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Undercover Investment Tips

Tim Harford writes the "Dear Economist" column for The Financial Times, in which he answers readers' personal dilemmas, tongue-in-cheek, with the latest economic theory. His new book, The Undercover Economist, reveals the hidden economic ideas in day-to-day life. It includes chapters on how to think about the stock market, the connection between scarcity and profits -- and how to buy a cheaper cappuccino.

Tim, what's so Foolish about economics?
Economics has long been the preserve of the Wise -- spouting inscrutable statistics about inflation and unemployment. I thought that this was strange, because economics is all around us: When we buy a cup of coffee, roam around a supermarket, or get stuck in traffic on the way home, these are situations governed by economic ideas that the Foolish can understand. So I wrote a book about economics in everyday life -- and that includes, for the Fools among us, the stock market. I try to explain how the stock market works and how economics can help you demystify it.

A lot of economists seem to believe in efficient markets. Do you?
The market is smart, not perfect. You can beat the market, but it won't happen by accident or because you trust the stock tips in the papers.

The stock market is a bit like a row of lines at the supermarket checkout. Picking a great value stock is like picking the shortest line: It's possible, but never obvious. If it had been obvious which was the shortest line, then people would have joined it, and it wouldn't be the shortest anymore. The same with a good stock pick: If it were a sure thing, the price would already have risen. That doesn't mean there are no good picks, just that you need to work to find them.

The truth is, unless you've made a study of supermarket lines, you may as well just pick one at random and not worry about it. In the same way, if you have no time or inclination to research the stock market, then you should just buy an index fund. I would only advise someone to start picking their own stocks if they enjoy it and are willing to do the homework.

You wouldn't advise people to trust a fund manager?
No. We all know the basic statistics that index funds beat most fund managers, and we also know that even if a fund manager is doing well today, he may not do well tomorrow. For me, there's a reason for these statistics: Fund managers are much better informed than ordinary investors, but they aren't necessarily rewarded for making the right calls. The Undercover Economist tells the story of Tony Dye, a British fund manager widely known as "Doctor Doom" for his repeated predictions that the bubble was ... well, a bubble. He made absolutely the right call over a five-year time horizon, but he was ridiculed by the newspapers, abandoned by his clients, and took early retirement just before the bubble burst, with many observers concluding that he had been forced out. But what's a fund manager for, if not to make the right calls over five to 10 years? Tony Dye's experience suggests that fund managers are not being rewarded for maximizing returns to their investors, but for running with the herd.

What do you look for in a stock?
Think very carefully about whether the company you're investing in has some scarce resource, something that competitors can't easily duplicate. In my book, I talk a lot about the value of scarcity, and I think that we would never have had an Internet bubble if investors had thought more sensibly about this. Any company that can operate out of someone's bedroom is not going to make sustainable profits, because sooner or later it will have lots of competitors.

Of all of the Internet stocks, the only one that has really established a position that's hard to imitate is eBay (Nasdaq: EBAY  ) . To copy eBay, you'd need to lure the buyers and the sellers away simultaneously, and that's not easy. Yahoo! (Nasdaq: YHOO  ) got there first in Japan, so in Japan, it's Yahoo! with the unassailable position: eBay had to pull out. But the others, even Amazon (Nasdaq: AMZN  ) and Google (Nasdaq: GOOG  ) , are doing something that other companies can imitate. They're doing well at the moment, but we'll see whether they keep their privileged competitive position.

This all sounds quite Foolish. Do you disagree with The Motley Fool on much?
I'm a huge fan of the Foolish approach, but I do have a slightly different perspective. I think that Fools tend to focus too much on the stock market and not enough on other investments. There's a good reason for that: Historically, the stock market has been dominated by the Wise, and it's been intimidating for the average person. I think that in the future we're going to see more Fools, and that will mean wider participation in the stock market -- great news for the newcomers, but it will mean that stocks will be more expensive and won't deliver quite such exciting returns as in the past.

Most people understand that a diversified portfolio is an easy way to reduce risk, but forget that real diversification means looking beyond the stock market: bonds, cash, property, and more. An education is an investment -- it ties up cash now and delivers rewards later. When I took unpaid leave to write my book, that was an investment, too. I am sure most Fools wouldn't disagree, so this is a difference of emphasis.

What about your own portfolio?
That's a great question for an economist, because economists always argue that you should judge people by their actions, not their words.

My major investments are The Undercover Economist book, a house in London (although I live in Washington, D.C.), a modest pension in a British index fund, and high-interest savings in pounds and dollars. I expect to retire to England one day, and so too much foreign investment exposes me to a lot of unwelcome currency risk. I keep a fair amount of my investments in quick-access bank accounts because I am about to change jobs from being an economist to being a writer. That change has some costs and some uncertainties, so it's worth giving up some investment returns to have the flexibility to respond.

The house and the pension have done very well. I invested fairly heavily in British stocks just before the invasion of Iraq, when everyone was very gloomy. They've climbed about 60% since then. The highest-risk investment, though, has to be the book. In a few months, I'll have a much better idea as to whether it's paid off, but I can promise that writing it was even more fun than picking stocks.

Let's close by playing Motley Fool co-founder David Gardner's game, which is called "Buy, Sell, or Hold." So what's your view on GM? Buy, sell, or hold?
Hold. The company's market capitalization is about $16 billion, and I've seen estimates of the unfunded liabilities of $70 billion. They're losing money at a rate of over $5 billion a year. Their bonds are now "junk" status. If we lived in a free-market world, I'd say the shares were next to worthless, but politics matters, too. I think General Motors (NYSE: GM  ) may still have the political clout to dump some of their liabilities onto their workers, pensioners, and the taxpayers. Surely that must be what the current shareholders are holding out for.

How about Apple?
Sell. The price-to-earnings ratio is around 35, and Apple (Nasdaq: AAPL  ) can't justify that ratio without dramatic further growth. Profits have already quadrupled over the previous year, but is it reasonable to expect the phenomenon to continue forever? Can you imagine Apple having a decade of success that leaves 2005 in the shade? That's what is necessary to justify the current prices. As far as I can see, everyone in the world already has an iPod, and the competitors will catch on. Sony (NYSE: SNE  ) invented the Walkman, but it didn't have a monopoly forever.

Finally, what about American real estate?
Sell, unless you have other good reasons to keep hold of the property -- such as, you live in it and you love it. My reasoning is pretty simple: Bob Shiller, the economist who called the Internet bubble early, used a very simple argument that I describe in my book. He just looked at the relationship between stock prices and corporate earnings for more than a hundred years, and it was as clear as day that the market was totally out of proportion to anything that had come before, even the bubble of the late 1920s. Now, Shiller has constructed a long-term index for house prices, and guess what -- it looks frighteningly similar.

Who isn't looking for great stocks at great prices? But it takes time and effort to identify the contenders. Let Motley Fool co-founders Tom and David Gardner help you zero in on the hottest picks with afree trialsubscription to Motley Fool Stock Advisor.

Tim Harford's book,The Undercover Economist, was published today, Nov. 1, 2005, by Oxford University Press.

Neither Tim nor John owns any shares in any of the companies mentioned in this article.

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