Businessweek recently broke away from their traditional audience, and featured an article of Advice for Young Investors. The name is slightly misleading, as it includes all financial facets – from insurance to home ownership – as investments.

The advice is mediocre at best, but it’s an interesting read, because it offers insight into the young financial mind (or at least what the media is telling us to think).

As I like to do with these types of articles, here is their list, along with my commentary.

1. Cash is king

Although cash offers the lowest returns, it’s a good foundation for any financial plan.

Without a cash reserve, your plans are at risk to be derailed by emergencies or a loss of income. Most young people just make up the difference with credit cards, but others could be forced to sell assets at the worst possible times.

Having cash may not help you get ahead, but it will make sure you don’t go backwards.

How much of a reserve do you need? That’s a question of eternal debate, but the most common answers suggest anywhere from 3-9 months.

2. Got insurance?

It’s probably not the insurance you’re thinking about. Most young people don’t need life insurance, but everyone needs disability. You don’t want a lifetime of potential income to disappear because of an accident.

I signed up for as much disability insurance as possible from work, paying extra for additional coverage.

3. To own or not to own, that is the question

The biggest decision that most young people make is whether to rent or buy their home. The common perception is that owning is an investment, but real estate generally doesn’t perform as well as stocks, and it’s a lot more expensive. There is maintenance, taxes, emergency repairs, etc… that are exclusive to owning a house. Not to mention there is a significant time commitment.

In the end, it really comes down to your personal preference. Just make sure that you do the math, and consider all costs in your decision.

Also, don’t buy more house than you need, thinking it will increase as an investment… you’re much better off being modest and saving/investing the extra money you would’ve put into the house.

4. What job security?

The author points out that no ones job is safe right now, which I agree with. However, I disagree with one of his takeaways.

He says that your job security should be taken into considering when choosing a risk level for your investments. I disagree.

Investments are done over the long term. If you need your money to supplement your regular income, then you’re not really investing, and you’re gambling with cash that you don’t have.

Your risk tolerance should be determined by how long you’ll be investing… not how secure your current job is.

5. What’s your risk tolerance?

Another failure for the author. He underestimates the impact of long term investing.

If you’re saving for the long term, you probably have some time to ride out market turbulence… That’s how it’s supposed to work in the abstract, anyway. In reality, the ups and downs of the market can leave you anxious and cause you to bail out of investments too early.

While that statement is technically true, to me it doesn’t do enough to explain that short term ups and downs are normal, and you should just ride them out. It also doesn’t do anything to remind young investors that being overly cautious is a bigger threat than being too aggressive.

6. Stocks are risky

Another swing and a miss! Three in a row.

The author is right…stocks are risky, and you shouldn’t have any money in the market if you’ll need it in the next five years.

But the article again continues to be overly cautious, suggesting that:

For young people in their twenties, 50% or more of a 401K or other retirement plan could go into equities. (my emphasis).

Choosing 50% as a benchmark is misleading, because it suggests that it’s an upper limit. This could deceive people into choosing a 50% stock mix and thinking that they’re being aggressive enough. In reality, investors of any age – and almost certainly young investors – will probably want a portfolio that is more than 50% stocks.

Some people are even suggesting that young investors should put 100% of their portfolio in stocks (a strategy which I follow).

By choosing an overly cautious approach, you’re selling yourself short and missing out on decades of earning power.

7. Get started – now now now!

We’re back on solid ground with this one. Whatever your plan – start now. The best time to plant an oak tree is 20 years ago. The second best time is now.

8. Balance your priorities

Managing your finances is a lot like a juggling act. You’ve got to balance the short-term and long-term, paying down debt vs. investing for retirement, etc…. It’s important to make sure you’re meeting all your goals, and not selling yourself short by focusing on only one thing at a time.

As an example, I’m building an emergency fund as I’m paying down debt. I’ll be opening a Roth IRA soon. Starting on all three will be better for me financially than just focusing on one.

9. Be flexible

It sounds like decent advice at first, but this is another area where the author just doesn’t get it.

The financial crisis and stock market collapse have changed the rules for investors… For now, he’s allocating a maximum of only 50% of portfolios to stocks… This may not be the best time to set up a financial plan that you stick with for life.

Financial plans are not dependent upon the ebb and flow of the market. If anything, it’s more important to stick to your plan in tough times.

Being cautious after the market has crashed won’t help you get your money back. If anything, it will only hurt your recovery when it finally turns around.

10. Can you save and invest too much?

It’s rare that young people set aside too much money, so I don’t think we have to worry about this. If saving too much is a problem for you, then I’m jealous.

Most people should be saving more cash and investing more in their retirement, but there are times when it makes sense to put your money elsewhere. Investing money in yourself – through training or education – could greatly increase your earning ability over your lifetime.

My thoughts

The advice in this article says more about the media than it does finance.

I feel like the mainstream media just doesn’t get it when it comes to young adults and money. It seems like they’re trying to use the economy to frighten us, when in reality, it’s an opportunity. We have 30-40 years until retirement.

They should be giving on advice on how to take advantage of the market… not telling us to bury our heads in the sand because the economy is scary.

We’re turning into a nation of whimpering slaves to fear – fear of war, fear of poverty, fear of random terrorism, fear of getting down-sized or fired because of the plunging economy, fear of getting evicted for bad debts…

- Hunter S. Thompson, 2003

One thing that’s always bugged me about the media is how they pretend to be impartial observers, when the reality of it is that there is no way to observe something without interfering.

It’s physically impossible, even on a sub-atomic level. With the stock market, the stories that the media covers – and how they cover them - affects how investors behave.

The media loves to cover a sob story or train wreck, and they’ve been doing it to perfection with the economy. Fear gives them higher ratings than practical advice, so they resort to scare tactics.

Take a recent headline I saw on CNN on Friday, February 20th.

WALL STREET ON THE SKIDS

It was even accompanied by a live report from the floor of the NYSE. With a headline so shocking, you’d expect that the market was bottoming out.  But you’d be wrong.

The market was only down 129 points, which would have represented a decline of 1.73% from the previous day’s close. But why did CNN have the shocking headline? Is a drop of 1.73% unusual?

Not at all.

Over the past year, the average daily change in the market has been 1.71%.

In fact, 37.2% of the previous year’s trading days had a swing that was greater than what CNN was reporting on with doom and gloom. 13% actually had a change that was more than double what CNN was covering live.

(source: data from Yahoo Finance and my love of spreadsheets)

The take away? Don’t believe the hype. Make your decisions because you’ve done the math and thought about the consequences. Not because you’re reacting to a talking point, or some angry screaming haircut on TV told you to “SELL SELL SELL”.

I’m going to end this with another Hunter S. Thompson quote, because one is never enough. The man was a genius, and believed in never quitting – especially when “the establishment” gets you down. Here’s a quote from one of my favorite books, “Fear and Loathing in Las Vegas”, that shows his view on persistence in the face of fear.

“I hate to say this,” said my attorney…”but this place is getting to me. I think I’m getting the Fear.”

“Nonsense,” I said. “We came out here to find the American Dream, and now that we’re right in the main vortex you want to quit.” I grabbed his bicep and squeezed. “You must realize,” I said, “that we’ve found the main nerve.”

“I know,” he said. “That’s what gives me the Fear…”

“It won’t stop,” I said. “It’s not ever going to stop.”

You did what you were supposed to do.  College. Graduate school, maybe. Bought a home. Invested in mutual funds.

And now? You have student debt.  Your degree has not shielded you from unemployment. The house is worth 20% less than two years ago, and your retirement portfolio is down 40% from its peak.

While this isn’t an unusual situation for anyone, it’s especially dangerous for younger people who are just getting started in the world of finance. 

We have less to lose money-wise, but we’re also at a delicate and impressionable stage.  Many young people will get burned, and some may resort to a lifelong pattern of fear and risk aversion.

Do not avoid risk - or insult Ukraine

The author agrees, and asks his readers:

Are we in the process of minting a new generation of adults who are averse to taking chances, whether it’s buying real estate or investing in stocks?

It’s too early to tell how anyone – let alone young adults – will respond to the financial crisis, but there are already some troubling signs.

According to a study quoted by the article, only 45% of young households (defined as under the age of 40) have a majority of their investments in stocks instead of bonds.  While it may not seem shocking on its own, its worth noting that more than 50% of older households (ages 41-64) choose a more aggressive portfolio consisting of at least 50% stocks.

That means that older investors – even those close to retirement – are investing more aggressively than young people.

Another indicator is a survey of a financial management class at De Sales University.  The class was asked what portion of their portfolio they would invest in stocks.  Even though this was a class of  informed and well-read students, most of the class said they would put less than half of their money in stocks.  When asked for the reason why, they cited fear of job loss, lack of morals on wall street, and general economic fear.

This is counter productive.  The time to have been conservative would have been when you expected the markets to go down.  Not after they’ve already crashed.

Why would you consider taking less risk NOW after most of the risk has already been paid for in the market over the past 12 months?

Of course, you should only make decisions based on what you think your investments will do in the future…not what they’ve already done.  But for younger investors, being overly cautious can be worse than being too aggressive.  Keep in mind the following facts (all according to the Oblivious Investor):

• Inflation averages 3.25%
• Bonds earned an average return of 5.2% from 1928 to 2008
• Stocks earned an average return of 9.07% from 1928 to 2008

That means that after inflation, bonds return 1.95%, while stocks return 5.82%. The percentages don’t give a good indication of how much being cautious can cost you though.

Instead, I’m going to give an example. I’m assuming that you start with $10,000 in your 401K, and contribute an additional $200 a month for 30 years. For the math, I relied on a calculator from the Suze Orman’s Young, Fabulous and Broke website.

If you invest exclusively in bonds, you’ll have a total of $115,772 after thirty years:

Invest exclusively in stocks, and you’ll have $244,160:

I know that is oversimplifying things a bit, but still – you’ll have 110% more with the aggressive portfolio. That’s a huge difference, especially considering that stocks only return about 4% more per year.

To be fair, the difference may or may not be that big over time. You’re likely to invest more than $200 a month, but you’re also probably going to gradually convert more of your portfolio from stocks to bonds each year. But the point is still valid – you’re missing out if you’re too conservative.

Many investors are afraid of losing money, so they keep out of stocks. Ironically enough, they end up missing out on even more money by doing this.

I’m not suggesting that you invest only in stocks, and I’m not telling you to stay away from bonds. My point is that any decision you make should be motivated by reason. Don’t sell yourself short by giving into fear and emotion.

Want to know how to succeed at investing?

Stop trying.

No, I don’t mean that in some sort of New Age/philosophical way. I mean it quite literally.

Far too many investors waste time and money engaging in what history has shown (repeatedly) to be fruitless endeavors:

• Timing the market
• Picking stocks to outperform the market
• Predicting the next move in interest rates, real estate, commodity prices, or anything else.

Just stop trying. Instead, how about focusing on one of the things that you really can control? For example…

Asset Allocation

Without a doubt, an investor’s asset allocation will have an enormous impact on what his/her returns look like (both year-to-year returns as well as long-term returns).

The more heavily you weight your portfolio toward equities (stocks), the greater your long-term return will be. On the other hand, more equities also means more volatility, so it’s important not to go too heavily into stocks if you’re going to be retiring soon.

For younger investors, I often suggest a 100% stock allocation. After all, if you’re not going to be using the money for another 20-30 years, a temporary market decline has literally no negative effect on you. (Unless you let it scare you into selling at a market low point!)

Minimizing Costs

Investment costs are overlooked surprisingly often. It’s easy to understand, I suppose, given that the difference between low-cost funds and high-cost funds is really just 1-2% per year. But over a long enough period of time, a 1% difference is huge.

Example: $1,000 invested at a 9% rate of return over 40 years turns into $31,409. $1,000 invested at an 8% rate of return over 40 years turns into just $21,725. That’s more than a 30% decline in ending value.

When selecting mutual funds, it can be tempting to ignore investment costs and simply look at historical returns instead. The big problem with this strategy, however, is that funds have a very strong tendency to revert to the mean. (In other words, after a period of outperforming the market, they generally have a period of underperforming.) Investment costs, however, tend to stay the same from year to year. As a result, the expense ratio of a fund has proven to be one of the best predictors of its long-term performance.

Minimizing Taxes

There’s no sense in paying more taxes than you absolutely have to. Take advantage of the preferential tax treatment given to 401k’s and IRAs. If you have a 401k at work, make sure that you’re contributing enough to get the maximum matching contribution from your employer. If your employer doesn’t offer a 401k (or doesn’t make matching contributions), it’s probably best to open a Roth IRA.

In Summary

Again, given that history has shown us that things like picking stocks and timing the market tend not to be successful, why bother wasting your time and money on them (especially when there are other things that you could be doing that really do improve your investment results)?

About the Author: Mike writes at The Oblivious Investor, where he regularly reminds readers not to bother with things they cannot control, and focus instead on things they can. If you like this post, subscribe to his blog to read more.

They tell the story of a few investors who have come to their senses…but are they really good examples?  Let’s take a look.

One investor said:

I certainly had a queasy stomach throughout October,” said the 61-year-old retired lawyer from Vancouver, B.C. “I had to keep saying to myself … These things will pass.

The article goes on to say that “now he’s feeling better….”

Sounds great, doesn’t it?  But let’s take a closer look and see what Mr. Bass did when he wasn’t so calm.

During the darkest days of the stock market’s slide last month, Jack Bass withdrew stock from his retirement accounts

I know Mr. Bass is older, but selling when stocks are crashing can be a deadly mistake. 

Let’s take a look at another of their relaxed investors.

An avid investor from Providence, R.I., isn’t feeling the anxiety he did a few weeks ago at the height of the market scare…

Another good start!  It sounds like he has stopped reacting emotionally, and is thinking of the big picture.  But let’s read some more just to make sure:

…when he shifted $50,000 from stocks to cash in his 401(k) account.

By selling at the height of the scare, he realizes his losses at the worst time.  He may think his funds will continue to drop indefinitely, but it’s more likely that he’s just reacting emotionally, rather than considering any long term implications.

According to tradingsphere.com, most investors tend to sell low and buy high, not because of rational decisions, but because of human psycology and the tendency to chase yesterday’s hot returns.

If that’s not enough, smartmoney.com takes it a step further and says:

An overwhelming impulse to get out, cash out, hide out; it’s all-too human. That’s why it’s a grave error. Emotional investors are poor investors. They buy high and sell low. Today’s market swoon is just the latest perfect trap to lock in losses. Don’t do it.

It goes on to say that if you have two to five years to ride out the downturn, you should stick it out.  After all, when you chose an investment strategy, it was (presumably) a rational, well thought out decision.  You should not abandon your game plan when things start going downhill.

If your strategy needs updating, you still should not pull out en masse.  Instead, take a disciplined approach and adjust your investments over time.  It’s another example of dollar cost averaging.  By changing your allocation over regular intervals, you can protect yourself from fluctuations in the market.

The bottom line is that your investment strategy should not depend on wild swings.  It should be based off of long term perfomance.  If your strategy needs adjusting, it should be done gradually and rationally - not as a knee jerk, emotional reaction to the latest financial news.

I am not confident in my ability to pick individual stocks, so this discussion applies to index funds, whether they be broad such as the S&P 500 or international index funds, or more targeted like mid-cap or small-cap funds.

One indicator of the value of a stock is its price-to-earnings ratio.  The price is the market price of a stock, and the earnings is the earnings per share for the most recent twelve month period.  It stock A has a price of $50, and earnings of $10 per share, the P/E ratio is $5.  You are essentially paying $5 for every dollar of earnings.  In general, when comparing similar companies, a stock with a lower P/E ratio is seen as a more attractive investment, as you are paying less for every dollar of earnings.

Here are some of the current P/E ratios for a variety of countries and indices: (source: http://finance.yahoo.com/expert/article/futureinvest/118916):

The last time prices and P/E ratios were this low was in the late 70’s and 80’s, but the economy is in much better shape today.  The unemployment rate then was 10.8%, more than 4% higher than it is today.  Inflation was much worse too, hitting as high as 15%.

So why is the low P/E ratio significant?  Historically, the P/E ratio of the US stock market has been around 15.  This suggests that current stocks MAY be underpriced.  Again, past performance is not an indicator the future, but it is one thing to consider.

Additionally, starting in 1982 - the last time P/E ratios were this low – the US experienced one of the biggest bull markets in history.  In January 1982, the Dow Jones Industrial Average closed at $871.10.  Five years later (December 1986), it had more than doubled to $1895.95.  Another five years later (December 1991), the average closed at $3168.83 – almost four times as much as it started in 1982.

This growth isn’t typical, but it does seem to suggest that stocks could be in for a big rebound in the next few years, even if there is still another year or two of declines.

What am I going to do about the stock market?  I’m going to take the advice of Douglas Adams, and not panic.

I’ve been very hesitant to check my 401K recently, partially because I knew it would be bad, but also because I know that I’m investing for the long term.  The crashing stock market just means I’m buying the same funds I normally buy, only at a 25% (or more) discount.

But curiosity finally got the better of me, so I’ve been checking my returns several times a week recently.  The result?  I’ve lost 43% year-to-date.  But I’m not worried.  In fact, I’m actually buying more stocks.  Here’s why.

I’m investing for the long term.  I know that the stock market will eventually recover, and thanks to the wonders of dollar cost averaging, I’ll be up significantly when the market eventually starts increasing again.

I have faith that the financial system isn’t going to collapse.  If it does, we’ve all got a lot bigger problems than our retirement, because that means that the country is probably in a state of chaos and martial law.  Again, I just don’t see that happening.  If you do, then you’re probably better reading www.survivalblog.com instead of finance sites.

But regardless, 43% looks bad.  And it is, but I wanted to try to give that number some context.  First, I looked at the sum of deposits in my 401K, both from myself and my employer: $13,048.  Then, I looked at the present value of my 401K as of closing today: $9315.27.  That means that over the history of my 401K, I’ve lost 28.6%.  Still bad, but not nearly as bad as 43%.

After that, I took it a step further.  I divided the present value by the sum of my personal deposits.  The number: 165.9%.  Yes.  That’s right.  Right now, I have a profit of 65.9% on my investments.  So even with the market spiraling out of control, I’m still getting an incredible rate of return on my money.  I know that employer match programs vary, but if you have any such program available to you, it’s probably best for you to take advantage of it.

Still, I’ll admit that I’ve been tempted to change my higher risk investing strategy.  Then reason got the better of me, and I decided to stay the course.  When I chose my investments, I chose them carefully, looking at ten year returns, expense ratios, and Morningstar ratings.  That logic hasn’t changed.  It’s hard to stay on a losing path, but I realize that when the market recovers, I’ll be making above average gains, just like I’m having below average returns now.

I have only made one change in my plan: to invest more in stocks.  I had been investing in about 5% bonds, because that number tends to yield just as good of results as investing 100% in stocks, but with a lot less risk and volatility.  But the week before last, I moved my money – 7% of my portfolio – from bonds to a very low expense (.03%) S&P 500 index fund.  I also changed my future contributions in a similar manner.  Please note – such an aggressive strategy is not for everyone.  All I’m trying to say is that now is not the time to abandon stocks.  If anything, now is a good time to invest more in them.

My reasoning is that the market is down significantly.  It may not have bottomed yet, but I’m posetive that the market will recover.  Even if it continues to go down, it won’t stay this low in the long run.  It was below 9000 when I changed my strategy, and closed above 9600 today. 

I don’t believe in timing the market, but If I want to take advantage of this temporary downturn, I need to be in stocks – not bonds.  It may take some time, and cause even more short term losses, but I’m posetive that this will be a decision that pays off eventually.  After all, I do have 30+ years before retirement.