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WTH's Informal Getting Started Guide

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By WatchingTheHerd
October 11, 2001

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I've noticed over the last couple of weeks that the CSCO board seems to have a relatively new investor in our midst. There was also a recent posting asking a question about whether CSCO would be a good long term (5+ year horizon) investment at this point.

I've seen posts on other boards (mostly the tech stock boards that I watch) asking similar questions to the effect of "Is NOW a good time to invest in XYZ now that it's 80% off its peak?" Maybe I'm reading too much into the question but what I think some people are actually thinking is "Is NOW a good time to shoot my wad on that one stock touted to be the next MSFT or CSCO now that it's trading at 80% off its high?"

There's tremendous danger in "gambling" in the long-term portion of your portfolio on one or a few stocks. While attempting to summarize why that's a bad idea and a more sensible way to pick your long-term stocks, it occurred to me that many new investors should first ensure their short term investments are sound before thinking about the long term.

I offer the following as a free guide for those just getting started. And remember, I promise it's worth every penny you paid for it... (smile)

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If you're just starting out investing, here's some suggestions of steps you should take before diving in....

1) Use Quicken or your favorite spreadsheet program to first categorize and track WHERE you currently spend your money on a monthly basis. One of the best ways to save money so you HAVE something to invest is to first understand where the money you have is going. Categories would include:

* mortgage interest / principal or rent expense
* real estate taxes (for homeowners)
* food
* car payments, car repairs, gasoline, car insurance, and car-related personal property taxes
* monthly utilities (electric, natural gas, water, sewer)
* entertainment
* gifts / charitable contributions
* child tuition / your tuition, etc.

2) In a separate spreadsheet page, mock up a yearly projection of your cash flow that reflects all sources of income, systematic savings (such as 401j contributions and employer 401k matching), and fed/state/local taxes and use this spreadsheet to figure out how much you SHOULD be able to be saving each year in cash. (If you really knock yourself out on this spreadsheet, you can use it to predict your yearly tax bill and adjust your withholding to minimize your over-withholding if you're like me and don't like lending the IRS your money until tax refund day.)

3) Compare the figures in 1 and 2 with your checkbook and savings account balances over the past few years. If your spreadsheets tell you that you should be saving $8000 per year and your checking/savings have not been increasing by $8000 each year, go back to your logs of expenses and try to find out what you're forgetting. Again, if you don't know where your money's going, you should probably focus on sorting that out first before investing in stocks, bonds, CDs, etc.

4) Once you're comfortable with the accuracy of your budget and cash flow spreadsheets, figure out how much free cash you should be creating in a calendar year.

5) At this point, you can now consider going about allocating that free cash to the following three "buckets" of assets:

* an emergency / rainy-day fund (***)
* a mid-term horizon investment fund
* a long-term horizon investment fund

(*** also referred to in some circles as your "[mad]" fund for cases where you either lose your job or quit it in sheer frustration at your Pointy-haired boss...)

Different people have different rules of thumb for figuring how much money you should have (in absolute dollars or relative percentages) in each of these categories. For the emergency fund, I would suggest you save an amount equal to 6 months' expenses so you can make mortgage payments, etc. so you're not immediately out on the street at the whim of your employer. Your emergency fund bucket should be "filled" then remain so before you begin allocating money to your other investment buckets. Your emergency funds should NEVER be held in stocks or bonds but should be "cash" (interest-bearing savings account) or "near-cash" (CDs or money markets).

The allocation of money between the mid- and long-term buckets requires much more thought. Mid-term investments should involve stocks or bonds with a low-moderate to moderate amount of risk associated with them. The long-term investments can involve stocks with more risk associated with them. DO NOT TAKE THIS TO MEAN YOU SHOULD THROW YOUR "LONG-TERM" MONEY AT WALL STREET'S LATEST FAD STOCK THAT PEOPLE SWEAR WILL BE THE NEXT MSFT, CSCO, BRK, etc. This only means investments in this bucket can have much more short term up/down volatility as long as you are confident their long term trend is UP.

6) If you have cash that you are willing to "gamble" on risky but longer term investments, it is critical to avoid concentrating that gamble on one or even a handful of stocks. SPREAD IT AROUND. As an example, suppose in 1986, there were 20 stocks at that time that appeared to have IDENTICAL prospects as MSFT. At that time, suppose you had $10,000 to invest and you could choose any investment strategy between the following extremes:

* bet all $10,000 on one of those stocks
* divide the $10,000 up and invest $500 in each of the 20

Of course, if you lucked out and bet all $10,000 on MSFT, you wouldn't be reading this board right now -- you'd be on a beach in Tahiti slurping margaritas and watching the setting sun. If you divided up the money, your $500 in MSFT would have still doubled about 8 times yielding about $128,000. Of the other 19 stocks, a few might have kept pace with the S&P 500 (not a bad deal either) and the majority might be out of business now. If you bet all $10,000 on some other stock out of the 20, that one stock might have been one that tanked 50% before you cut your losses. If you were a real LTBHer and stuck with your mistake to the bitter end, your $10,000 could have vanished entirely.

One of Louis Rukeyser's favorite sayings is that "On Wall Street, bulls make money, bears make money, pigs get eaten." Don't be a pig and try to pick the one stock that's going to skyrocket. Spread it around some sectors that might produce such a skyrocket and count your blessings if it happens on one and periodically (quarterly or yearly) review all of them and cull out the dead wood before you're down 60% from your basis.

7) If you're starting really small and can't afford to be purchasing more than a handful of shares of any one stock, I'd recommend first starting out in mutual funds, which invest in the approximate area you want to invest in. If you buy and sell stocks in lots of (say) 5-20 shares, unless those stocks really skyrocketed, it is likely that most of your gains are going to be negated in brokerage fees (even if you're only paying $10-$12 with on-line brokers). If you're starting small and are buying larger lots to minimize the impact of brokerage fees, you're probably not diversified enough to protect yourself from a single company surprising you with a horrendous quarter and a 20% one-day drop.

WatchingTheHerd

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