under this category. For most individu-
als looking to have a healthy blend of service with a
reasonable fee structure, this company probably warrants the
most consideration.
Chapter 8 Tools of the Trade 205

Other Firms (Fidelity, E*TRADE, TD Ameritrade, etc.)

What they offer: There are, of course, subtle nuances to each of
these companies, but all offer generally similar services. They
also offer up-to-date information pertaining to your brokerage
account, are very secure, and provide ample research on stocks
and mutual fund investments along with trading and money
management advice.

Where they fall short: For the most part, the charting serv-
ices, research, and news provided by these companies is average
at best. Also, their banking services could use a little work. In
some cases, the customer service leaves a lot to be desired.
Most of the differences lie in the fact that each of us has our
own unique wants and needs. Some like chocolate, some
vanilla. That does not mean that one is necessarily better than
the other.

Profile of a typical user: This person is interested in tools

that provide accurate account information but less interested
in the research. These are all suitable companies for most
investors and as noted, it really comes down to a matter of
personal preference.

Options: The fee structure, in almost all cases, is very sim-

ilar to that of Schwab. Each company will have an area of
specialty that will put it ahead of the other for that service.
Overall, there is not much criticism that can be directed
toward any of these fine firms.

Final Word on the others: Even if you put the “independent”

in “independent investor,” it is important to consider employ-
ing a company such as one of those listed in this section to help
206 The Disciplined Investor

centrally manage your portfolio. However, tools and services

provided by all of these companies are by no means considered
replacements for the ones provided by companies such as
StockCharts. Even so, they are all excellent additions for most
investors.

Money-Management Software
While this portion of the balanced plan may be on its way out
(at least in the out-of-the-box sense of the word), a few money-
management tools should be considered. They may not
provide the best advice to help you plan your investment
approach, but they are certainly effective when it comes to
organizing your holdings.

There are only two such software programs that dominate

the industry, and they are quite similar. A quick discussion of
each will be presented here.

Around 1995, a few companies began to work on the idea

of creating account aggregation software that would help to
consolidate a person’s financial accounts. Two companies,
Quicken and Microsoft, believed this kind of software would
promote changes as dramatic as the day man put down his
slide-rule and picked up a calculator. Today, both companies
have programs and sites that are excellent to help consolidate
your finances. They are completely configurable and user-
friendly, and are quite useful when it comes to integrating the
numbers on your computer with the numbers provided by
your bank, credit card company, or brokerage.

Since they are so exceptional for managing a virtual bank

account, it should come as a surprise that they not at that
same level when used for investment accounts. They have the
Chapter 8 Tools of the Trade 207

capability of syncing with online brokerage firms, but tend to

come up short in the actual delivery. With their lack of real
time function and without accurate charting features, they
both represent a rich set of possibilities that falls rather flat. In
any case, their only real benefit is the enhanced security over
the alternative of having several online accounts with differing
passcodes and usernames. It is important to stress that the
Internet is not the insecure environment that it was only a few
years ago.

Also, anyone who gets nervous about typing his account

information into a website should probably consider the fact
that they quite regularly, willingly, and happily hand their
credit cards over to waiters, hotel clerks, and the like. Who
knows what an unscrupulous person may do with that kind
of opportunity?

Conclusion
As an investor, it is possible to do all the research in the world
and create the most detailed projections imaginable about the
future. You may also be talented at making investment deci-
sions, and may be very successful at sifting through all of the
over-hyped advice available to you. Even so, you may still find
yourself overworked and your portfolio underperforming. It is
The Disciplined Investor who understands the reasons for this
and, as such, takes all the steps necessary to create the most
balanced plan of action possible.

The tools listed herein are designed with the self-driven

investor in mind. The good news is that if you were so
inclined, you could manage your own portfolio for a relatively
low price. Even if you do not own a computer and must start
entirely from scratch, you can still be up and running and
managing your own assets with start-up costs under $1,000.
208 The Disciplined Investor

Although the material presented in this chapter may seem

a bit overwhelming, each of the tools mentioned can help to
enhance and simplify the process of managing a portfolio.
Realize that no matter how efficient you are at it, money man-
agement is still a time-consuming and difficult endeavor.

Remember, finding success on your own may be an

incredibly liberating and fulfilling achievement, but the
central goal to all of this is to make money efficiently and pro-
tect it well.

It is true that making money is the most important thing

when investing, but it is also true that the second most impor-
tant thing is balancing that with an appropriate comfort level.
If it becomes too much to handle, The Disciplined Investor
must be able to identify the need for help and accept advice.
In response to that fact, the next chapter covers everything
from guarding your assets to picking the proper advisor.
 Chapter 9

Implementing the Plan

Now that you are well on your way to understanding how to

best use the tools for choosing an investment, how do you
decide which asset classes will provide the best return with the
least risks? This question needs to be answered on an ongoing
basis. If the task becomes overwhelming you may want to con-
sider hiring a qualified advisor to assist with many of the
important day-to-day decisions. You can hire outside help for
your entire portfolio or simply to get assistance with the
overall asset allocation model.

You need a plan, a roadmap, and directions. Otherwise,

you may find yourself chasing your tail. Here is a common
story that helps to illustrate this key point:

A man from North Dakota was headed to Montana for a

three-week ice-fishing trip. En route, a massive snowstorm
blew in, reducing the drive to a crawling pace. Undeterred, the
man kept on driving since he did not want to miss this great
fishing opportunity.

In time, his perseverance paid off, and he saw a snowplow

churning up ahead. In a few moments, he was behind the

209
210 The Disciplined Investor

plow—and driving on concrete again for the first time in

hours. He was thrilled to be on-track once again.

For the next 20 minutes or so, the man followed the snow-
plow, happy to have finally caught a break in his star-crossed
journey. His happiness was short-lived, however, because after
a few more minutes he watched as the plow operator came to
a stop, cut off his engine, and began slowly trudging his way
back toward him. In a moment, the plow operator was beside
the man’s car, rapping on the glass with his gloved knuckle.

As the window opened, the plow operator began to speak.

“Where you headed, buddy?” he asked.

“Montana,” said the man as he wondered what this was all

about.

“Montana? That’s a long way from here. Especially in this

storm.”

“Yep. Good thing I’ve got you paving the way, huh?”

The plow operator politely smirked and then laughed out

loud. When he finally gained his composure, he began to
speak again. “Well, sir, you’re gonna have a tough time getting
there if you plan to keep following me,” he said.

“Oh yeah? Why’s that?” the man asked with curiosity.

“Look around you, buddy. I’m plowing a parking lot.”

It might seem slightly absurd, but this story is perfect for

highlighting the importance of having an investment plan with
Chapter 9 Implementing the Plan 211

a system of checks and balances to ensure you stay on course.

Even if you have learned everything you will ever need to know
about how to analyze and create a strategy for investing, your
portfolio may still take a dive without proper management.

Fortunately, the industry has created both a term and a

strategy to help the average investor avoid blindly following
plows. It is known as asset allocation.

 ASSET ALLOCATION
The way in which an investment portfolio is divided among
different kinds of assets, such as stocks, bonds, real estate,
or cash equivalents. By investing in different kinds of assets,
an investor can balance growth potential and risk. It is also
a process that provides ongoing rebalancing of portfolio
positions to ensure it remains properly diversified.

The first thing to know when considering the prospect of

asset allocation is that, as do most things related to investing,
it comes in many forms. The simplest concept to grasp is that
in order to avoid incredible downside risk, you have to diver-
sify. As a Disciplined Investor, you cannot put all your eggs in
one basket and expect your portfolio to perform consistently.

To illustrate, here is the simple (and pretty flowery)

metaphor:

Recall that in Chapter 5 it was suggested that a portfolio

should look and act like a flower garden. Comparing your
investments to a flower garden may seem strange, but the idea
is to have a portfolio stand up to the test of time and its chang-
ing seasons. You will want to have the gorgeous colors and you
will also need a good mix of perennials. Your garden (portfolio)
212 The Disciplined Investor

should include varieties (sectors) that need direct sun along with
those that grow better in the shade. For good measure, add some
evergreens (cash equivalents), as they will stay in bloom during
even the harshest months.

You need to strongly consider the climate of where your

garden is growing, similar to the economic climate for your
portfolio. Your portfolio needs to be able to stand up to the
harsh winters seen as the sporadic storms of the economy.

It is possible to go as far as building a portfolio that is

almost completely risk-free, but the tradeoff comes with the
loss of upside potential. Risk-free portfolios are entirely pre-
dictable. They are not going to lose much money, but they are
probably not going to gain much, either. If you want that
upside, you have to be willing to balance it against some meas-
ure of risk.

During the early portion of the last century, Benjamin

Graham suggested that a perfectly diversified portfolio carried
a position in stocks, bonds, cash, and real estate. That seems
clear-cut enough. The statement certainly outlines the basis for
a balanced plan, although that simple definition is not enough
anymore. Markets are more complicated in our ever-expand-
ing and ever-volatile investment environment.

For example, bonds are not what they used to be. What
had been a fairly straightforward topic can now be broken
down into complicated categories that sometimes carry non-
intuitive names. When sizing up a bond, it is important to
know more than if it is simply a municipal, corporate, or
government bond. You have to know what each category means,
too. Furthermore, each of those categories can be segregated into
Chapter 9 Implementing the Plan 213

subcategories such as maturity, rating, pre-refunding, tax qualifi-

cation, and so on.

The modern significance of asset allocation came from the

minds of three academics named Brinson, Hood, and
Beebower (BHB). In the late 1980s, they determined that
somewhere between 90 and 93.6 percent of all portfolio returns
could be explained by the chosen mix of assets. The study was
titled, “Determinants of Portfolio Performance.” Essentially,
this meant that allocation decisions, rather than specific invest-
ment decisions, dictated portfolio performance.

Of course, as with everything in this free-world economy,

there are polar opposite viewpoints to point out. At that time,
economic scholars like Ibbotson and Kaplan essentially backed
the BHB claims. They went on further to say that these stud-
ies demonstrated asset allocation’s responsibility for 100
percent of returns over time, 90 percent of variability of
returns over time, and 40 percent of variability of returns from
investment manager to investment manager.

Of course, it probably did not hurt that Ibbotson’s com-

pany was also marketing a complex and expensive software
package that aided advisors with the application of asset allo-
cation theories based on the BHB study.

Not long after, there was a ground-breaking follow-up study

by William Jahnke which suggested that asset allocation was
only a viable measure of success in the absence of traditional
active trading and security selection. Jahnke believed that strate-
gies like market timing and researched stock selection were just
as important to a portfolio’s performance as allocating assets.
214 The Disciplined Investor

In fact, in the February 1997 edition of the Journal of

Financial Planning, Jahnke wrote a controversial article entitled
“The Asset Allocation Hoax” contradicting the BHB study. He
clearly and rather convincingly wrote that “While most
investors agree that explaining the range of returns over their
investment horizon is more important than explaining the fluc-
tuations of quarterly returns, short-term volatility of returns is
also important. However, the study misrepresents the relative
importance asset allocation policy has on portfolio volatility
when Brinson, Hood and Beebower observe that asset alloca-
tion policy explains 93.6 percent of the variation in quarterly
portfolio returns. They define variation as the variance of quar-
terly returns. In fact, the most appropriate measure is the
standard deviation of quarterly returns, which operates in the
same units of measurement as return. That is why portfolio risk
is reported in terms of standard deviation, not variance.”

He went on further to suggest, “While the BHB study

observes that asset allocation policy explains 93.6 percent of the
variance of quarterly portfolio returns, when using the more
appropriate standard deviation asset allocation policy explains
only 79 percent of the variation of quarterly returns. Though
still a big number, it does not appear to be as conclusive as the
reported 93.6 percent.” That was the final nail in the study’s
coffin.

The excitement around what was thought to be a revolu-

tionary breakthrough was subdued. Regular talk about the
asset allocation process and the more common use of the
mean variance optimization strategy diminished. The timing
was rather coincidental to the huge gains in the market
toward the end of the millennium. During that time, there
was no pressing need for a sophisticated strategy to help
Chapter 9 Implementing the Plan 215

make money beyond throwing a few darts at a newspaper’s

business section.

What remained was the principal that asset allocation of a

portfolio could be quantified using statistics. The fine tech-
nique of employing historical measures together with forward
predictions can help investors mathematically optimize portfo-
lios in order to reduce their risk.

It is a complicated matter, yes, but there are really only

three core terms that you need to know before considering a
strategy based on the complex and more sophisticated asset
allocation process. They are: mean variance optimization,
the efficient frontier and semi-variance.

 MEAN VARIANCE OPTIMIZATION (MVO)

A calculated ratio that measures the amount of risk an
investor is willing to take in comparison to the anticipated
level of return. This methodology takes a look at historical
economic environments and tries to emulate them, project-
ing the expected return into the future.

 THE EFFICIENT FRONTIER (EF)

This term is related to MVO in the sense that it is the ulti-
mate goal of that calculation to find the greatest risk/reward
ratio. The Efficient Frontier refers to the point of a portfolio’s
greatest competence. Once optimized, an investor and an
advisor can sit down and determine which blend of foreign,
domestic, and bond investments is necessary to best emu-
late the Efficient Frontier. If a portfolio passes a certain point
on the risk/reward scale, there is no further benefit that can
be realized by changing the allocation. The Efficient Frontier
shows the “sweet spot” related to risk and reward.
216 The Disciplined Investor

 SEMI-VARIANCE (SV)
This term refers to how much downside risk can be associated
with a given portfolio. It is a benchmark for risk in the same
way that the EF is a benchmark for performance. The term
enjoyed great popularity following the downturn that culmi-
nated in the spring of 2000. At that time almost everybody,
regardless of how well diversified their portfolios were, took
a significant beating because of the market correction.
Essentially, if you stayed the course, you got hurt. If you tried
to reallocate your assets, you had a hard time due to the
complete lack of relatable historical evidence to base the
current situation upon. There was nowhere to hide, and
even portfolios created with the finest allocation systems
were vulnerable to the market’s rage.

With all of that in mind, it is easy to see that asset alloca-

tion is more than a complicated process. It would be
impossible to get into all the tools and methodologies available
to the average investor without a significant lesson on statistics
and market theory. Rather, here is a quick fix for how to size
up your risk needs. In this case, stocks (an investment on the
higher end of the risk spectrum) will be used as the measure.

While it may be overly simplistic, here is a start: to assess

your percentage of risk tolerance, consider your age against the
backdrop of 100 years. If you are 60, assessing the kind of risk
you should be willing to take is as simple as subtracting 60
from 100. Therefore, you should have a portfolio that includes
40 percent stocks. If you are 50, it is 50 percent, and so on.

This simple calculation is certainly not the only thing you

will need in order to craft a sensible asset allocation plan, but
again, it will at least get you started. Then, you will know just
Chapter 9 Implementing the Plan 217

how much risk and stability you will need in order to maxi-
mize your ability to continue making money after retirement
and, at the same time, avoid the withering of your nest egg due
to cost of living increases.

What Asset Allocation Is and Is Not

First of all, the task does not simply involve buying three dif-
ferent mutual funds. Mutual funds, by their nature, are an
excellent way to avoid putting all your eggs in one basket. That
does not translate to the idea that you can just pick a few and
be done with it.

For example, an investor who purchases mutual funds such

as the Vanguard Index 500, the Wilshire Index 5000, and the
American Funds Fundamental Investors may believe that his
or her portfolio has a diverse foundation. Without doing the
research, though, the investor will have grossly overlapped
investments since many of the stocks that these funds hold are
the same.

Basically, a person investing this way is buying many of the

same stocks, only doing it through three different avenues
without diversifying.

A better solution would be to buy a small cap fund, a mid

cap fund, a large cap fund, an international fund, and possibly
even a sector fund like health care, gold, oil, or natural resources.

Remember that asset allocation is not a quantifiable sci-

ence, even if you use the most complex optimization software.
Any website or advertisement that claims to have developed a
tool that can comprehensively assess your asset allocation
218 The Disciplined Investor

needs is a bit too enthusiastic. This is because allocating assets

is a matter of reducing risk, and risk is not always a black and
white issue. There are just too many human biases and data-
mining scenarios, which a piece of software cannot accurately
predict. Asset allocation, therefore, should be considered more
of an art form.

Working With an Advisor

Protecting your assets from all the potential pitfalls can be a
rather trying matter. For many people, enjoying money is
much more rewarding than constantly searching for ways to
improve the bottom line. For others, it may make better finan-
cial or personal sense to focus daily attention on their career,
their family, or retirement, and let a paid professional handle
the kind of painstaking research it takes to maintain a prof-
itable portfolio.

Fortunately, for the many people out there who do not like
the idea of braving the waters alone, there is an entire fleet of
financial professionals willing to help. The degree and quality
of that advice varies greatly, and as this book has stressed again
and again, it is important to do your homework.

Financial professionals come from many different back-

grounds, biases, skill sets, and influences, and have varied
levels of experience. Therefore is it imperative to assess the
kind of investment strategies you are looking for as well as
the kind of person you would like to work with. It is critical
that you take the time to size up the benefits and drawbacks
of dealing with a particular financial advisor as if you are
looking to buy and test-drive a car.
Chapter 9 Implementing the Plan 219

During your evaluation, there are a few easily recognizable

key indicators that The Disciplined Investor must pay attention
to. The following two segments conveniently lump them into
two categories: what to avoid and what to look for.

Choosing an Advisor: What You Should Know

At the grocery store, most people comparison shop. They are not
likely to buy a $2.00 can of corn from one reputable brand when
another equally reputable name is selling for $1.50. Unless, of
course, you are dealing with a canned corn connoisseur. In that
case the discerning consumer would more likely buy the $5.00
can that was imported from Europe.

Choosing an advisor is a similar process and carries many

of the same potential influences. Know this: when looking for
an advisor, you usually get what you pay for.

Getting what you pay for, in this case, has a rather compli-
cated connotation, especially considering that you are not just
dealing with varying price tags. This time you are also dealing
with varying pricing structures. It is true that highly regarded,
experienced advisors tend to charge more than lesser known or
inexperienced advisors. It is also true that the method of payment
tends to complicate things. Financial advisors earn their income
by charging their clients in one of the following manners:

• Pay-per-trade
• Fee-only
• Fee-based
• Commission-based

Pay-Per-Trade: This is a term that refers to any advisory

practice that charges a rate for the simple act of trading a stock
or other investment. The term “pay-per-trade” actually refers
220 The Disciplined Investor

to the kind of online, self-directed investment approach cov-

ered in Chapter 8. Some companies employ advisors who may
receive a base salary. In addition, bonuses may be based on the
many thousands of flat-rate trading fees that the company
earns every day from the clients that use their services. For the
most part, this type of advisor is considered a “broker” and
merely assists with your trades rather than providing advice.

Fee-Only: This term refers to the type of advisor that

charges a standard hourly fee, a flat fee, or a percentage fee for
his or her advice. Think of the way in which one pays a lawyer
or psychiatrist. This sort of pay structure may also come with
an annual fee associated with the types of investments that you
and your advisor agree on. Most often, you will pay a percent-
age of the assets managed for ongoing advice and support
beyond the initial consultation.

Fee-Based: This is probably the loosest term in the entire

group. Fee-based advisors may charge a flat hourly rate plus
a fee for managing your portfolio. In addition, investments
purchased may pay a commission to the advisor. The degree
of those commissions varies greatly between advisors and
some firms will actually work in a manner closer to the cate-
gory of fee-only than others. With this arrangement, clients
will have the broadest range of investment options available
to them.

Commission-Based: Anyone who has ever gone into a

shoe store or car dealership knows that salespeople who live
exclusively off of commissions are nothing short of relentless
when it comes to their advice on products or services they rep-
resent. If they do not get you to “pull out the old checkbook”
they do not make any money. It is essentially the same with
commission-based advisors, who are paid only when you
Chapter 9 Implementing the Plan 221

implement suggestions that they make on stocks, loaded

mutual funds, insurance, or annuity products.

In summary, you can determine what to avoid in an

advisor by following a few basic rules. The first is that while the
online, self-directed advisory firms may be great for those who
wish to maintain some degree of control over their own port-
folios, when it comes time to offer expert advice, they tend to
fall short. Basically, it is pretty easy to figure out that the
advisors working for one of these services (with no commis-
sion, a base salary, and little motivation to perform well for the
client) may not exactly be the “cream of the crop.”

The second point is that when dealing with a fee-only

advisor (specifically those that charge by the hour) you may
find yourself paying for some services that you do not really
need. Look at an interior decorator analogy: it may happen that
your new decorator takes a look at your entire home and tells
you that everything is perfect and no changes are needed. More
probable though, he or she will suggest all of the things that
need to be updated and improved. Of course this service will be
provided for an hourly fee. Even with that analogy in mind, the
fee-only advisor is still an excellent choice if you are looking for
ongoing investment management.

Then there are advisors that are primarily commission-

based. Imagine for a moment that you are in a mall shopping
for shoes. You walk into a well-stocked retail establishment and
find that it only sells brown shoes. The pleasant salesman walks
over and asks if you need help. Let’s agree that you are most
assuredly not going to walk out of there with a brand new pair
of black shoes. No matter how badly you may want a black pair,
the benefits and beauty of the brown shoes will be extolled.
222 The Disciplined Investor

Now, with that in mind, think about the commission-based

planner. If you are working with an advisor whose income is
based on the commissions from selling specific investments,
how can you ever be certain that what you are buying is not a
membership at the country club for that advisor?

At what point does adding a mutual fund to the portfolio

or jumping on a stock become an action that is less in your
interest and more in theirs?

By process of elimination, the best pick out of the group is

the fee-based advisor. Typically, these advisors employ a nice
blend of all the fee structures. Basically, you will be able to
choose which pay structure is best suited for you and the advi-
sor. This gives you the greatest flexibility and control.

Apart from the fee structure, there are additional factors to

consider when determining the best advisor for your unique
situation.

Choosing an Advisor: What to Look For

Before deciding which specific advisor to hire, the best
approach would be to assess what kind of investor you are.
That may not seem like the easiest task at first. Fortunately,
there have been several studies done over the past few decades
that have focused squarely on the range of investor styles.
When it comes to managing assets, studies show that most
people can be divided into three groups:

• Do-it-yourselfers
• Collaborators
• Outsourcers
Chapter 9 Implementing the Plan 223

Do-It-Yourselfers: These investors are likely to gain the

most from carefully reading Chapter 8. They have a propensity
toward absolute control over a portfolio’s destiny. The problem
with trying to control your destiny is that it does not always go
as planned. Good or bad, the pure do-it-yourselfers are rather
unlikely to ever seek the aid of a financial advisor of any kind. If
they do, it is likely that the relationship will be short-lived.

Collaborators: These investors prefer to maintain some

sense of control, but recognize that the process of managing a
portfolio is something that they cannot do on their own. They
tend to view the advisor-advisee relationship in much the same
manner as a partnership. They like to delegate responsibility
rather than handling it on their own. This is the classical defi-
nition of a “team effort.” Both parties are working with a
common goal, synergistically.

Outsourcers: This group of investors would rather play

golf or do almost anything other than have the “chained-to-
the-desk” feeling that comes with watching the stock-ticker all
day. They enjoy the prospect of being able to hand their finan-
cial matters over to an experienced and trusted advisor. Their
plan is to let the advisor do the work and then simply forget
about it for a while. Of course, these are the same people who
can get “burned” unless they do a good amount of research
before choosing an advisor. If they fail to employ the services
of a reputable professional with the proper experience, they
may find themselves with poorly constructed financial plans.
On top of that, if the advisor is not keeping portfolio perform-
ance in line with the investor’s goals, the extreme outsourcer
will never know if their advisor is staying on course.
224 The Disciplined Investor

In some capacity, it is important to seek counsel of some

kind. Bear in mind that old saying: The man who represents
himself as an attorney has a fool for a client. Nobody—not
even an experienced advisor—has the answers to all of life’s
(or Wall Street’s) questions. Furthermore, almost no one can
completely separate their emotions from their own portfolio.
This happens to be one of the most important lessons to be
learned when dealing with your own money.

That is why advisors have a decided advantage. If they gain

or lose $5,000 in a day for your portfolio, they are less likely
to lose sleep over it. Of course this is not something to be taken
lightly, even with a very large portfolio. Yet the simple fact of
the gain or loss is less likely to dictate the advisors’ next move.
This is what separates the successful investor from the rest of
the pack.

In short, the greatest benefit of utilizing an investment

advisor, in some capacity, is to gain objectivity. Portfolio deci-
sions that are based on logic, rather than emotion, will be
much more consistent with your long-term goals.

Take some time to assess what type of investor you are.

Once you have a good idea, start to think about whether or
not you want to even consider using an advisor. Either way,
you now have a good base of knowledge and are on the road
to becoming a Disciplined Investor.

If you feel that you would like to explore the advisor

route, here are a few important points you can use as a check-
list in the interview process. These are the main areas to focus
on, though they are definitely not the only ones you should
Chapter 9 Implementing the Plan 225

ask about. A capable advisor has any number of the following

to his or her credit:

• Certified Financial Planner™ (CFP) certification

• Experience
• Independent status
• Full-time status
• State insurance license
• An excellent and well-supported reputation

Not all of these are requirements. For example, if you are

only interested in an advisor working with your investments, an
insurance license may not be of consequence. On the other
hand, a full-time status is non-negotiable. There is no way that
this important profession can be moonlighted. If someone tells
you that they can help you in their spare time, run fast!

Look once more at the list. CFPs occupy the first position
for one good reason: They are committed and hard working
enough to pass the rigorous and exhaustive examination
process that comes with the territory.

Becoming a CFP certificant is not easy, as evidenced by

how relatively few there are in this country. To put this into
perspective, it is reported that as of 2007, there are approxi-
mately 50,000 Certified Financial Planners as compared to
over 500,000 Certified Public Accountants (CPAs). The main
benefit to the consumer is that the CFP certification is a sign
that shows advisors who are serious, committed and career-
minded. Of course there are also several other designations
that may help to identify qualified advisors such as ChFC,
CLU, PFS, CFA, among others. However, realize that “quali-
fied” does not necessarily mean they are “good.”
226 The Disciplined Investor

CFP certificants are usually able to take a broader and

more balanced look at your goals, your future, and your invest-
ment needs. They are also better equipped to provide you with
a wide range of non-investment-related services. The curricu-
lum they study covers the gamut of financial planning matters,
which is in sharp contrast to similar certifications that focus
more time on insurance sales and marketing.

Expert financial advice is a lot like major league pitching:

experience plays a huge role. A rookie is far less likely to con-
struct a time-tested and watertight plan for you than a seasoned
veteran. As a rule of thumb, you should seek out an advisor that
has at least five years of service under his or her belt.

Independent advisors are also better equipped to meet

your needs than those who are associated with a big insur-
ance or brokerage firm. This is because advisors who work
for one of the big names on Wall Street may be required by
the company to sell you many of the products that their
company markets.

These are usually termed “proprietary.” For example, if the

brokerage firm your advisor works with is Worthmore
Investments and the fund she recommends is the Worthmore
Stock Fund, start asking questions.

Is there a financial incentive or bonus for the recommen-

dation of this investment? How does it stack up against its
peers? Are the fees competitive? What are the other options
and why are they not being presented?

What if there is a cheaper financial product offered by a

competing firm, but you have been pigeon-holed into buying
Chapter 9 Implementing the Plan 227

the more expensive one from your advisor’s affiliated company?

Who is benefiting from this? Basically, an independent advisor
is not hindered by a narrow range of products and services. He
or she does not try to pound a square peg into a round hole.

At some point in the life of many successful advisors, there

comes a time when a great deal of the work can be pawned off
on an assistant or rookie partner. The trouble with an advisor
who spends more time away from the desk than at it is that he
or she may often miss investment opportunities that could
have served you quite well.

Choose an advisor who spends at least 8 to 10 hours per

day directly serving the needs of their clients, rather than wear-
ing the hat of the firm marketer. Unless there is a staff member
or partner that you have agreed to work with in advance, your
advisor should be the primary contact for your finances.

Of course, for the administrative matters, the advisor

may not be needed, so make sure you develop a good rela-
tionship with the office administration and staff. Though
you may not think so at first, they are a key component to
your long-term success.

A state insurance license means that your advisor deals

with more than just market investments—it means that they
can provide a whole host of value-added services to help you
meet many of the needs that will help protect your money.
Most effective asset allocation plans include some kind of
insurance. Can your advisor provide that for you?

The final point is the most traditional and the most impor-
tant. Choosing an advisor, like choosing any product or
228 The Disciplined Investor

service, is still essentially a “smell test.” It is still a good prac-

tice to ask a friend or get a professional recommendation. The
process still comes with an awful lot of gut feeling. You can
find an advisor who has the world’s greatest track record
behind them, but if you are not comfortable in their presence,
keep looking.

Continue to ask your friends about their advisors. Find out

what they like or dislike about them. Then, interview two or
three of the best candidates for the job. Hold yourself back
from picking the one with the cheapest services because you
are most likely to get what you pay for.

Never underestimate the importance of written materials.

If a potential advisor has written and published articles, a
book, or a newsletter that you can read—something more than
a shiny and colorful brochure—at least you can see what areas
they have specific knowledge and expertise in. In addition,
written materials serve as historical evidence for what an advi-
sor has done in the past. If they have documented proof that
they bought Google and then stuck with it, that might be a
good thing to know.
 Chapter 10

Putting It All Together

Now what? You are equipped with all this new wisdom and it
is time to take the next step and put everything into action.
Throughout this book, many key points have been presented
for you to consider when crafting an investment portfolio on
your own. Before getting into the heart of the matter, though,
it may be prudent to review the central tenets of what has been
covered.

You have learned that to have a successful investment strat-

egy you must apply a strict and sturdy sense of discipline. It is
easy to be tempted by the get-rich kind of mentality that can
sometimes come with market investing. It is essential to stay
focused and, where possible, conservative. To that end, assess-
ing your risk tolerance is the first and most important step
when constructing a plan for a better future.

You have also learned that emotions must be kept as far

away from investment decisions as possible. With the strict
application of quantitative investing, you can filter out and
navigate through all of the potential biases that line the way to
successful investing.

229
230 The Disciplined Investor

Studying the present while keeping a sharp eye on the past

is a smart idea. This will boost your overall success with the
application of technical analysis. The markets tend to follow
trends that can be fairly well predicted if you are willing to do
the research and you have the right data at hand. With a finely
honed understanding of history, you may be able to better
determine the direction of a market’s future.

Fundamental analysis, meanwhile, teaches us that while

employing a focus on trends may be a good idea, before invest-
ing in a given company it might also behoove any investor to
learn everything that he or she can about it. Earnings histories,
balance sheets, and product lines, along with details on man-
agement structure and staff: all of this essential information is a
part of public record and, more often than not, as a package,
serves as an excellent economic indicator for any publicly
traded stock.

Distant and not-so-distant history has also taught the

harsh lesson of the benefit of a well-planned risk management
strategy. Look no further than the turn of this century to see
how easy it is to get caught up in the rising tides of a charging
bull market, only to lose your bottom dollar when the bear
finally rears its ugly head once again.

Many have suggested that the best way to avoid this lose-
your-shirt kind of scenario is to invest heavily in mutual funds,
but again, even the prepackaged, reduced-risk, and increased-
stability kinds of investments require a good amount of smart
research. As with anything else, not all mutual funds are cre-
ated equal. Remember: it is important to do your homework.
Chapter 10 Putting It All Together 231

A valuable lesson learned is that annuities and guaranteed

investment contracts, while attractive investment strategies, tend
to come in all different shapes and sizes. In order to maximize
this kind of investment, it is crucial to understand the many pit-
falls and study the fine print in each product.

This book finishes with the topic of choosing an advisor

for a good reason. Nobody—not even those intrepid readers
who took the time to absorb all the information written in this
and other books—has all the answers. The best portfolio is cre-
ated on the foundation of diversity. The best practice for
managing a portfolio is based on collaboration. Two minds—
especially when one of them is able to remove a good part of
the emotion from the equation—are better than one.

From the beginning, you have learned the value and

importance of sound and thorough analysis. The analytical
approach is in fact the best way to separate yourself from the
“feelings” (gut or otherwise) that tend to lead to investment
decisions that are made with the heart instead of the head.

As with anything in life, you must take heed of the past

and study the details of the present if you ever hope to predict
the future. Because there are so many indices and trends to
take into consideration, you must remain ever-vigilant to the
numbers at hand. They have a story to tell and if you hope to
beat the markets and make your investments matter, you must
listen to and study that story as thoroughly as possible.

In response to uncertainty a great many sound strategies

have been devised to help keep your portfolio safe. There are a
myriad of security nets at your disposal. It is important to size
up the viability of each. Opinions, goals, and fears vary from
232 The Disciplined Investor

investor to investor. Before you may begin to build an invest-

ment strategy, you must first determine the best path to
protect yourself from the random downturns that the econ-
omy and the markets are sure to take.

Investment tools are plentiful in today’s highly connected

marketplace, but the sheer abundance of tools does not equate
to quality. If you indeed plan to venture off into the world of
investing on your own, be sure to do your homework on the
applications that you intend to employ. Not all of them are as
accurate or thorough as The Disciplined Investor calls for.

No matter how you intend to invest, be sure to protect

your investments. If anything has been learned from the sharp
decline that followed the turn of this millennium, it should be
that the markets are never immune to corrections, even if it
seems that “this time will be different.” There is no such thing
as a sure-fire investment bet. There are no “get-rich-quick”
schemes that work. Take the time to protect yourself from
such inclinations.

With this book as a guide and tool, you now have an excel-
lent base for evaluating the methods and strategies for
developing a winning and balanced financial plan. Do your
research and, above all, maintain your discipline, and you will
be well on your way to finding success.
NOTES
NOTES
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