Investing with your eyes open

Arthur Levitt

WE ARE amidst the longest period of economic expansion in our nation's history. A new, heightened optimism is fuelling an almost unbridled culture of entrepreneurship, innovation, and investing.

The markets are more a part of America's consciousness than ever before. Standing in line at the supermarket or the hardware store, you are as likely to hear people talking about the Nasdaq's performance as you are about the latest Harry Potter.

Even truck and beer commercials seem to be outnumbered by advertisements for on-line trading and investment advice. Just a few years ago, that would have been as unthinkable as a Labour Day weekend in Cleveland without the Air Show.

But, some of the basic but important fundamentals of investing are being lost on investors. Unless investors truly understand both the opportunities and the risks of today's market, too many may fall victim to their own wishful thinking.

Some points to check out: These times demand an even greater commitment to staying disciplined and understanding risk.

Investors must remain focussed on what makes sound investing sense for their families, for themselves, and for a more financially stable future.

One must not fall prey to an urge that tells us it is okay to suspend good judgment and invest, eyes closed and fingers crossed. This means researching the investments and understanding what one is investing in.

Start with the age-old question ``How do I figure out what a company's worth?'' Most analysts and investors refer to a P/E ratio -- that is, the stock price and the earnings per share -- to gauge growth potential. But in today's market, does it even make sense anymore to look at a P/E ratio -- are some of today's companies really worth 1000 times nothing?

Consider how today's multiple stock splits have helped drive up the market value for many of these companies. If, for example, a stock splits two-for-one, while the number of shares has doubled, the company's total market value has stayed the same. If more investors dive back in and the stock shoots back up to where it was, the company's valuation is now worth twice what it was.

Today's increased activity in buying and selling stocks highlights an important difference between trading and investing. Trading is buying on the hunch that the stock price will rise -- regardless of what the buyer actually thinks it is worth. Studies show that the more times you trade the less profit you make. There is nothing wrong with such a strategy as long as one understands the risks.

Investing for the long term means focussing on the fundamentals that make up a solid company. Does the company have a vision, a business model that works, a strong management team, or a quality product? Is it well-positioned to embrace new technology or innovation? Does it use its resources to become a better company?

Margin trading perils: Another common practice today that can also be risky for investors is buying stocks on margin. In too many cases, investors are focussing on the upside -- without carefully considering the downside. When you buy on margin, you can double your money, but you can also double your losses.

Some investors have been shocked to find out that the brokerage firm has the right to sell their securities that were bought on margin -- without any notification and potentially at a substantial loss to the investor. Many investors are stuck paying principal and interest for stock they no longer own.

If one is margined, and the market moves against him/her, and one cannot get a hold of one's broker -- he/she might be in some trouble. More generally, one should also understand how the overall portfolio is tailored for risk.

Distribute risk: There is no better way -- over the long term -- to distribute risk than to diversify the investments. Now, some markets will outperform a diversified investment strategy in the short term. That is just a fact. But do not forget that investors who boast of fantastic returns by investing in a single stock or one sector have also assumed the higher risks of a more narrow investing strategy.

But remember, if a one-stock or one-sector portfolio starts to spiral downward, there is no other gain to offset the loss. You are also less likely to hear them boasting ``Hey, I just lost my entire portfolio by buying only three stocks.''

Managing risk also means researching what you read and hear about potential investments. Unfortunately, it is not always just separating good information from the bad -- often, it is a question of gauging objectivity or bias, or salesmanship from honest advice.

Analysts who never `sell': How many have seen analysts from Wall Street firms on television talking about one company or another? Not many have thought twice about that person's recommendation to buy or sell a particular stock. But one should.

A lot of analysts work for firms that have business relationships with the same companies these analysts cover. Some analysts' paychecks are tied to the performance of their employers.

One can imagine how unpopular an analyst would be who downgrades his firm's best client. Is it any wonder that today, a ``sell'' recommendation from an analyst is as rare as an empty seat in the ``Dawg Pound'' at a Brown's game?

The net catch: What is more, the Internet -- with its low cost, anonymity, and large number of innocent investors -- makes it ripe for out-and-out fraud. Be wary of illusions of easy money, or fancy websites promising a fortune with one quick gamble. Chat rooms increasingly have become a source of information -- and misinformation -- for many investors.

To research a company, visit the SEC's Internet website, www.sec.gov and click on EDGAR, the SEC's electronic database. One can retrieve every report a public company has filed with the SEC in the past five years.

The Investor Assistance section of this site is also useful. A more informed investor stands a better chance of avoiding the pitfalls of investing in today's market.

The SEC requires that the annual reports filed by companies be certified by independent auditors. Auditor independence is a covenant between auditor and investor that says the auditor works in the interests of shareholders, not on behalf of management. This covenant says the auditor must steer clear of having financial interests in the companies he/she audits. The auditor's work must stand separate and apart from the clients' business.

There are ever more complicated audit engagements and interwoven business relationships. It is become abundantly clear that a more modern and effective approach to self-regulation in the accounting profession today is an absolute necessity.

The long-term lesson: The SEC chairman, Mr. Arthur Levitt has been involved with the markets, in one way or another, for over four decades -- almost as long as Dick Goddard's been doing the weather on television in Cleveland. He has seen markets go up, and down and stay down for extended periods. In that time, he says he has learned one incontrovertible fact: Successful investors, through good times and bad, focus a vigilant eye on managing risk.

Periods of promise and prosperity are not an excuse to let one's guard down. In fact, it is times like these when one needs to raise it even higher. In today's environment, with all the financial information, advertisements, and advice being meted out, it is even more important -- not less -- for investors to focus on the fundamentals of investing. The ease of today's technology is not an excuse to do less. It is an opportunity and a mandate to do more; to learn more; to be aware of more; to be informed of more and to achieve more -- as individuals and as a nation.

Be careful with mutual funds

ONE way to diversify one's risk profile is to consider mutual funds. But like any investment, before choosing a fund, do your homework. Today, it seems one cannot open a newspaper or read a magazine without seeing ads promoting the stellar performance of ``hot'' mutual funds -- some boasting returns of over 100 per cent.

Past performance is not as important as one may think. Maybe a fund invested early in a few successful IPOs gives it unusually high returns. Or maybe a fund had an extraordinary year or two, but over the longer term, has not done as well as recent returns suggest. If past performance were all that mattered, the Cleveland Indians would be in first place.

Scrutinise the fund's fees and expenses. Over time, expenses and fees can really make a difference. On an investment held for 20 years, a one per cent annual fee will reduce the ending account balance by 18 per cent.

One is reminded of a story that Bob Hope used to tell. When he was growing up in Cleveland, he helped his family make ends meet by selling the Cleveland Plain Dealer in front of a small grocery store on East 105th. One day Hope sold a copy to none other than John D. Rockefeller. This was back in 1909. Rockefeller handed Hope a dime for the two-cent newspaper, and made Hope run into the grocery story to make change. Even one of the richest men on earth cared about even relatively small amounts of money. You should, too.

Know the effect that taxes will have on one's mutual fund returns. The SEC's website also has a Mutual Fund Cost Calculator to help one estimate and compare the costs of owning mutual funds. You will find the calculator in the Investor Assistance section of www.sec.gov.

Ask some fundamental questions about one's investment goals. What is the time frame for investing? What happens to the overall portfolio if a certain investment does not do well? Ultimately, maintaining a diversified and balanced portfolio is key to maintaining an acceptable level of risk and reaching one's financial goals.

As one does his/her research, ask specific questions about products and ask questions about those who sell them. For example, look at money market funds.

In any market investment, one stands a chance of losing one's principal. It is a fundamental fact of investing that with any investment, one stands a chance of losing one's money. It is a risk one has to take.

Edited-extracts from a speech by Mr. Arthur Levitt, Chairman, US Securities and Exchange Commission at Investors Town Meeting, Cleveland, Ohio on July 25, 2000.