Five Golden Rules

If we look back over the recent past, we can see some of the tallest peaks and deepest valleys of our time.

Just five years ago, in December of 1999, the U.S. economy was booming, the Nasdaq was surging past the 5,000 mark and most investors were making money hand over fist.

Just three years later, in the fall of 2002, we faced precisely the opposite situation: Unemployment was surging. The Nasdaq had lost roughly three-fourths of its peak value; the S&P 500 stocks, about half. And over $10 trillion in investor wealth had been destroyed from peak to trough.

Now, at the half-way point of the millennium’s first decade, we are also at the half-way point between those two extremes. The stock market has recouped, but not nearly enough to make investors whole. The economy shows some signs of life, but with the weakest jobs recovery in over half a century.

And yet, some of the least desirable side-effects â€” typically associated with an overheated economy â€” are already upon us: The worst trade deficit in history, a sinking dollar, and rapidly rising inflation.

In sum, you are caught in a twilight zone where good times and bad times overlap, and where, more than ever before, planning for the future is a patchwork of guesses.

If this roller-coaster, neither-here-nor-there environment persists in 2005 and beyond, how will you continue to build your wealth? I recommend you follow my five golden rules of investing …

Golden Rule #1
Keep your priorities straight:
Aim first for savings and capital preservation, second for growth, and third for speculative profits.

People often ask me: “How did you start building your own nest-egg?”

My answer: I began when I was nine years old; and at that early stage in my life, I did it exclusively by working hard and saving religiously.

I was too young to qualify for a newspaper delivery route. So I partnered with my older brother. He signed up; I did all the work.

But I also kept all (or most) of the rewards, putting away every penny, week after week, month after month.

If you are already retired with a substantial nest-egg, please pass this advice along to your children or grandchildren. Then take advantage of the advice I outline below for capital preservation (steps 4 through 6, below).

But if you do not yet have a substantial nest-egg, you must not skip over this critical aspect of wealth building. Even with today’s low interest rates you will be pleasantly surprised to discover how much you can accumulate by taking some simple steps:

Step 1. Start immediately. If you do not have a savings plan in place, the sooner you begin one, the better. Even at today’s low interest rates of just 2% per year:

Saver A, who saves $10,000 per year beginning at age 25, will have $604,020 at age 65.
Saver B, who saves $10,000 per year beginning at age 35, will have $405,680 at age 65.

As you can see, starting just 10 years earlier makes a big difference. At age 65, Saver A has 49% more than Saver B. Moreover, interest rates are unlikely to stay at these low levels for long. In the years to come, I expect them to average about double what they are today. If I’m right, the power of saving earlier will be greatly magnified.

Step 2. Be consistent. Figure out how much you can comfortably save each month. Many people aim too high, fail, and then give up. Better to aim low and then stick with it.

Step 3. Automate your savings. If at all possible, set up a program to save automatically. Your employer, your credit union, or your bank can provide additional information.

Step 4. Stick with safe institutions. To preserve your nest-egg, make sure it is kept at a safe bank, credit union, insurance company, brokerage firm or money market fund.

Wouldn’t it be ironic â€” and heartbreaking â€” if, after all your diligence and care, your accumulated savings are threatened by a financial failure or mishap? To help you avoid that kind of disaster, we provide you with lists of the weakest financial institutions in America at www.weissratings.com. Plus, for ratings on credit unions, visit www.veribanc.com.

Step 5. Use Treasuries. Seriously consider my favorite savings vehicle: Short-term Treasury securities or Treasury-only money funds, despite the low yields they currently offer. For more detailed instructions on our recommended savings plans and vehicles, see The Wise Investor’s Guide to The Best Safety With The Most Yield, available free to all Martin on Monday readers.

Step 6. Don’t confuse savings with investments. Be sure to maintain a clear separation between the two:

Investments inevitably expose your capital to some risk; savings are designed to protect your capital.
Investments can be in stocks, stock mutual funds, or real estate that can go up or down. Savings should be limited to vehicles that are highly unlikely to go down in value. They prioritize the return of your money rather than the return on your money.
With investments, it often makes sense to time the market. With savings, it usually does not. As I stressed above, consistency and regularity is more important than market timing.

Golden Rule #2
Controlling risk is just as important as maximizing gains.

We all like to focus on the spice and excitement of investing â€” the performance. There’s nothing wrong with that â€” the profit potential can indeed be a very important driver of your ultimate success. However, the steps below to avoid and control risk are equally vital.

Step 1. Objectively evaluate your personal tolerance for risk. An investment that may be suitable for someone else could be inappropriate for you, depending on how much risk you are comfortable taking, the number of years you have before retirement, your income level and tax rate, your other existing investments and personal net worth, plus your expectations about investment performance.

So to help you evaluate each of these issues â€” and come up with a total “risk score,” be sure to run through our Risk Self-Test. It will only take a few minutes. But it could make a real difference in your results and your peace of mind.

Step 2. Determine portfolio allocations that are right for you. Included with the Risk Self-Test, you’ll also find guidelines on how to use your results to help you decide how much of your money to allocate to savings or capital preservation how much to allocate to growth, and how much you could spare for speculation.

Step 3. Control your risk. High-risk investments are not bad. Indeed, often they are the outstanding performers. So, there certainly is a place for risk, provided you take advantage of the devices that can help you control that risk. Specifically:

* For investments that expose you to large potential losses, use stop-loss orders. If the value of your security falls, there is no guarantee that you will get a price that corresponds exactly to the stop-loss level we specify. But it should help protect your capital to a large extent â€” either to prevent a larger loss or to protect an open profit.

* Diversify beyond the stock market by investing in various asset classes. Some people think that “diversification” means spreading your money among multiple stocks or stock market sectors. We have never believed that to be adequate, and the wholesale decline of nearly all market sectors in 2000-2002 vindicated our views.

A truly diversified portfolio should also include Treasuries, gold-related investments, other hedges against inflation, and, at the right time, other asset classes like real estate.

* Maintain a balanced portfolio. Too many investment decisions are based on just one theory about the future direction of the market. I myself have strong views about the future, but I also recognize that, ultimately, the future is not predictable.

Warning: These and other risk-control devices are never foolproof. But if you use them consistently and wisely, they are bound to improve your overall performance in the long term.

Golden Rule #3
When you speculate, use only money you can afford to lose.

Far too many people speculate with the keep-safe portion of their nest-egg. They fail to realize that speculation can ruin them just as easily as it can pay off huge potential rewards. Some words of caution regarding speculative investing:

Do not use funds that you’ll need for emergencies, your children’s or grandchildren’s education, basic necessities, retirement living expenses, or long-term health care. One key danger signal to watch for: If you find yourself counting on the expected gains in order to make your financial plan a success, you have probably exceeded your limits.
Even if you do have enough capital, do not speculate if you find yourself losing sleep over it.
Similarly, do not speculate if it causes stress between you and your significant other, or threatens other family relationships. It’s not worth it. Certainly do not speculate if you feel it’s having a negative impact on your physical health.
If you feel comfortable with various categories of aggressive investments, fine. They do have the potential to generate very handsome profits. Nevertheless, learn as much as you can about the risks inherent in each:

Small cap and penny stocks can often suffer from poor liquidity. If a small group of large investors â€” or a large number of small investors â€” rush to buy before you do, they can drive the price you pay far above its true value. Then, as soon as that buying pressure subsides, the price can often fall back down sharply, leaving you with severe losses.

Similarly, if there is rush to sell, it can drive down the value of your shares despite no changes in the company’s prospects. For more information on the risks of investing, visit the Securities Exchange Commission’s (SEC) website.

Futures contracts offer very high leverage â€” the ability to effectively control large sums with a very small deposit. Therefore, relatively minor moves in the market can bring about very large gains or losses.

I never provide futures trading recommendations. However, if you decide to play this game, be sure to learn all about the risks and the devices for controlling them, including stop losses and disciplined money management. For more information on the risks of futures, visit the website of the Commodity Trading Futures Commission (CFTC).

Options on securities: When you purchase put or call options on a stock or an index, and you stick strictly with the options (never exercising them to hold positions in the underlying instruments), your risk is strictly limited to the amount you invest, plus the commission you pay your broker. However, your potential profits are generally not limited. This can often provide a favorable risk-reward ratio.

Indeed, provided you do not purchase expensive options, the risk limitation inherent in the option itself can often be enough to protect the balance of your capital, without the need for stop-loss orders.

However, if you continue to buy losing options, your losses can still pile up over a period of time. So, like with any other speculative investment, you must never invest more than you can afford to lose. For more details on prudent option investing, see my report 15 Rules To Get The Most Out Of Options. And for more information on the risk of options, visit the Chicago Board of Options Exchange (CBOE) website.

Options on futures: The same principles and rules apply as with options on securities: When you buy puts or calls on a futures contract, your risk is strictly limited to the price you pay, plus commissions.

There is just one exception: If your option gets exercised, you may wind up holding an actual short or long position in the underlying futures contract, which, in turn, would expose you to risk that could be greater than your original investment. Therefore, to limit your exposure, make sure you stick with the options only, and instruct your broker accordingly.

For more information on the risks, visit read this online brochure from the CFTC.

Golden Rule #4
Keep your emotions in check.

This may go without saying, but I must say it anyhow: No matter what aspect of your finances â€” your savings, your investments, your speculative portfolio â€” the ability to control emotions is a critical key to success.

If you let emotions get the better of you, your chances of success in any area can be greatly diminished. How do you stay unemotional, disciplined, and objective? Some key points to remember:

Treat your money as a business. It’s not a game. Consider your income as revenues. Categorize and keep track of your expenses, including broker commissions and fees, as you would in any business. The more you do so, the more objective you will be about every aspect of your money.
Review your financial position monthly. Do this much like you would review your business’s monthly financial statements.
Pay attention to trends. If you have what looks like a continuing declining trend, stop, re-evaluate, and seriously consider changing your strategy.

Golden Rule #5
Especially if you trade actively, reduce your commission costs to the bone.

Most investors often ignore or underestimate how much of an impact broker commissions can have on their final results.

Consider this scenario: You’re not a buy-and-hold investor. But you’re not an active trader, either. Starting with $100,000 in your brokerage account, you buy 20 different securities, with an average initial value of $5,000 each. Then, you buy and sell each one only twice a year, with an average profit of 5% per trade before commissions.

With consistent profits like those, you’ll retire rich, right? Not necessarily.

According to a survey of broker commissions we conducted a while back, if you’re paying top-dollar commissions (actually charged by 27% of the firms in our survey), your entire $100,000 will be totally wiped out by commissions by the end of year nine.

Why? Because although your trading is consistently profitable before commissions, after commissions you will actually lose money every year, until every single penny in your account is gone â€” all into your broker’s pocket.

You can avoid disaster simply by using a broker who charges you the average commission rate among the brokers we surveyed. That’s what most investors like you are doing today. But, assuming the exact same scenario with the exact same profits, the results are still very disappointing. All you’d make is a meager $21,675 in profits. And that’s after 10 long years, with every single trade profitable and with reinvestment of profits at the beginning of every new year.

The only way to make good money trading semi-actively in the stock market is to find brokers with commissions on the low end of the scale. In the above scenario, instead of just $21,675, you’d walk away with $108,374 in pure profits to you, after commissions. In other words, just by switching from average commissions to low commissions, you’d multiply your profits by nearly five times.

One final word: Don’t expect perfection. It is rarely possible to apply every golden rule in every situation. However, prudent investing and prudent risk-taking will almost invariably outperform imprudence in the long run.

Next Monday, December 27, I’m taking a day off for a change. So your next Martin on Monday will be in your e-mail box two weeks from today, on January 3rd. Until then, I wish you …

The happiest of holidays and a safe new year!

Martin

Martin D. Weiss, Ph.D.
Editor, Safe Money Report
Chairman, Weiss Ratings, Inc.
martinonmonday@weissinc.com

P.S. The dollar remains under siege and on the brink of a wholesale decline with a potentially devastating impact on both our country and your investments. Click here to help my non-profit Sound Dollar Committee support a strong dollar and fight for the integrity of our nation’s budget.

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