I view investing as a method of purchasing assets to gain profit in the form of reasonably predictable income (dividends, interest, or rentals) and/or appreciation over the long term.

On Stock Valuation

The firm-foundation theory argues that each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. When market prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling) opportunity arises, because this fluctuation will eventually be corrected—or so the theory goes. The theory stresses that a stock’s value ought to be based on the stream of earnings a firm will be able to distribute in the future in the form of dividends.

The castle-in-the-air theory of investing concentrates on psychic values.

The key to investing is not how much an industry will affect society or even how much it will grow, but rather its ability to make and sustain profits. And history tells us that eventually all excessively exuberant markets succumb to the laws of gravity.

The lesson, however, is not that markets occasionally can be irrational and that we should therefore abandon the firm-foundation theory of the pricing of financial assets. Rather, the clear conclusion is that, in every case, the market did correct itself.

Valuation metrics have not changed. Eventually, every stock can only be worth the present value of the cash flow it is able to earn for the benefit of investors. Stock valuations depend upon estimations of the earning power of companies many years into the future. Such forecasts are invariably incorrect. Moreover, investment risk is never clearly perceived, so the appropriate rate at which the future should be discounted is never certain. Thus, market prices must always be wrong to some extent. Markets are not always or even usually correct. But NO ONE PERSON OR INSTITUTION CONSISTENTLY KNOWS MORE THAN THE MARKET.

Technical analysis is the method of predicting the appropriate time to buy or sell a stock used by those believing in the castle-in-the-air view of stock pricing. Fundamental analysis is the technique of applying the tenets of the firm-foundation theory to the selection of individual stocks.

The first principle of technical analysis is that all information about earnings, dividends, and the future performance of a company is automatically reflected in the company’s past market prices. A chart showing these prices and the volume of trading already comprises all the fundamental information, good or bad, that the security analyst can hope to know. The second principle is that prices tend to move in trends: A stock that is rising tends to keep on rising, whereas a stock at rest tends to remain at rest.

The technician is interested only in the record of the stock’s price, whereas the fundamentalist’s primary concern is with what a stock is really worth.

  • Determinant 1: The expected growth rate.
  • Rule 1: A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings. To this is added an important corollary: Corollary to Rule 1: A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.
  • Determinant 2: The expected dividend payout.
  • Rule 2: A rational investor should pay a higher price for a share, other things equal, the larger the proportion of a company’s earnings paid out in cash dividends or used to buy back stock.
  • Determinant 3: The degree of risk.
  • Rule 3: A rational (and risk-averse) investor should pay a higher price for a share, other things equal, the less risky the company’s stock.
  • Determinant 4: The level of market interest rates.
  • Rule 4: A rational investor should pay a higher price for a share, other things equal, the lower the interest rates.
  • Caveat 1: Expectations about the future cannot be proven in the present.
  • Caveat 2: Precise figures cannot be calculated from undetermined data.
  • Caveat 3: What’s growth for the goose is not always growth for the gander.

On Selecting Stocks

  • Rule 1: Buy only companies that are expected to have above-average earnings growth for five or more years.
  • Rule 2: Never pay more for a stock than its firm foundation of value. Look for growth situations with low price-earnings multiples. If the growth takes place, there’s often a double bonus—both the earnings and the multiple rise, producing large gains. Beware of very high multiple stocks in which future growth is already discounted. If growth doesn’t materialize, losses are doubly heavy—both the earnings and the multiples drop.
  • Rule 3: Look for stocks whose stories of anticipated growth are of the kind on which investors can build castles in the air.

The technician believes that knowledge of a stock’s past behavior can help predict its probable future behavior. In other words, the sequence of price changes before any given day is important in predicting the price change for that day. The results reveal that past movements in stock prices cannot be used reliably to foretell future movements.

Mathematicians call a sequence of numbers produced by a random process (such as those on our simulated stock chart) a random walk. The next move on the chart is completely unpredictable on the basis of what has happened before. The stock market does not conform perfectly to the mathematician’s ideal of the complete independence of present price movements from those in the past. There is some momentum in stock prices. In addition to some evidence of short-term momentum, there has been a long-run uptrend in most averages of stock prices in line with the long-run growth of earnings and dividends. The history of stock price movements contains no useful information that will enable an investor consistently to outperform a buy-and-hold strategy in managing a portfolio.

Human nature likes order; people find it hard to accept the notion of randomness.

If past prices contain little or no useful information for the prediction of future prices, there is no point in following any technical trading rule for the timing of purchases or sales. A simple policy of buying and holding will be at least as good as any technical procedure.

No reliable pattern can be discerned from past records to aid the analyst in predicting future growth. Not one industry is easy to predict. No analysts proved consistently superior to the others.

Security analysts have enormous difficulty in performing their basic function of forecasting company earnings prospects. Investors who put blind faith in such forecasts in making their investment selections are in for some rude disappointments. It is simply impossible to count on any fund or any investment manager to consistently beat the market—even when the past record suggests some unusual investment skill. No public information will help the analyst select undervalued securities.

The index performance is not mediocre—it exceeds the results achieved by the typical active manager.

Another major advantage of HFT is that it ensures that the exchange-traded broad-based index funds, which I recommend for individual investors, are appropriately priced. Any discrepancy between the price of the ETF and the underlying stocks can be quickly arbitraged away.

On Risk

Risk, and risk alone, determines the degree to which returns will be above or below average. Financial risk has generally been defined as the variance or standard deviation of returns. Only the possibility of downward disappointments constitutes risk. A measure of variability such as standard deviation is so often used and justified as an indication of risk.

One of the best-documented propositions in the field of finance is that, on average, investors have received higher rates of return for bearing greater risk.

Securities with negative covariance can reduce risk. In general, diversification will not help much if there is a high covariance (high correlation) between the returns of the two companies. Negative correlation is not necessary to achieve the risk reduction benefits from diversification. Markowitz’s great contribution to investors’ wallets was his demonstration that anything less than perfect positive correlation can potentially reduce risk.

What part of a security’s risk can be eliminated by diversification and what part cannot. The result is known as the capital-asset pricing model.

The basic logic behind the capital-asset pricing model is that there is no premium for bearing risks that can be diversified away. Thus, to get a higher average long-run rate of return, you need to increase the risk level of the portfolio that cannot be diversified away. According to this theory, savvy investors can outperform the overall market by adjusting their portfolios with a risk measure known as beta. Systematic risk, also called market risk, captures the reaction of individual stocks (or portfolios) to general market swings. This relative volatility or sensitivity to market moves can be estimated on the basis of the past record, and is popularly known by—you guessed it—the Greek letter beta. The calculation begins by assigning a beta of 1 to a broad market index. If a stock has a beta of 2, then on average it swings twice as far as the market.

Systematic risk cannot be eliminated by diversification.

Investors should be compensated for taking on more risk with a higher expected return. Stock prices must, therefore, adjust to offer higher returns where more risk is perceived, to ensure that all securities are held by someone.

But not all of the risk of individual securities is relevant in determining the premium for bearing risk. The unsystematic part of the total risk is easily eliminated by adequate diversification. So there is no reason to think that investors will receive extra compensation for bearing unsystematic risk. Thus, the capital-asset pricing model says that returns (and, therefore, risk premiums) for any stock (or portfolio) will be related to beta, the systematic risk that cannot be diversified away. The CAPM then asserts that to get a higher average long-run rate of return, you should just increase the beta of your portfolio. The beta for any security is essentially the same thing as the covariance between that security and the market index as measured on the basis of past experience.

The relationship between beta and return is essentially flat. Beta, the key analytical tool of the capital-asset pricing model, is not a useful single measure to capture the relationship between risk and return. The beta measure of relative volatility does capture at least some aspects of what we normally think of as risk. And portfolio betas from the past do a reasonably good job of predicting relative volatility in the future.

Better explanations than those given by the CAPM can be obtained for the variation in returns among different securities by using, in addition to the traditional beta measure of risk, a number of systematic risk variables, such as sensitivity to changes in national income, in interest rates, and in the rate of inflation.

Eugene Fama and Kenneth French have proposed a factor model, like arbitrage pricing theory, to account for risk. Two factors are used in addition to beta to describe risk.

Returns are related to the size of the company (as measured by the market capitalization) and to the relationship of its market price to its book value.

On Behavioral Finance

Behavioralists believe that market prices are highly imprecise. Moreover, people deviate in systematic ways from rationality, and the irrational trades of investors tend to be correlated.

Basically, there are four factors that create irrational market behavior: overconfidence, biased judgments, herd mentality, and loss aversion.

Researchers in cognitive psychology have documented that people deviate in systematic ways from rationality in making judgments amid uncertainty. One of the most pervasive of these biases is the tendency to be overconfident about beliefs and abilities and overoptimistic about assessments of the future. They overestimate their own knowledge, underestimate the risks involved, and exaggerate their ability to control events. If an investor tells you he is 99 percent sure, he would be better off assuming that he was only 80 percent sure. Such precision implies that people tend to put larger stakes on their predictions than are justified. And men typically display far more overconfidence than women, especially about their prowess in money matters.

First and foremost, many individual investors are mistakenly convinced that they can beat the market.

They found that the more individual investors traded, the worse they did.

This illusion of financial skill may well stem from another psychological finding, called hindsight bias. Such errors are sustained by having a selective memory of success.

People are prone to attribute any good outcome to their own abilities.

Overoptimism in forecasting the growth for exciting companies could then be one explanation for the tendency of “growth” stocks to underperform “value” stocks.

There is reversion to the mean. Similarly, the laws of financial gravity also operate in reverse. At least for the stock market as a whole, what goes down eventually comes back up.

It is this illusion of control that can lead investors to see trends that do not exist or to believe that they can spot a stock-price pattern that will predict future prices.

One widely recognized phenomenon in the study of crowd behavior is the existence of “group think.” Groups of individuals will sometimes reinforce one another into believing that some incorrect point of view is, in fact, the correct one.

Groups of individuals will sometimes reinforce one another into believing that some incorrect point of view is, in fact, the correct one. It seems that other people’s errors actually affect how someone perceives the external world. One of the most important lessons of behavioral finance is that individual investors must avoid being carried away by herd behavior.

Losses are considered far more undesirable than equivalent gains are desirable.

Kahneman and Tversky concluded that losses were 2½ times as undesirable as equivalent gains were desirable. In other words, a dollar loss is 2½ times as painful as a dollar gain is pleasurable. People exhibit extreme loss aversion.

In the face of sure losses, people seem to exhibit risk-seeking behavior. Investors find it very difficult to admit, even to themselves, that they have made a bad stock-market decision. Many investors may feel that if they hold on to a losing position, it will eventually recover and feelings of regret will be avoided. These emotions of pride and regret may be behind the tendency of investors to hold on to their losing positions and to sell their winners.

In perhaps the most pathological case, individuals appear to go mad in herds and bid some categories of stocks to unreasonable heights.

Behavioralists believe that important limits to arbitrage exist that prevent out-of-whack prices from being corrected.

Any investment that has become a topic of widespread conversation is likely to be especially hazardous to your wealth. Chasing today’s hot investment usually leads to tomorrow’s investment freeze.

Behavior except to incur transactions costs and to pay more in taxes. Short-term gains are taxed at regular income tax rates. The buy-and-hold investor defers any tax payments on the gains and may avoid taxes completely if stocks are held until distributed as part of one’s estate. Remember the advice of the legendary investor Warren Buffett: Lethargy bordering on sloth remains the best investment style. The correct holding period for the stock market is forever.

If you are contemplating making a stock trade (and you are married), ask your wife whether you should do it. If You Do Trade: Sell Losers, Not Winners.

A “paper loss” is just as real as a realized loss.

The decision not to sell is exactly the same as the decision to buy the stock at the current price.

Stay Cool to Hot Tips.

There is no universally accepted definition of “smart beta” investment strategies. What most people who use the term have in mind is that it may be possible to gain excess (greater than market) returns by using a variety of relatively passive investment strategies that involve no more risk than would be assumed by investing in a low-cost Total Stock Market index fund.

They argued that “value” wins over time. To find “value,” investors should look for stocks with low price-earnings ratios and low prices relative to book value.

There is some evidence that a portfolio of stocks with relatively low earnings multiples (as well as low multiples of book value, cash flow, and/or sales) produces above-average rates of return even after adjustment for risk, as measured by the capital-asset pricing model. Stocks that sell at low ratios of price to book value tend to produce higher future returns.

Over short holding periods, there is some evidence of momentum in the stock market. For longer holding periods, reversion to the mean appears to be present.

All “smart beta” strategies represent active management rather than indexing.

On Investment Portfolios

The most important driver in the growth of your assets is how much you save.

A specific need must be funded with specific assets dedicated to that need.

Perhaps the most important question to ask yourself is how you felt during a period of sharply declining stock markets. If you became physically ill and even sold out all your stocks rather than staying the course with a diversified investment program, then a heavy exposure to common stocks is not for you.

A second key step is to review how much of your investment return goes to Uncle Sam and how much current income you need.


Assuming that you are protected by medical and disability insurance at work, this reserve might be established to cover three months of living expenses.

For individuals, home and auto insurance are a must. So is health and disability insurance. Life insurance to protect one’s family from the death of the breadwinner(s) is also a necessity. Two broad categories of life insurance products are available: high-premium policies that combine insurance with an investment account, and low-premium term insurance that provides death benefits only, with no buildup of cash value. For most people, I therefore favor the do-it-yourself approach. Buy term insurance for protection and invest the difference yourself in a tax-deferred retirement plan. My advice is to buy renewable term insurance; you can keep renewing your policy without the need for a physical examination. So-called decreasing term insurance, renewable for progressively lower amounts, should suit many families best, because as time passes (and the children and family resources grow), the need for protection usually diminishes.

I would avoid buying variable-annuity products, especially the high-cost products offered by insurance salespeople. A deferred variable annuity is essentially an investment product (typically a mutual fund) with an insurance feature. The insurance feature stipulates that if you die and the value of the investment fund has fallen below the amount you put in, the insurance company will pay back your full investment. The only reason you should even consider a variable annuity is if you are super wealthy and have maxed out on all the other tax-deferred savings alternatives. And even then you should purchase such an annuity directly from one of the low-cost providers such as the Vanguard Group.


Money-market mutual funds often provide investors the best instrument for parking their cash reserves. They combine safety and the ability to write large checks against your fund balance, generally in amounts of at least $250.

T-bills offer an advantage over money-market funds and bank CDs in that their income is exempt from state and local taxes. In addition, T-bill yields are often higher than those of money-market funds. For information on purchasing T-bills directly, go to www.treasurydirect.gov.

You take advantage of every opportunity to make your savings tax-deductible and to let your savings and investments grow tax-free.

My advice is to save as much as you can through these tax-sheltered means.

“529” college savings accounts allow parents and grandparents to give gifts to children that can later be used for college education. Moreover, as of 2014, the plans allow an individual donor to contribute as much as $70,000 to a 529 plan without gift taxes and without reducing estate tax credits. - 529 plans are sanctioned by individual states, and some states allow you to take a tax deduction on your state income tax return for at least part of your contribution. If your state does not allow a tax deduction, choose a plan from a low-expense state such as Utah.

In my view, there are four kinds of bond purchases that you may want especially to consider:

  1. zero-coupon bonds (which allow you to lock in yields for a predetermined length of time). These securities are called zero coupons or simply zeros because owners receive no periodic interest payments, as they do in a regular interest-coupon-paying bond. Instead, these securities are purchased at discounts from their face value (for example, 75 cents on the dollar) and gradually rise to their face or par values over the years. Zero coupon bonds are excellent vehicles for putting money aside for required expenditures on specific future dates.
  2. no-load bond mutual funds (which permit you to buy shares in bond portfolios).
  3. tax-exempt bonds and bond funds (for those who are fortunate enough to be in high tax brackets).
  4. U.S. Treasury inflation-protection securities (TIPS). TIPS are far from ideal for taxable investors and are best used only in tax-advantaged retirement plans.

If you buy bonds directly (rather than indirectly through mutual funds), I suggest that you buy new issues rather than already outstanding securities.

Inflation is the deadly enemy of the bond investor.

Real Estate

I believe that real estate investment trusts (REITs) deserve a position in a well-diversified investment portfolio.

A good house on good land keeps its value no matter what happens to money. As long as the world’s population continues to grow, the demand for real estate will be among the most dependable inflation hedges available.

Hence, individual pieces of property are not always appropriately priced.

In sum, real estate has proved to be a good investment providing generous returns and excellent inflation-hedging characteristics. Real estate returns have often exhibited only a moderate correlation with other assets, thereby reducing the overall risk of an investment program. Moreover, real estate has been a dependable hedge against inflation.

1. Although rent is not deductible from income taxes, the two major expenses associated with home ownership—interest payments on your mortgage and property taxes—are deductible; 2. realized gains in the value of your house up to substantial amounts are tax-exempt. In addition, ownership of a house is a good way to force yourself to save, and a house provides enormous emotional satisfaction.

My advice is: Own your own home if you can possibly afford it.


Portfolios of relatively stable dividend growth stocks have yields much higher than the bonds of the same companies and allow the possibility of growth in the future.

Firms that buy back stock tend to reduce the number of shares outstanding and therefore increase earnings per share and, thus, share prices.

Managers acting in the interest of the shareholder will prefer to engage in buybacks rather than increasing dividends.

Although I remain convinced that no one can predict short-term movements in securities markets, I do believe that it is possible to estimate the likely range of long-run rates of return that investors can expect from financial assets.

When interest rates (and inflation) are low, somewhat higher price-earnings multiples and lower dividend yields are justified.

In general, the exhibit shows that investors have earned higher total rates of return from the stock market when the initial P/E of the market portfolio was relatively low, and relatively low future rates of return when stocks were purchased at high P/E multiples. In measuring the P/E for the market, these calculations do not use actual earnings per share but rather cyclically adjusted earnings. Thus, the measured P/Es are often referred to as CAPEs—cyclically adjusted P/E multiples. The CAPEs are available on Robert Shiller’s website, and the earnings are calculated as average earnings over the last ten years. CAPEs do a reasonably good job of forecasting returns a decade ahead.

  1. History shows that risk and return are related.
  2. The risk of investing in common stocks and bonds depends on the length of time the investments are held. The longer an investor’s holding period, the lower the likely variation in the asset’s return.
  3. Dollar-cost averaging can be a useful, though controversial, technique to reduce the risk of stock and bond investment.
  4. Rebalancing can reduce risk and, in some circumstances, increase investment returns.
  5. You must distinguish between your attitude toward and your capacity for risk. The risks you can afford to take depend on your total financial situation, including the types and sources of your income exclusive of investment income.

The longer the time period over which you can hold on to your investments, the greater should be the share of common stocks in your portfolio.

Dollar-cost averaging simply means investing the same fixed amount of money in, for example, the shares of some index mutual fund, at regular intervals—say, every month or quarter—over a long period of time. No matter how scary the financial news, no matter how difficult it is to see any signs of optimism, you must not interrupt the automatic-pilot nature of the program. Because if you do, you will lose the benefit of buying at least some of your shares after a sharp market decline when they are for sale at low prices. But remember, because there is a long-term uptrend in common-stock prices, this technique is not necessarily appropriate if you need to invest a lump sum such as a bequest.

Never take on the same risks in your portfolio that attach to your major source of income.

I believe that if an investor is to buy only one U.S. index fund, the best general U.S. index to emulate is one of the broader indexes such as the Russell 3000, the Wilshire 5000 Total Market Index, the CRSP Index, or the MSCI U.S. Broad Market Index—not the S&P 500.

I am convinced that true value will out, but from time to time it doesn’t surprise me that anomalies do exist.

Retirement Savings

The annuity guarantees that you will not outlive your money. Risk-averse investors should certainly consider putting some or even all of their accumulated savings into an annuity contract upon retirement. At least partial annuitization usually does make sense.

Under the “4 percent solution,” you should spend no more than 4 percent of the total value of your nest egg annually.

By spending less than the total return from the portfolio, the retiree can preserve the purchasing power of both the investment fund and its annual income.

The general rule is: First estimate the return of the investment fund, and then deduct the inflation rate to determine the sustainable level of spending.

Taxes are a crucially important financial consideration because the earlier realization of capital gains will substantially reduce net returns.


One of the biggest mistakes that investors make is to fail to obtain sufficient international diversification.

Emerging markets are likely to sustain high growth rates well into the twenty-first century. Indexing also is an extremely effective strategy in emerging markets.


Exchange-traded index funds (ETFs) such as “spiders” (an S&P 500 Fund) and “vipers” (a Total Stock Market fund) can be more tax-efficient than regular index funds because they are able to make “in-kind” redemptions. In-kind redemptions proceed by delivering low-cost shares against redemption requests. ETFs also happen to have rock-bottom expenses, sometimes even lower than those of equivalent mutual funds.

Basically, Morningstar is one of the most comprehensive sources of mutual-fund information an investor can find.

On Derivatives

The two most popular forms of financial derivative securities are futures and options contracts. A futures, or forward, contract involves the obligation to purchase (or deliver) a specified commodity (or financial instrument) at a specified price at some specific future period. A stock option, just as the name implies, gives the buyer the right (but not the obligation) to buy or sell a common stock (or group of stocks) at a specific price on or before a set date. They permit both producers and consumers to transfer risks in such a way that all market participants can be better off.