As with many of us, when you look back at where your portfolio was in the summer of 2000, you are probably asking yourself, "Why didn't I get out of equities?" Or, "Why was I so heavily weighted in technology?" Of course the next question is "What do I do now?" I have been asked this question enough that I decided to put my response on my website. Note: This was written before the terrorist attack and I re-read it to see if I should make any modifications. I didn't. Investing involves the assumption of the risk of loosing some of your assets. Now more than ever, you need to diversify and adjust your risk assumption based on the time horizon of your life goals.

There have been enough brilliant people in the investment community that have shared their investment philosophy that I did not have to reinvent the wheel. One example is John C. Bogle (the founder of Vanguard) who published The Twelve Pillars of Wisdom. These pillars have guided his conservative investment strategy over the latter part of a half-century. What is more, his lifelong conviction is that while experienced investment professionals may have a pretty good idea of what is going to happen in the market, we have no idea of when. In an uncertain world, tactical changes should be made sparingly. These guidelines to successful investing are lessons that investors should have learned before the bear market arrived, but that many are only learning now. Bull markets come and bull markets go, inevitably followed by bear markets, which too come and go. But these pillars of wisdom are timeless.

(My comments are italicized)

Pillar 1: Investing Is Not Nearly As Difficult As It Looks
Do a few things right. Focus on broad-based mainstream equity funds with wide diversification; evaluate funds relative to peers with similar objectives; ignore short-term performance in favor of performance of at least a decade; carefully consider the drag of high expense ratios and sales charges; pay careful attention to portfolio quality, in stock funds, bond funds and money market funds alike; and focus on an asset allocation that is consistent with you own risk tolerance. You have probably already guessed that John is a promoter of mutual funds. Read on and you will notice, not just any fund.

Pillar 2: When All Else Fails, Fall Back On Simplicity
Rely heavily on index funds, and begin with the idea of a 50/50 bond/stock ratio, adjusting the ratio in accordance with your own financial profile. I agree with John, this is truly simple, but you must pick the index funds that are right for your financial situation and periodically review their appropriateness. This is the basis of good financial planning. See Pillar 5 for some thoughts on this.

Pillar 3: Time Marches On
Time dramatically enhances capital accumulation as the magic of compounding accelerates. At an annual return of +10%, the total value of the initial $10,000 investment is $108,000, at the end of 25 years, nearly a tenfold increase in value. Give yourself the benefit of all the time you can possibly afford. As you get closer to the time when you will need the money from your investments, you should be reallocating to less risky investments and, therefore, your annual return will be less.

Pillar 4: Nothing Ventured, Nothing Gained
The stock market is a risky place. Even the value of an S&P 500 index fund fell 28% from the March 2000 high to the recent low. Over the past decade, a $10,000 investment in the S&P Index had grown to $48,700 by March 2000, only to tumble to $38,400 a year later. But consider, if you will, the risk of not being willing to assume market risk. Ten thousand dollars invested in a money market fund a decade ago would be worth but $15,500 today-a $5500 profit that was less than one-fifth of the $28,400 appreciation in the index fund, even after the sharp market decline. The numbers reinforce the reputation of equities both as productive investments and as risky ones-a reminder that is both valuable and long overdue.
Reasonable expectations suggest to me that we might see stock returns in the 6% to 10% range during the coming decade. If that seems too modest an expectation for common stocks based on past history, don't forget that a possible 8% return on stocks would take each dollar to $2.16 by 2011, while a possible 4% future return on savings would take each dollar to $1.48, less that half the gain. Eschewing the risk of stocks, therefore, carries a risk of its own. Yes, "nothing ventured, nothing gained."

Pillar 5: Diversify, Diversify, Diversify
By owning a broadly diversified portfolio of stocks and bonds, specific security risk is eliminated. Only market risk remains. This risk is reflected in the volatility of your portfolio and should take care of itself over time as returns are compounded.
As the bear market of the past year makes clear, investing in stocks is risky:
First, there is individual stock risk. We have seen some stocks soar and some plummet, with little means of knowing which stock will do which, and when. Who would have expected that Cisco, whose $500 billion market capitalization a year ago made it the largest stock in the world, would soon plummet by 80%, erasing$410 billion in value?
Second, there is style risk. Growth funds trumped value funds during the first nine years of the decade, rising an amazing 609% through March 2000, more than double the 281% increase for value funds. Since then, growth funds have fallen 38% on average, while value funds have actually risen 5%, erasing nearly the entire growth-fund advantage, and their cumulative records are now virtually identical. Who among us is wise enough to know how to "time" those changes?
Third, there is a manager risk. A growth-fund manager, for example, may outpace his peers, or may fall short, and the difference is apt to be enormous. Consider that in the past decade, the top decile of growth-fund managers produced an average annual return of 17%, almost three times the 61/2% return for the bottom decile. How would you go about picking the winners in advance?
These three risks can be mitigated. For example, when you own the entire stock market through an index fund, there is neither individual stock risk, nor style risk, nor manager risk. Only market risk remains. If the past year demonstrates nothing else, it surely demonstrates that stock market risk, standing alone, is quite substantial.
I believe John would agree that Index funds should be chosen wisely. For example the S&P 500 Index is not a cross section of American enterprise. It only represents about 7% of the publicly owned and traded companies and since it only includes large companies, it should be considered a large cap growth fund. Since it is a market capitalization weighted index, it will be highly concentrated in a few very large companies. Ten stocks counted for over 25% of the money invested in an S&P Index fund. This means there is very little diversification so you have not reduced your market risk or individual stock risk to any great extent. Remember, this Pillar only addresses equity risk and market allocation. It does not consider the proper asset allocation based on your current financial situation and life goals.

Pillar 6: The Eternal Triangle
Never forget that risk, return and cost are the three sides of the eternal triangle of investing. Remember also that the cost penalty may sharply erode the risk premium to which an investor is entitled. You should understand unequivocally that investing in a fund with a relatively high expense ratio-more than 0.5% per year for a money market fund, 0.75% for a bond fund, 1% for an equity fund-bears careful examination. Unless you are confidant that the higher costs you incur are justified by higher expected returns, select your investments from among the lower-cost no-load funds.
Although not stated in his pillars, in addition, financial advisor's (who used to be called brokers) management fees, layered on top of fund fees, dramatically increase the cost penalty. There are a lot of people drooling over managing your investments, but watch the costs. This is especially true of so called "Managed Accounts." Here a brokerage fee can be 2% on top of a manager fee that is usually at least 2%. This means your portfolio has to earn at least 4% before you see any gain. In today's market that could mean you actually loose money when the market is advancing. Ask a lot of questions on how everyone gets compensated.

Pillar 7: The Powerful Magnetism Of The Mean
In the world of investing, the mean is a powerful magnet that pulls financial market returns toward it, causing returns to deteriorate after they exceed historical norms by substantial margins and to improve after they fall short. Reversion to the mean is a manifestation of the immutable law of averages that prevails, sooner or later, in the financial jungle. No question 2001 reminded us of that fact. High double digit gains cannot go on forever, so do not bet your retirement or other financial goals on it.

Pillar 8: Do Not Overestimate Your Ability To Pick Superior Equity Funds, Nor Underestimate Your Ability To Pick Superior Bond And Money Market Funds.
In selecting equity funds, no analysis of the past, no matter how painstaking, assures future superiority. In general, you should settle for a solid mainstream equity fund in which the action of the stock market itself explains about 85% or more of the fund's return, or a low-cost index fund (100% explained by the market). But do not approach the selection of bond and money market funds with the same skepticism. Selecting the better funds in these categories on the basis of their comparative costs holds remarkably favorable prospects for success.
Here John oversimplifies the task. At one time picking your own funds may well have been realistic for the average investor, but now with over 7000 funds and a myriad of styles, it is a daunting task to select an equity mutual fund. Bond funds can also be risky basing your selection on past performance. Look at the Heartland example. Trying to stay diversified with overlapping holdings of certain stocks by fund managers is difficult even for the sophisticated investor. Complicating the task is if you have a combination of individual stocks, a 401k and maybe even stock options. This is the area where professional help is a good investment and a financial plan is a must.

Pillar 9: You May Have A Stable Principal Value Or A Stable Income Stream, But You May Not Have Both
Contrast a money market fund-with its volatile income stream and fixed value-and a long-term government bond fund-with its relatively fixed income stream and extraordinarily volatile market value. Intelligent investing involves choices, compromises and trade-offs, and your own financial position should determine the most suitable combination for your portfolio.

Pillar 10: Beware of "Fighting the Last War"
Too many investors-individuals and institutions alike-are constantly making investment decisions based on the lessons of the recent, or even the extended, past. They seek stocks after stocks have emerged victorious from the last war, bonds after bonds have won. They worry about the impact of inflation after inflation, having turned high real returns into so-so nominal returns, has become the accepted bogeyman. You should not ignore the past, but neither should you assume that a particular cyclical trend will last forever. None does.

Pillar 11: You Rarely, If Ever, Know Something The Market Does Not
If you are worried about a coming bear market, excited about the coming bull market, fearful about the prospect of war, or concerned about the economy, the election, or indeed the state of mankind, in all probability your opinions are already reflected in the market. The financial markets reflect the knowledge, the hopes, the fears, even the greed, of all investors everywhere. It is nearly always unwise to action insights that you think are your own but are in fact shared by millions of others.
Here we are again, in the grip of a bear market, and worried about whether it will get worse. No one knows when it will be over. Maybe it is over. Nonetheless, provided only that your asset allocation going into the bear market last March had been set in accordance with a) your risk tolerance, b) the years you have remaining to build your investment, c) your wealth level and d) your income needs, you shouldn't change the allocation. Times of market duress are almost always terrible times to change investment strategies. The market, however fickle, has usually taken into account almost every eventuality.

Pillar 12: Think Long Term
Do not let transitory changes in stock prices alter your investment program. There is a lot of noise in the daily volatility of the stock market, which too often is "a tale told by an idiot, full of sound and fury, signifying nothing." Stocks may remain overvalued, or undervalued, for years. Patience and consistency are valuable assets for the intelligent investor. The best rule: Stay the Course.
During the past two years, the stock market's noise has been the loudest in history as volatility has reached record highs. Millions of speculators are scared half to death, as they should be. But long-term investors must realize that, as greed turns to fear, much of the worry is already reflected in the lower level of stock prices. And even if it turns out we should be reducing our stock position until the decline is over, where on earth would we ever get the insight that tells us the right time to get back in? One correct decision is tough enough. Two sequential correct decisions-both made at the right moment-are nigh on impossible. Impulse is your enemy, and patience and consistency are your friends.
When you are concerned about what is happening in the market, call your financial planner. If he or she is any good, they have already called you.