Cy Lynch tells you all that you need to know to beat the averages in the stock market and have fun doing it.

Why Invest in Stocks? (con't)

Since 1802, the worst that stocks have performed in a single year is minus 38.6% after inflation. In other words, a real loss of 38.6% is the worst case for stocks for any one year period. Extend the holding period to five years and the worst average yearly loss declines to 11%. Hold stocks for 10 years and your worst case would have been an average annual loss of 4.1%. The 10 year point is significant because the worst case for bonds over a 10 year period since 1802 was an average annual loss of 5.4% after inflation. Even cash did worse than stocks if held for ten years, losing 5.1% after inflation. In other words, stocks are less risky then both bonds and cash on a worst case basis if you hold them for 10 years or longer.

Even more significant is the fact that stocks have never declined in value (even after adjusting for inflation) since 1802, provided you held for 17 years or longer. Thus, stocks have historically returned much better than bonds or cash and are actually less risky if you hold for 10 years or more.

The next question is whether to invest in stock mutual funds or in individual stocks. Like many individuals, I started out investing in mutual funds. One big reason was that I didn't feel like I knew enough to intelligently decide which individual stocks to buy and sell.

The fact of the matter is that all of us have the ability to be successful stock investors. One of the best money managers around, Peter Lynch has said so as I quoted above. One thing to consider is that mutual fund managers-those who invest for a living-don't do very well when compared to the various stock market indices.

It is frequently reported that most mutual funds do worse than a stock market index, such as the Standard & Poor's 500 (S&P 500) index, which is one of the most widely, followed. In fact, over the past few years between 80 and 90% of the mutual funds have done worst than the S&P 500. That is not an entirely fair comparison since not all funds try to buy the same sort of stocks as are in the S&P 500. Even so, the fact remains that most mutual funds don't make as much money as you could by simply buying a group of stocks reflecting an index for whatever the applicable portion of the market is.

Comparing our potential success as individual investors to the performance of mutual fund managers is not entirely fair because we have several advantages over them.

First, we can manage our portfolios for free. Owners of mutual funds pay a management fee of anywhere from about .75% to over 2% each year to the manager of the fund. That alone puts mutual fund managers at a disadvantage to stock market indexes and to us as individual investors.

Second, we can take a long term outlook while mutual fund managers tend to be evaluated based on their performance over the past three months, one year or maybe three years. As a result, mutual fund managers cannot afford to be as patient with their stock investments as we can as individuals.

Third, mutual fund managers are discouraged from taking chances and being "different." For example, imagine Sam Jones, manager of Fast Buck Jones Growth Fund. If he invests in Slow Grow Fertilizer, Inc., a company that is basically ignored by all other mutual fund managers, and he loses money on the investment, he will be asked why he wasn't as smart as all the other managers in avoiding that "loser." In contrast, assume that he invests in Doggy.com, a favorite investment of all mutual fund managers. Even if that stock loses money, he can take refuge in the fact that "everybody" got fooled. Consequently, Wall Street professionals tend to move in herds, tending to like or hate particular stocks in unison.

We as individuals, however, can afford to be different, to buy stocks that the herd is ignoring or rejecting. Eventually, other investors, including the Wall Street herd, will recognize the good companies that we invest in and the stock will rise in price.

I started out buying individual stocks in 1984--using an intuitive and common sense approach--I bought stock in a couple of companies that I personally patronized. Peter Lynch has called that "doing stock research at the mall." That method led to both my best stock investment, Home Depot, and my worst, Delites of America. Home Depot has increased in price over 100 times what I paid, Delites went bankrupt and I lost every dollar I invested.

I learned a very important lesson in those two companies, specifically the importance of having a long term outlook. It is important to minimize your losses if you can, however, buying good companies and letting their stock price increase over and over can far outweigh even losing every bit of your investment in another stock. Looking at Delites and Home Depot specifically, I lost 100% of my investment in Delites. On the other hand I have made 10,000% in Home Depot. We will make mistakes, but we have no reason to needlessly fear those mistakes as we will also make good decisions that can outweigh those mistakes.

Shortly after taking the plunge and starting to buy individual stocks, I joined an investment club associated with the National Association of Individual Investors (the "NAIC"). The NAIC is an educational organization that has a simple yet powerful approach to investing. I have been a member of that investment club and the NAIC for nearly 15 years. What I hope to pass along to you in this and upcoming columns is what I have learned over those years of putting the NAIC methodology into practice.

Recall from earlier that stocks have returned, on average, 10.6% a year since 1926. My goal-and the goal of the approach I will show you-is to invest in stocks with the potential to double in total value every five years. That represents an average annual return of about 15%, nearly 50% higher than historical returns since 1926, and thus significantly better than most mutual funds as well.

Next month, we will begin to look at the basic strategies underlying this simple but effective methodology and discuss some general tactics to follow in putting together a portfolio of stocks. Then in subsequent months, I will explain in detail how to choose individual stocks to include in that portfolio.