As Aleks already pointed out, the last few days have been a bumpy ride. However, smart investors are not scared. Not at all.

The main thing that keeps people from investing in stocks is the volatility. This year your account is up 12%, next year it is down 3%. Unless you are different from every other person I have ever met, realizing your portfolio is down 3% for the year (that you have less money in your account on December 31st than you did on January 1st) is going to bother you… but it shouldn’t.

If you were planning on moving to a new city next year, would you want the cost of housing in that city to go up or down over the next year?

Down, of course. No one wants to spend more than they have to, and we are confident that, over time, the average selling price of house will rise, so it makes sense to get the lowest price possible for the house you are going to buy, right? Right.

However, most investors are upset when the market goes down, despite the fact that they have 25 years or more until retirement and thus are not finished buying stocks yet. Perhaps this is best illustrated by a quick story. I first heard this one from the great broker Nick Murray and it completely changed the way I buy stocks.

The Tuna Fish Story

I like Tuna Fish. A Lot. In fact, I have always liked tuna fish and know that I always will, so I look for sales on tuna fish so I can stock up when the price is low.

Now, in my part of the country, a can of tuna costs about $.75 a can, on average. This morning I open the paper and see that Food Lion has a sale: $.25 a can. Happy Day! I take the truck to Food Lion and buy as many cans as they will let me, because I am buying three cans for what I normally pay for just one can. While I am out, I stop by Kroger and notice that their Tuna is $.80 a can, so I say “no thanks” and keep on going.

You see, I am not through buying tuna fish. I am going to eat tuna fish until the day I die, so it makes sense for me to buy it whenever I can, provided it is a good deal. Being of Scottish ancestry, I pray regularly for good deals.

If the market has a large correction, it is not a disaster. It is not a cause for panic. It is not the end of the world. It is simply a big sale. They happen on average every seven years or so and buying heavily when they happen can give you wealth beyond the dreams of avarice.

Well, It’s Thursday, January 24, 2008, and unless you have been living under a rock, you have to know that the markets have taken a huge hit over the past few days/weeks. The numbers have reached such levels that most of the experts have agreed we are past a “correction” and approaching a full blown recession.

To clarify these terms a bit, a recession is defined as the economy has had two consecutive quarters of negative growth (as determined by a decreasing gross domestic product. A Correction is when you have a decline of 10% in a stock or in this case, the overall market. A correction is viewed as normal; the market is cyclical. When that figure reaches 20% some say we are past a correction and into a recession, which can lead to a depression.

Luckily, it seems like we may avoid that. There has been an emergency reduction of the prime rate by .75 points. It was the largest cut in the federal funds rate since 1982. This will help to help combat the market’s drop. The drop seems to have slowed the trend and may help to reverse it.

What does this all mean to the average investor? It means that the value of your portfolio has very likely dropped, but the lion’s share of the drop is done. This is not the time to decide that the market is too risky. Actually the exact opposite is true. The losses we have seen have already taken their toll, and now the time is ripe to buy. If you take the opposite stance; what are you really doing? You are selling low, with plans to buy high. Not the best plan for your future worth.

My thoughts are to hold on and continue to add to my portfolio. These are the lowest prices we are probably going to see for a while, so why not buy low and continue to hold?

Virtually every investor that ever lived wishes he could have bought more stocks then he did when the market was down and less than he did when the market was up. After all, the name of the game is to buy low and sell high, right?

Wouldn’t it be nice if there really was a way to time the market, so you invested heavily when prices were low and cut way back when prices are high? Right now you are probably thinking something along the lines of “Dream on”, but I am here to tell you that there is such a technique and, properly applied, works every single time. If the market is low, you load up; if the market is high, you don’t. Using this system will simplify your investing, remove stress from your life, increase your long term rate of return and remove wrinkles (I made that last one up). What is this magic formula?

Dollar Cost Averaging, and it is both incredibly powerful and incredibly simple. Simply put, you systematically invest the same dollar amount on a routine basis (such as monthly), regardless of what the market is doing. This will cause you to automatically buy fewer shares when the price of the stock is high and to buy more shares when the price is low.

Let’s use an example:

You have researched XYZ company and think it makes sense to invest in it. Lets say the stock of XYZ sells for $10 a share as of today and lets also say we have $100 a month to invest. In the first month, your $100 buys 10 shares; no surprises here. In the next month, the price of XYZ drops to $7.50 a share, but it does not bother you a bit - in fact, you were hoping it would. Your $100 now buys you 13 shares. The next month rolls around and you see the price of XYZ is up to $8.00 a share, which means your $100 will buy 12 shares. Then, the expected uptick happens: The fourth month you are investing, the stock of XYZ soars to $12.50 a share and so you only buy 8 shares.

Lets stop here and look at what we have so far. We have invested $400 and bought 43 shares of stock in XYZ, with a current account value (ignoring fees or commissions) of $537. On the other hand, if we had invested the entire $400 at one time, we would have 40 shares of stock and a current account value of $500. By dollar cost averaging, we managed to increase our rate of return by 7% and we did not spend one extra dime to do it.

If you decide to dollar cost average (and I hope you do) you will be unique among your friends by actually hoping the market goes down, so you can buy more.

The biggest reason I am nuts about equities is, quite simply, their long term return potential. While rates vary dependent upon a wide range of factors, the average debt instrument out there (such as a bond, for example) is going to pay you somewhere in the range of 4-7% annually in the current marketplace. The long term rate of return of equity instruments (such as stocks), on the other hand, is somewhere around 10-12% annually.

Note the key phrase in the above paragraph is ‘long term’. By long term, I mean at least 10 years. Yes, I know that in any given year, the stock market may do better than the 12% I mentioned above, but, as Damon Runyon, the great sports writer once said, “that is not the way to bet”. If you are going to be investing for the long term (and you should be), why not go after the best long term rate of return?

By using the rule of 72, we can see that the difference to us over time:

Money that receives an average rate of return of 6% (like you can expect from bonds, for example) a year will double every 12 years. However, money invested at an average rate of 12% (like the average rate of return from a stock account) will double every 6 years. In other words, in the example above, if you start with $10,000 dollars, by the end of 12 years you will have $20,000 in your bond account or $40,000 in the stock account. Exactly twice as much money.

Which would you rather have?

I have a passion for equities. I do. If there were a 12 step program for people like us, I would be standing in the middle of the circle and saying ‘My name is Hugh, and I am an equities addict”.

So, why exactly am I so passionate about equities? And for that matter, what exactly do I mean when I say equities? Let’s take those in reverse order, shall we?

As I mentioned last time, equity essentially means ownership. If you buy your house for $100,000 and put $20,000 down, you have $20,000 of equity. If, over a year or two, the house appreciates by $10,000 and you pay another $10,000 in principle payments, you now will have $40,000 in equity (even though you have only invested $30,000, effectively giving you a 25% return on your money. This is what keeps us equity nuts up at night…).

If you buy a share of stock, you are, in effect, buying equity in the company whose stock you purchased. By buying a share of IBM, you now have ownership (or equity) in IBM.

Keeping this fact in mind is what drives investors like Warren Buffet. Buffett believes that the way you determine if a company’s stock is a good deal or not is by asking what he would be willing to pay for the whole company, and then divide that number by the number of shares outstanding. The resulting number is the price he is willing to pay for a share of stock… if the market price is less than that number, he buys. If it is more than that number, he does not. (This is what Benjamin Graham meant when he referred to investing in a business-like manner)

So, remember, any time you own something - a share of stock, a bar of gold, a house, an apartment building, a long option contract - you are investing in equities. And the reason we invest in equities is because we think that, over some period of time, the value of it will increase and someone will be willing to buy it for more than we put into it.

In the next installment I will cover exactly why my blood races at the thought of equities and why I am virtually 100% in equities, virtually 100% of the time.

As I mentioned before, I am going through and talking about various news and finance sites I like and use. Today, I will talk about USA Today’s money page.

At first glance, there is much to recommend it;  the page is packed with information, the site is trusted as a source of news and, as we have discussed elsewhere, they have an awesome stock screening tool.  In fact, this would be an ideal news portal except for one thing…

There are too many ads! 

Now, do not get me wrong; I understand the need to monetize content. I know that someone has to pay for the servers, the overhead and (lest we forget) the writers. However, there has to be a balance, and the good folks at USA Today opassed it a long time ago.

Most bothersome are the full page ads that insert themselves between you and a link. For example, you click on a headline to read the rest of a story about e-trade. However, before you can read the rest of the story, they take you to a full page ad for the new Honda Civic. I do not want to see an ad for a car, I want to read the story (that is, after all, why I clicked on the link).

The ads are simply too much. They invade the entire site, making using it absolutely a headache.  If they did not have such an awesome stock screener, I could think of no reason to go to this site at all.

If it were a perfect world, the sky would always be blue, everyone would be skinny and healthy and Warren Buffet would manage my stock portfolio.

It NOT being a perfect world, I guess I will have to put up with occasional thunderstorms and I will have to learn to stay on a diet; however, there IS a way to get investment returns like Warren Buffet. Two ways, actually.

The first, and most obvious thing you could do is buy shares of his company, Berkshire Hathaway. Since Warren is the chief stock picker for this company, literally he will be investing your money, along with his own and that of the other shareholders. Of course, their is a small problem… one share of this company is currently selling for about $140,000.00 (!).

Yeah, that stinks.

The other thing you could do is invest in a mutual fund that owns Berkshire, or buy shares in a mutual fund that holds the same stocks. A few such funds can be found in this post over at the Motley Fool.

Perhaps you are struggling to find that oh-so perfect Christmas present for your children or grandchildren. Well, join the club, because it seems like it gets harder and harder each year. You ask yourself if those kids really need another toy, another gadget or more clothes that will just be out of style next year or, much more likely, next month!

Every year, banks all over the US push savings bonds on ill informed grandparents and parents, urging them to buy these bonds to “help pay for college”. While it is no doubt better for their future than the latest ipod, there are much better ways to pay for college.

I suggest that you look into some sort of investment vehicle, such as the 529 plan. The 529 plan (the exact details vary from state to state) allows you to put after tax dollars into an account that grows tax deferred and can be withdrawn tax free for qualified educational expenses. The funds are invested in mutual funds that can be tracked and followed on the Internet or in the local paper and you are allowed to move the money between funds in the plan.

Even if you did not opt to use a 529 plan, or if you live outside the US, it is still a good idea to skip the savings bonds and buy your grandchild a stock or a mutual fund. After all, the sooner they learn about investing in equities, the more likely they are to be comfortable investing when they get older.

With the advent of the internet, the phenomenon of the day trader and near instant access to information, more and more people are focusing on the short term with their investing. This is almost always a mistake.

If you are a short term investor (which used to mean 5 years or less, but in todays hyper-frenzied world is measured in weeks or months), you honestly have no business being in the stock market. Many people have grown used to the near perpetual bull market over the last 30 years (with, admittedly, minor hiccups along the way) and have lost site that participating in the stock market is, in fact, participating in the ownership of a company.

My favorite analogy is that of home ownership. If you were only going to live in a new city for 3 months, you would not dream of buying a house, because you know that, over a three month time frame, you are unlikely to have enough growth to make it worth your while. However, if you will live there for 5 years, it might be worth it to buy, and if it is 10 years then it is an absolute no brainer.

If your time line is less than 3 years and you are buying stock, you are doing more gambling than investing. After all, there is something to be said for having a long term perspective.

If you were to pick a list of the greatest stock market investors of all time, any serious list would be topped by Warren Buffett. His exploits as the Prime Mover behind Berkshire Hathaway are the stuff of legend, with consistent double digit returns and occasional years when he beat the overall market by 10 percentage points or more. However, the real secret to Buffett’s success is his long term perspective.

Over on Motley Fool, they point out that there are occasional five year periods when even the Oracle of Omaha falls behind the S&P 500 (for a chart, check this one out). If you looked at just that five year period, you would think this guy is an idiot, that he did not know his armpit from third base and why in the heck would anybody follow his advice. Obviously, you would also be very, very wrong.

The real key though, is that Buffett has a 10-20 year perspective, and sometimes much, much longer. After all, this is from the guy who said that his favorite holding period is “forever”.

The original article points out that in addition to his outstanding understanding of the market, Warren Buffett also has tremendous patience (that 10-20 year perspective) and tremendous confidence, as seen in his famous statement that “risk is not knowing what you are doing”.

What sort of time frame are you looking at to meet your investing goals? Let’s talk about it in the comments.