In screening an adviser, your goals should be to:

• determine whether he or she cares about helping clients, or just

goes through the motions

• establish whether he or she understands the fundamental principles of investing as they are outlined in this article

• assess whether he or she is sufficiently educated, trained, and

experienced to help you.

Here are some of the questions that prominent financial planners recommended any prospective client should ask: Why are you in this business? What is the mission statement of your firm? Besides your alarm clock, what makes you get up in the morning? What is your investing philosophy? Do you use stocks or mutual funds? Do you use technical analysis? Do you use market timing? (A “yes” to either of the last two questions is a “no” signal to you.) Do you focus solely on asset management, or do you also advise on taxes, estate and retirement planning, budgeting and debt management, and insurance? How do your education, experience, and credentials qualify you to give those kinds of financial advice? What needs do your clients typically have in common? How can you help me achieve my goals? How will you track and report my progress? Do you provide a checklist that I can use to monitor the implementation of any financial plan we develop? 276 Commentary on Chapter

Commentary on Chapter 10 WORDS OF WARNING The need for due diligence doesn’t stop once you hire an adviser. Melanie Senter Lubin, securities commissioner for the State of Maryland, suggests being on guard for words and phrases that can spell trouble. If your adviser keeps saying them-or twisting your arm to do anything that makes you uncomfortable-”then get in touch with the authorities very quickly,” warns Lubin. Here’s the kind of lingo that should set off warning bells: “offshore” “the opportunity of a lifetime” “prime bank” “This baby’s gonna move.” “guaranteed” “You need to hurry.” “It’s a sure thing.” “our proprietary computer model” “The smart money is buying it.” “options strategy” “It’s a no brainer.” “You can’t afford not to own it.” “We can beat the market.” “You’ll be sorry if you don’t . . .” “exclusive” “You should focus on performance, not fees.” “Don’t you want to be rich?” “can’t lose” “The upside is huge.” “There’s no downside.” “I’m putting my mother in it.” “Trust me.” “commodities trading” “monthly returns” “active asset allocation strategy” “We can cap your downside.” “No one else knows how to do this.”GETTING TO KNOW YOU A leading financial planning newsletter recently canvassed dozens of advisers to get their thoughts on how you should go about interviewing them.

The CFA Certificate for Financial Analysts

An important step was taken in 1963 toward giving professional standing and responsibility to financial analysts. The official title of chartered financial analyst (CFA) is now awarded to those senior practitioners who pass required examinations and meet other tests of fitness.

The subjects covered include security analysis and portfolio management. The analogy with the long established professional title of certified public accountant (CPA) is evident and intentional. This relatively new apparatus of recognition and control should serve to elevate the standards of financial analysts and eventually to place their work on a truly professional basis.? The Investor and His Advisers

• It is highly unusual today for a security analyst to allow mere commoners to

contact him directly. For the most part, only the nobility of institutional investors are permitted to approach the throne of the almighty Wall Street analyst. An individual investor might, perhaps, have some luck calling analysts who work at “regional” brokerage firms headquartered outside of New York City. The investor relations area at the websites of most publicly traded companies will provide a list of analysts who follow the stock. Websites like www.zacks.com and www.multex.com offer access to analysts’ research reports-but the intelligent investor should remember that most analysts do not analyze businesses.

The financial analyst, formerly known chiefly as security analyst, is a person of particular concern to the author, who has been one himself for more than five decades and has helped educate countless others. At this stage we refer only to the financial analysts employed by brokerage houses. The function of the security analyst is clear enough from his title. It is he who works up the detailed studies of individual securities, develops careful comparisons of various issues in the same field, and forms an expert opinion of the safety or attractiveness or intrinsic value of all the different kinds of stocks and bonds.

The Investor and His Advisers late 1990s. These firms spent millions of dollars on flashy advertising that goaded their customers into trading more and trading faster. Most of those customers ended up picking their own pockets, instead of paying someone else to do it for them-and the cheap commissions on that kind of transaction are a poor consolation for the result. More traditional brokerage firms, meanwhile, began emphasizing financial planning and “integrated asset management,” instead of compensating their brokers only on the basis of how many commissions they could generate.By what must seem a quirk to the outsider there are no formal requirements for being a security analyst. Contrast with this the facts that a customer’s broker must pass an examination, meet the required character tests, and be duly accepted and registered by the New York Stock Exchange. As a practical matter, nearly all the younger analysts have had extensive business school training, and the oldsters have acquired at least the equivalent in the school of long experience. In the great majority of cases, the employing brokerage house can be counted on to assure itself of the qualifications and competence of its analysts.* The customer of the brokerage firm may deal with the security analysts directly, or his contact may be an indirect one via the customer’s broker. In either case the analyst is available to the client for a considerable amount of information and advice. Let us make an emphatic statement here. The value of the security analyst to the investor depends largely on the investor’s own attitude. If the investor asks the analyst the right questions, he is likely to get the right-or at least valuable-answers. The analysts hired by brokerage houses, we are convinced, are greatly handicapped by the general feeling that they are supposed to be market analysts as well. When they are asked whether a given common stock is “sound,” the question often means, “Is this stock likely to advance during the next few months?” As a result many of them are com264 The Intelligent Investor

• This remains true, although many of Wall Street’s best analysts hold the

title of chartered financial analyst. The CFA certification is awarded by the Association of Investment Management & Research (formerly the Financial Analysts Federation) only after the candidate has completed years of rigorous study and passed a series of difficult exams. More than 50,000 analysts worldwide have been certified as CFAs. Sadly, a recent survey by Professor Stanley Block found that most CFAs ignore Graham’s teachings: Growth potential ranks higher than quality of earnings, risks, and dividend policy in determining P/E ratios, while far more analysts base their buy ratings on recent price than on the long term outlook for the company. See Stanley Block, “A Study of Financial Analysts: Practice and Theory,” Financial Analysts Journal, July/August, 1999, at www.aimrpubs.org. As Graham was fond of saying, his own books have been read by-and ignored by-more people than any other books in finance.pelled to analyze with one eye on the stock ticker-a pose not conducive to sound thinking or worthwhile conclusions.* In the next section of this article we shall deal with some of the concepts and possible achievements of security analysis. A great many analysts working for stock exchange firms could be of prime assistance to the bona fide investor who wants to be sure that he gets full value for his money, and possibly a little more. As in the case of the customers’ brokers, what is needed at the beginning is a clear understanding by the analyst of the investor’s attitude and objectives. Once the analyst is convinced that he is dealing with a man who is valueminded rather than quotation minded, there is an excellent chance that his recommendations will prove of real overall benefit.

The leading investment counsel firms make no claim to being brilliant; they do pride themselves on being careful, conservative, and competent. Their primary aim is to conserve the principal value over the years and produce a conservatively acceptable rate of income. Any accomplishment beyond that-and they do strive to better the goal-they regard in the nature of extra service rendered. Perhaps their chief value to their clients lies in shielding them from costly mistakes. They offer as much as the defensive investor has the right to expect from any counselor serving the general public.

What we have said about the well established investmentcounsel firms applies generally to the trust and advisory services of the larger banks.*

Financial Services

The so called financial services are organizations that send out uniform bulletins (sometimes in the form of telegrams) to their subscribers. The subjects covered may include the state and prospects of business, the behavior and prospect of the securities markets, and information and advice regarding individual issues.

There is often an “inquiry department” which will answer questons affecting an individual subscriber. The cost of the service averages much less than the fee that investment counselors charge their individual clients. Some organizations-notably Babson’s and Standard & Poor’s-operate on separate levels as a financial service and as investment counsel. (Incidentally, other organizaThe Investor and His Advisers

• The character of investment counseling firms and trust banks has not

changed, but today they generally do not offer their services to investors with less than $1 million in financial assets; in some cases, $5 million or more is required. Today thousands of independent financial planning firms perform very similar functions, although (as analyst Robert Veres puts it) the mutual fund has replaced blue chip stocks as the investment of choice and diversification has replaced “quality” as the standard of safety.tions-such as Scudder, Stevens & Clark-operate separately as investment counsel and as one or more investment funds.) The financial services direct themselves, on the whole, to a quite different segment of the public than do the investment counsel firms. The latters’ clients generally wish to be relieved of bother and the need for making decisions. The financial services offer information and guidance to those who are directing their own financial affairs or are themselves advising others. Many of these services confine themselves exclusively, or nearly so, to forecasting market movements by various “technical” methods. We shall dismiss these with the observation that their work does not concern “investors” as the term is used in this article.

Most investors simply buy a fund that has been going up fast, on the assumption that it will keep on going. And why not? Psychologists have shown that humans have an inborn tendency to believe that the long run can be predicted from even a short series of outcomes. What’s more, we know from our own experience that some plumbers are far better than others, that some baseball players are much more likely to hit home runs, that our favorite restaurant serves consistently superior food, and that smart kids get consistently good grades. Skill and brains and hard work are recognized, rewarded—and consistently repeated—all around us. So, if a fund beats the market, our intuition tells us to expect it to keep right on outperforming.

Unfortunately, in the financial markets, luck is more important than skill. If a manager happens to be in the right corner of the market at just the right time, he will look brilliant—but all too often, what was hot suddenly goes cold and the manager’s IQ seems to shrivel by 50 points. Figure 9-1 shows what happened to the hottest funds of 1999. This is yet another reminder that the market’s hottest market sector— in 1999, that was technology—often turns as cold as liquid nitrogen, with blinding speed and utterly no warning.1 And it’s a reminder that buying funds based purely on their past performance is one of the stupidest things an investor can do. Financial scholars have been studying mutual-fund performance for at least a half century, and they are virtually unanimous on several points:

• the average fund does not pick stocks well enough to overcome its costs of researching and trading them;

• the higher a fund’s expenses, the lower its returns;

• the more frequently a fund trades its stocks, the less it tends to earn;

• highly volatile funds, which bounce up and down more than average, are likely to stay volatile;

• funds with high past returns are unlikely to remain winners for long.

Your chances of selecting the top-performing funds of the future on the basis of their returns in the past are about as high as the odds that Bigfoot and the Abominable Snowman will both show up in pink ballet slippers at your next cocktail party. In other words, your chances are not zero—but they’re pretty close.

But there’s good news, too. First of all, understanding why it’s so hard to find a good fund will help you become a more intelligent investor. Second, while past performance is a poor predictor of future returns, there are other factors that you can use to increase your odds of finding a good fund. Finally, a fund can offer excellent value even if it doesn’t beat the market—by providing an economical way to diversify your holdings and by freeing up your time for all the other things you would rather be doing than picking your own stocks.

Stocks are crashing, so you turn on the television to catch the latest market news. But instead of CNBC or CNN, imagine that you can tune in to the Benjamin Graham Financial Network. On BGFN, the audio doesn’t capture that famous sour clang of the market’s closing bell; the video doesn’t home in on brokers scurrying across the floor of the stock exchange like angry rodents. Nor does BGFN run any footage of investors gasping on frozen sidewalks as red arrows whiz overhead on electronic stock tickers.

Instead, the image that fills your TV screen is the facade of the New York Stock Exchange, festooned with a huge banner reading: “SALE! 50% OFF!” As intro music, Bachman-Turner Overdrive can be heard blaring a few bars of their old barnburner, “You Ain’t Seen Nothin’ Yet.” Then the anchorman announces brightly, “Stocks became more attractive yet again today, as the Dow dropped another 2.5% on heavy volume—the fourth day in a row that stocks have gotten cheaper. Tech investors fared even better, as leading companies like Microsoft lost nearly 5% on the day, making them even more affordable. That comes on top of the good news of the past year, in which stocks have already lost 50%, putting them at bargain levels not seen in years. And some prominent analysts are optimistic that prices may drop still further in the weeks and months to come.” The newscast cuts over to market strategist Ignatz Anderson of the Wall Street firm of Ketchum & Skinner, who says, “My forecast is for stocks to lose another 15% by June. I’m cautiously optimistic that if everything goes well, stocks could lose 25%, maybe more.”

“Let’s hope Ignatz Anderson is right,” the anchor says cheerily. “Falling stock prices would be fabulous news for any investor with a very long horizon. And now over to Wally Wood for our exclusive AccuWeather forecast.”

ment.” If, after checking the value of your stock portfolio at 1:24 P.M., you feel compelled to check it all over again at 1:37 P.M., ask yourself these questions:

• Did I call a real-estate agent to check the market price of my house at 1:24 P.M.? Did I call back at 1:37 P.M.?

• If I had, would the price have changed? If it did, would I have rushed to sell my house?

• By not checking, or even knowing, the market price of my house from minute to minute, do I prevent its value from rising over time?10 The only possible answer to these questions is of course not! And you should view your portfolio the same way. Over a 10- or 20- or 30- year investment horizon, Mr. Market’s daily dipsy-doodles simply do not matter. In any case, for anyone who will be investing for years to come, falling stock prices are good news, not bad, since they enable you to buy more for less money. The longer and further stocks fall, and the more steadily you keep buying as they drop, the more money you will make in the end—if you remain steadfast until the end. Instead of fearing a bear market, you should embrace it. The intelligent investor should be perfectly comfortable owning a stock or mutual fund even if the stock market stopped supplying daily prices for the next 10 years.11 Paradoxically, “you will be much more in control,” explains neuroscientist Antonio Damasio, “if you realize how much you are not in control.” By acknowledging your biological tendency to buy high and sell low, you can admit the need to dollar-cost average, rebalance, and sign an investment contract. By putting much of your portfolio on permanent autopilot, you can fight the prediction addiction, focus on your long-term financial goals, and tune out Mr. Market’s mood swings.

Now let’s take a moment to look at some of the major financial developments of the past few years:

1. The worst market crash since the Great Depression, with U.S. stocks losing 50.2% of their value—or $7.4 trillion—between March 2000 and October 2002.

2. Far deeper drops in the share prices of the hottest companies of the 1990s, including AOL, Cisco, JDS Uniphase, Lucent, and Qualcomm—plus the utter destruction of hundreds of Internet stocks.

3. Accusations of massive financial fraud at some of the largest and most respected corporations in America, including Enron, Tyco, and Xerox.

4. The bankruptcies of such once-glistening companies as Conseco, Global Crossing, and WorldCom.

5. Allegations that accounting firms cooked the books, and even destroyed records, to help their clients mislead the investing public.

6. Charges that top executives at leading companies siphoned off hundreds of millions of dollars for their own personal gain.

7. Proof that security analysts on Wall Street praised stocks publicly but admitted privately that they were garbage.

8. A stock market that, even after its bloodcurdling decline, seems overvalued by historical measures, suggesting to many experts that stocks have further yet to fall.

9. A relentless decline in interest rates that has left investors with no attractive alternative to stocks.

10. An investing environment bristling with the unpredictable menace of global terrorism and war in the Middle East.

Much of this damage could have been (and was!) avoided by investors who learned and lived by Graham’s principles. As Graham puts it, “while enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster.” By letting themselves get carried away—on Internet stocks, on big “growth” stocks, on stocks as a whole—many people made the same stupid mistakes as Sir Isaac Newton. They let other investors’ judgments determine their own. They ignored Graham’s warning that “the really dreadful losses” always occur after “the buyer forgot to ask ‘How much?’ ” Most painfully of all, by losing their self-control just when they needed it the most, these people proved Graham’s assertion that “the investor’s chief problem—and even his worst enemy—is likely to be himself.”