Three Things Every Investor Needs to Know

Novice investors and pros alike are bombarded with lots of media about investing, and it's hard to sort out the noise from the important things. In this article, I'll address three fundamental things every investor needs to know.

1. Figure Out a Reasonable Allocation
The first question investors have to ask is what the proper asset allocation is for them. Of the three questions, this is the one they should answer most definitively at the outset. The two most sensible and straightforward pieces of allocation advice, in my view, are Ben Graham's assertion that most investors should be 50/50 stocks/bonds with their long-term money and Jack Bogle's assertion that 100-minus-your-age should be your stock exposure. Some people make Bogle's rule a bit more aggressive by substituting 110 for 100. That's fine, too. The important thing is to settle on an allocation and stick with it.

If you're unsure about how to pick between Graham and Bogle, consider dividing your portfolio in two, and running half of it according to Graham's rule and the other half according to Bogle's. Investing doesn't have to be an all-or-nothing proposition.

Similarly, once you've established an allocation, if you're unsure whether you should use index funds or actively managed funds that Morningstar recommends, divide your portfolio in half and do both. Don't let nettlesome questions paralyze you. If you can't decide between two reasonable strategies, there's typically no harm in doing both.

Isn't the asset allocation advice I'm suggesting outdated? Indeed, after the market's collapse in 2008 and surge in 2009, the popular press has dubbed asset allocation or buy-and-hold strategies finished. Now "tactical allocation" (flipping among asset classes) is the order of the day.

But don't you believe any of this. Nobody can time the market's short-term gyrations. When Warren Buffett wrote his New York Times op-ed piece encouraging investors to stick with stocks, the S&P 500 Index was at 946, and proceeded to plummet over the next few months to 676 on March 9, 2009. Does that mean the Oracle of Omaha has lost his touch, and that maintaining a long-term allocation to stocks doesn't work?

Not at all. First, Buffett said in that piece that he had no idea what the market would do over the shorter term. More importantly, the S&P 500 Index is now at around 1200, making the Oracle still look pretty smart. Sticking with stocks as part of a prearranged asset-allocation plan has worked.

In fact, if you rebalanced your portfolio consistently, buying stocks the whole way down in late 2008 and early 2009 to maintain your prearranged allocation, you've come through the past two years relatively unscathed.  The Vanguard Balanced Index Fund (VBINX), for example, which maintains a 60%/40% split between the MSCI U.S. Broad Market Index and the BarCap U.S. Aggregate Bond Index is down 1.7% cumulatively from the beginning of 2008 through April 7, 2010. So stick to a prearranged allocation, and rebalance often.

Buffett's teacher, Graham, thought rebalancing was useful also because it gave the investor something to do, satisfying the urge to trade in a healthy way. Rebalancing can cause you to incur transaction fees and tax costs, but if you've got money in tax-advantaged accounts and you can avoid the fees by sticking with no-load funds or keeping within the same family of load funds, rebalance to your heart's content.

2. Know the Market's Valuation
Second, investors should look at economist Robert Shiller's website to see where the S&P 500 Index is trading relative to its underlying companies' 10-year average earnings. This is sometimes called the "cyclically adjusted P/E," or "CAPE." It's also sometimes called the "Graham & Dodd P/E" because Ben Graham and David Dodd, in their investing classic Security Analysis, talked about trying to understand a business's earnings over an entire economic cycle and paying as little as possible for them. Shiller's data does this for the whole market, or the S&P 500 Index. Right now, the market's trading at around 22 times cyclically adjusted earnings.

What's important about looking at CAPE is not that it can help you change your allocation, because, after all, CAPE only relates current prices to the average earnings companies have achieved in the past. So CAPE isn't perfect, but it does provide a valuation touchstone to set your expectations. The vast majority of investors should keep their allocations steady, but seeing CAPE at, say, 20x or above should lower expectations for the future, because that means earnings will have to grow at prodigious rates to produce strong future returns.

This can be useful in encouraging you to rebalance. It can help you when you're talking to your friends and family, and they're giddy with gains they've recently made. If you know stocks are starting to look expensive (Graham thought a cyclically adjusted P/E above 20x was expensive), you won't be as likely to get carried away with their giddiness and buy stocks at high prices. You'll be more inclined to rebalance by selling stocks into a surging market to maintain your original prearranged allocation.

3. Know the Yield of the 10-Year U.S. Treasury Note
Third, investors should know the yield on the 10-year U.S Treasury Note (right now, around 3.9%). This will tell you the interest rate you'll receive for lending money to the U.S. government for 10 years. This is important because lending to the U.S. Government is basically risk-free from a credit standpoint, so you can start to think about how much extra yield you're getting paid to lend to other entities like corporations that are typically riskier than the government. You can even invert CAPE to get an "earnings yield" of the stock market and compare it to the 10-year U.S. Treasury.

So if CAPE is at 20x (or yielding 5%--1/20) and the 10-year note is yielding 4%, you know that you're not getting paid a lot more to own stocks than bonds. Of course, stocks have the possibility for growth, while bonds don't, so, again, this isn't to argue for changing your allocation in a radical way based on these numbers. But it can help set your expectations. Having the proper expectations is one of the things that helps investors stay the course.