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You’re at a cocktail party, and the next-door neighbor is chattering away about how well his investments are doing. Maybe yours aren’t doing as well, and maybe they are. But you’re listening anyhow. After all, you just might pick up a good stock tip. Your neighbor’s stockbroker — and the guy might as well be E.F. Hutton himself — gave him the scoop on a down-and-out dot-com. It’s going to be flying again — soon. Now’s the time to buy. Should you? Your neighbor is. Or maybe you’re sitting at the bar of the corner restaurant. They’ve got CNN on one TV set and CNBC on the other. While stock quotes flash across the bottom of the screen, “a well-known analyst from a major Wall Street investment firm” is busy explaining why he’s given the stock a “strong buy” recommendation. This is the inside baseball of the financial world. How can you choose to ignore it? Well, no one wants to be played for a sucker. But the chances are that if you spend your spare moments listening to these self-proclaimed experts, you’re being suckered. It’s all part of a very old game. Brokerage firms would have us believe that the most important factors in successful investing are stock picking and timing. Which together result in decisions to buy and sell. Of course, it’s transactions like these that generate the commissions that fuel the industry. Happily, at least for the brokers, the interest of the media coincides with that of the securities industry. There’s a never-ending search for news about companies and developments in the financial markets. And much of that news has the potential to trigger the decision to buy or sell securities. But reporters and editors can’t just put out information on their own. They need experts to lend weight to their reports, to comment on what’s happening. More often than not, they turn to analysts and others engaged in the brokerage business for help. And they get it. Members of the brokerage fraternity compete fiercely for the chance to offer quotable remarks or, even better, to serve as talking heads. What the talking heads won’t tell you is that, viewed over time, the price of securities move virtually at random. This is the so-called random walk theory popularized by Burton Malkiel in his book “A Random Walk Down Wall Street,” first published in 1973. What Malkiel showed was that: • Price movements generally do not persist or trend in any given direction. • They do not form predictable, repeating patterns. • There are no trading rules that, when tested over long periods of time, produce superior results. • There is no such thing as an investor who consistently beats the market over the long term through skill rather than chance. • Market prices are quite efficient, reflecting nearly everything relevant to the true value of securities. (Of course, Malkiel’s study was written before dot-com fever seemed to turn this rule to mush.) It is difficult to accept that hard work and diligence cannot help you to “win.” It seems vaguely un-American that you can’t beat the market. But there it is — on average and over the long run, the fact is that you can’t. Oh, over 25 years you might be able to beat it by one-eighth of 1 percent. But it would be hard to prove that it was your talent rather than simple statistical variation that put you ahead. So if we can’t beat the market, what are we to do? The answer lies in diversification. First, consider that there is not one securities market, but many. There is the New York Stock Exchange, which is the market for stocks of large U.S. companies. There is Nasdaq, which is mostly made up of smaller U.S. companies. There are the markets of each of the European countries, the Japanese markets, the Australian markets, the markets of Latin American countries, the market for long-term U.S. government bonds, for intermediate term British corporate bonds, for mortgage-backed bonds, for high-yield bonds, convertible bonds, preferred stocks. And the list goes on. Each of these markets has a characteristic long-term historical average rate of return and risk level. While none of these markets can be beaten, we can select markets that have the performance characteristics that we want. We cannot beat any market within itself, but we can beat one market by investing in another with historically higher returns. Indeed, by blending our portfolio among markets, we can, in the long run, attain almost any reasonable overall level of expected return — so long as we’re willing to take the commensurate risk. That blending of markets within a single portfolio is called “asset allocation.” And asset allocation turns out to be the primary determinant of portfolio performance. Not individual security selection, nor market timing, but asset allocation. A number of studies have shown that for real-world professional investors, asset allocation accounts for more than 90 percent of their portfolio returns. Stock selection accounts for less than 5 percent of returns, and market timing for less than 2 percent. And if stock selection and market timing are such relatively fruitless exercises for full-time professionals, think of how futile they are for you as a part-time amateur. Take a simple example. Suppose your portfolio consisted only of long-term, grade A U.S. corporate bonds, whose market has had a historical average return of 5 percent. If you wanted to increase your portfolio’s return, you could try individual bond selection and/or try to time the purchase and sale of individual bonds. Over the long run, however, those techniques are unlikely to increase your portfolio return and might well decrease it, particularly given the commissions and tax consequences. If, on the other hand, you were to add securities to your portfolio from a different, higher-return market, you would be very likely to increase your long-term return. For example, by making half of your portfolio large U.S. common stocks, whose historical returns have been about 11 percent, you would increase your expected long-term portfolio return to 8 percent. Thus, by performing the relatively easy task of asset allocation, you can sculpt a portfolio of almost any reasonable return you want, remembering, of course, that you have to pay for that extra return with extra risk. But what return should you want? What risk level is right for you? Stay tuned. M. John Sterba, Jr., is the chairman of Investment Management Advisors, Inc., an investment advisory firm based in Manhattan. He is the author of “Fundamentals of Personal Investing — A Guide for Lawyers and Other Professionals,” published by the American Bar Association. He can be reached at [email protected]

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