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What Every Investor Should Know

SPECIAL TO THE TIMES

John has been investing for about five years--long enough to know that a bull market is when stock prices are climbing strongly and a bear market is when they’re languishing.

The trouble is, he’s never quite sure whether he’s got the bull by the horns or if he’s about to be mauled by the bear. With his life savings riding on the answer, he says that he approaches each day with nail-biting nervousness.

“Every time the market climbs, I’m wondering whether I should sell to lock in my profits. When it drops, I wonder whether I should sell to cut my losses,” he says. “Most of the time, I don’t actually do anything--other than worry about it.”

Anecdotal evidence indicates that John, a broker who asked not to be named for fear of losing all his clients, isn’t alone. Investing makes many people nervous because they know that their future financial health can hinge on the choices they make. And there is a huge variety of highly complicated options confronting investors every day.

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But investing doesn’t need to be difficult or nerve-racking. By learning some basic skills, you can reduce the worry and make savvier financial decisions to boot.

In this special Investment Strategies section, The Times will present a basic tutorial on those skills, examining each one step at a time.

Clearly, if you’re just starting, you’ll find it highly valuable. But even if you’re a seasoned investor, it should be useful as a refresher course.

Here are those fundamental skills:

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* How to use risk to boost your returns.

“Nothing ventured, nothing gained,” your mother used to say. But there’s nothing tired about that cliche when it comes to the financial markets. When investing over long periods, your reward for taking a risk is directly related to the size of the gamble.

“There’s a direct correlation between risk and return,” says James E. Andelman, consultant with Ibbotson Associates, a Chicago-based market research and consulting firm. “In order to get higher expected returns, you need to take on more risk.”

To be a good investor, you must know how to analyze risks and your own ability to tolerate them, based on your age, assets, family situation and disposition. Then make the proper investments to suit your risk tolerance.

* How to diversify to reduce risk.

Ralph Bloch, technical analyst at Raymond James Financial in St. Petersburg, Fla., pursues a scary investment strategy. “I’m a big advocate of putting all your eggs in one or two baskets--and then watching those baskets very closely.”

But he acknowledges that the average investor is wise to pursue the opposite tack, spreading his or her money among a variety of disparate investments. That strategy reduces the chance of reaping an incredible windfall, but it also reduces the risk of suffering a devastating loss.

You must learn how to find the investment mix that will protect you against catastrophic loss yet maximize your returns.

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* How to use fundamentals when choosing individual stocks.

Billionaire investment legend Warren Buffett looks for value in stocks. Peter Lynch, the investment whiz who once headed Fidelity’s Magellan stock fund, seeks growth. Both have been wildly successful, which proves but one thing: There’s no one formula for investment success.

However, your chances of investing well rise with your ability to recognize certain attractive qualities that good investments share. Among individual companies, those qualities include consistent growth in sales and earnings, good management and a reasonable stock price.

By checking a few investment resources such as company annual reports and independent evaluation services like Value Line Investment Survey, you can greatly boost your chances of making enriching choices.

* How and when to sell.

Hugh Johnson, chief investment officer at First Albany Corp. in New York, can remember one of his very first investments. It was an oil company that had all the trappings of a good buy--rising sales and earnings, good management and a stock price that indicated the shares were a bargain. But for five years the stock just didn’t move, trading in a narrow range of $25 to $29 a share.

“I finally gave up and sold it,” he says. “Two months later it was at $90.”

Deciding when to sell is often the hardest part of investing. There are a few strategies that can help you cut losses or lock in gains. These boil down to looking at key numbers on a regular basis, such as a stock’s price-to-earnings ratio and its earnings growth rate. But you need strength and stamina--and lack of emotion--to help you do what your strategies tell you.

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* How to invest in bonds.

Bonds were once considered the dowager of the investment world--predictable and safe, but deadly dull. Nothing could be further from the truth today.

Over the last several years, bonds have for long periods proved to be more volatile than stocks. And the wide array of bonds in the market today--from corporate “junk” issues to Third World bonds to exotic “derivative” issues--may in many cases be too dangerous for traditional conservative bond investors.

Yet all this diversity spells opportunity for those who understand bond choices and how to use them. Certain corporate bonds, for example, provide higher returns with relatively reasonable risks. Other bonds offer tax benefits. Some allow you to “hedge” a strategy to reduce investment risk. Still others provide both income and growth potential.

* How to use mutual funds.

If you haven’t got the time or money to invest well on your own, you can still invest wisely by choosing good mutual funds. They offer a wide spectrum of investment choices.

But that doesn’t mean you won’t need to do any homework. To do well with mutual fund investments, you’ve got to evaluate your needs and investigate the best options to address them. Then you have to monitor both how your fund is performing compared to its peers and how well it follows its own rules and guidelines.

* How to use international stocks.

Many Americans fear foreign financial markets--and for good reasons. Foreign stock and bond markets can be wildly volatile, swinging from poverty to wealth and back again in a matter of weeks. On top of that, there’s the risk that the currency your investment is denominated in could fall in value relative to the dollar, devaluing your holdings.

Yet for all that, there are compelling reasons to invest in foreign markets. For one, many experts believe that some young and vibrant foreign stock markets present better long-term opportunities for profits than the U.S. stock market.

In addition, there’s a low correlation between the performance of the U.S. market and foreign markets, says Ibbotson’s Andelman. That means that when U.S. markets are down, many foreign markets are likely to be up. That helps you diversify away large jolts in your portfolio.

Finally, a widely touted academic study indicates that investors can reduce their risk and increase their returns by having a chunk of their portfolio in foreign markets.

* How to use tax breaks to turbocharge investment returns.

The secret to tax planning is finding ways to delay paying taxes. And there are a host of ways to set up your investments that will allow you to do that. But there are trade-offs. Individual Retirement Accounts, 401(k) plans, Keoughs, SEP-IRAs and some tax-deferred annuities, for example, all allow you to accumulate investment income tax-free until you pull the money out at retirement. And you’ll get penalized if you try to get your money early.

Is the trade-off worth it? You bet.

Consider what would happen if you were to be presented with two similar investments, each paying 10% annually. One, though, is tax-deferred, whereas the other is immediately taxable. Your marginal tax rate for both federal and state taxes amounts to 30%, which you would pay out of your investment earnings before reinvesting the remainder.

How much would you have in the taxable investment if you invested $100 a month every month for 30 years? $121,997. What would you have in the tax-deferred investment? Nearly twice as much: $226,049.

When you withdrew from the tax-deferred investment, you’d have to pay income taxes on the earnings accumulated. Still, assuming you took all the money in a lump sum and paid tax at your 30% rate, you’d come away with $169,035--that’s $47,038 more than with the taxable investment.

Why the difference? For 30 years, you were able to earn investment returns on money that would otherwise be paid to the government.

* How to keep good records.

Barbara knows exactly how much she paid for 100 shares of stock way back in 1962. It’s what happened since then that makes her fuzzy.

That’s because she’s been reinvesting her dividends for the past 26 years. She never stopped to calculate how much extra money that amounted to. But now that she’s considering selling the stock, she’s in a quandary.

Going through 26 years of investment records to tabulate her total investment, including rein-vested dividends, will be a horrible--maybe even impossible--job. But if she doesn’t do it, she’ll pay too much tax.

Richard, meanwhile, has a different problem. He thought he was doing a fabulous job managing his own money. He was bragging that several of his investments posted double-digit returns in just a matter of weeks. But once he sat down with a financial planner, his confidence was shattered. He discovered that his total year-over-year returns were decidedly lackluster. Because he failed to keep good records, he didn’t realize that he would have been better off investing in something else.

Record keeping is one of the most important--and most widely ignored--steps in investing. Good records help you monitor your portfolio, aiding in deciding when to buy or sell. And they’re pivotal when determining how much tax you have to pay on your gains. Keeping records isn’t hard if you take a few minutes early in the game and get organized.

* How to manage expenses.

Excessive and unnecessary expenses on brokerage services, mutual funds and other necessities can eat away at your investment returns. You might be paying full-service commissions for your stock trades when lower costs through a discount brokerage might work just fine. Your mutual funds might be charging excessive sales or marketing fees, or their management expenses might be higher than the norm.

The ability to recognize such costs and reduce them could mean thousands and thousands of dollars over the years. And often, the lower-cost services and funds do just as well, if not better, than their higher-cost counterparts.


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