Dec. 29–With the Dow topping 10,000 and the financial media churning out “What’s in Store for 2004?” stories by the dozen, I thought this week might be a good opportunity to take a step back andlook at what really matters when it comes to investing.

Needless to say, it’s not the predictions that any “expert” might make in a magazine or newspaper article about macro stuff like the direction of the market or the economy. No one knows where the S&P 500 or interest rates will go next year, and while those kinds of prognostications might make for fun reading, they hardly constitute investment advice that you should take seriously.

For example, at about this time last year, the Mortgage Bankers Association was forecasting a moderate year in the mortgage market during 2003. As the main trade group for the mortgage industry, the MBA predicted that Americans would take out about $1.8 trillion in real estate loans during the coming year. Given how hot the housing market had been, and how low rates were in 2002 relative to historical levels, it was not an irrational or illogical assumption.

It sure turned out to be wrong, though. Rates dropped even further in the first half of 2003 amidst rumblings from the Fed about deflation, and it looks like we’ll end 2003 with about $3.4 trillion in mortgage originations — about twice what these experts had originally expected. Remember this the next time you hear someone predicting anything as complex as interest rates, the economy or the level of the overall market. Don’t accept any forecast without a huge grain of salt.

So, what should you expect the market to do in 2004? I don’t know, but I do know that the basic principles behind smart investing will be the same next year as they were this year. Following are four of the most important.

1. The last shall be first, and the first shall be last. You’ll have more success in investing if you look at the stocks that the market has discarded — if only temporarily — than if you chase whatever’s popular at the moment. When you’re reading all those year-in-review articles over the next few weeks, don’t look at the top of the performance tables for investment ideas. Instead, look at the bottom. More than a few smart investors find stocks by just scanning the list of 52-week lows every day.

2. Selling is not shameful. When you think about the tax implications of selling stocks, the IRS essentially pays you to sell your losers. Yet most of us hang onto our stinkers for way too long in the vain hope that time will heal our investing mistakes. Our egos interfere with making logical investing decisions because we don’t like to admit that we’re wrong, and selling is a clear admission of fault.

So, instead of focusing on how much money you’ve made or lost on a stock, look at your portfolio afresh on a regular basis. Ask yourself whether you’d buy each stock again if you were starting with 100 percent cash. If the answer is no, you should think long and hard about whether that stock belongs in your portfolio. (Of course, if you’re sitting on a large capital gain in the stock, you may have a very good reason not to sell — taxes are a real cost, after all.)

3. Your biggest enemy is closer than you think. Unfortunately, the biggest enemy to investing success is not hedge funds, the Fed or day-traders. It’s ourselves. We’re all riddled with psychological biases that hamper smart investing. Learn what these biases are, so you can recognize them in yourself and avoid them whenever possible. The field of behavioral finance has produced a wealth of research into the psychological traps that snare investors, but as a starting point I’d suggest the book “Why Smart People Make Big Money Mistakes” by Gary Belsky and Thomas Gilovich.

4. Homework and discipline pay off. Investing successfully is hard. We have empirical evidence of this fact in the (very) small number of professional investors who consistently beat the market, and in the wealth of studies that show that the average investor far underperforms the average investment. Most investors do not adequately research their investments (this is by far the most common answer I get when I ask people about their biggest investing mistake) and they don’t wait patiently for an appropriate price.

However, both these problems are easily fixed with some time spent researching the stocks you want to buy. One easy trick is to simply force yourself to read the 10-K — or at least the annual report — of every company you think you might want to purchase. This takes time, but it also gives you a cooling-off period that will likely help you avoid some ill-considered buys.

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For comprehensive daily mutual fund and stock data, articles and news, or to find out more about Morningstar and its products and services, please visit http://www.morningstar.com.

(c) 2003, Morningstar. Distributed by Knight Ridder/Tribune Business News.

Dec. 15–Investors should consider selling their holdings in Invesco Funds.

The securities and consumer fraud charges recently filed against the firm and its chief executive officer by state and federal authorities are more demerits for a fund family that has been in decline. Even before it was implicated in the widening mutual fund trading scandal, Invesco had been struggling with poor performance, significant manager changes, a massive restructuring and rising expenses. Learning that the fund family accommodated market-timers in the face of evidence that the rapid trades may have impeded portfolio managers and harmed long-term shareholders convinces us the complex doesn’t deserve investors’ money.

Before selling, fund investors should be sure to consider potential commission and tax costs of any trades. In addition, participants in 401(k) plans should be careful before dumping a fund if it is their only way to access an important asset class.

The charges against Invesco are grave, but they’re also different from those leveled at other large firms, such as Putnam Investments and Pilgrim Baxter & Associates. Authorities haven’t accused Invesco managers of rapidly trading their own funds or firm executives of directly enriching themselves through improper trading relationships.

Rather, Invesco was the first company to get into trouble solely for the way it interpreted and enforced its own prospectus. The fact that Invesco and its corporate parent Amvescap (AVZ) have asserted they did nothing wrong and have vowed to fight the charges and defend the implicated executive also sets this situation apart.

The complaints filed by New York Attorney General Eliot Spitzer, Colorado Attorney General Ken Salazar and the Securities and Exchange Commission say that from at least July 2001 to October 2003, Invesco made exceptions to its prospectus policy on trading for certain large clients without telling its funds’ owners or independent directors. Meanwhile, it rousted other investors who tried to market-time its funds without the firm’s approval and promoted long-term investing in its marketing materials and shareholder reports, according to the complaints.

The timing arrangements went right to the top, authorities say. Executives such as chief executive officer Raymond Cunningham, chief investment officer Tim Miller, senior vice president of sales Tom Kolbe and “timing police” chief Michael Legoski allegedly helped develop a policy for letting clients with $25 million or more in assets exceed the firm’s trading restrictions, the complaints say. Authorities also allege that Invesco referred to these customers as “Special Situations.” The firm’s policy toward them eventually included rules for “sticky money,” or “money that the Special Situation places in (Invesco) funds and is not actively traded.”

Between July 2001 and October 2003, Invesco let more than 60 brokers, hedge funds and advisors rapidly trade at least 10 of the family’s funds, the complaints say. At any given time market-timers accounted for up to $1 billion of the fund group’s assets, according to the complaints. The complaints say one of the largest Special Situations was the infamous Canary Capital Partners LLC, which in September paid $40 million to settle charges of improper mutual fund trading brought by Spitzer.

Invesco denies it ever sold market-timing privileges for sticky assets, but doesn’t dispute it allowed market-timers into its funds. Indeed, Invesco portrays its decision to open its doors to timers as an effort to protect its long-term shareholders. The firm has argued it was better off striking deals with large market-timers and setting limits on their trading than leaving itself at the mercy of “uncontrolled short-term traders who would go in and out of the funds when they chose.”

The firm argues its funds’ prospectuses allowed them to modify its policy limiting investors to four trades per year as long as the change was in the best interest of the fund and it notified fund owners of alterations that affected all shareholders 60 days before the exemptions took effect. Since the firm allowed only some investors to market time, technically the Special Situations didn’t affect all shareholders and didn’t require notification, Invesco officials argue.

We’re suspicious of such legal hairsplitting. Given the evidence in the complaints, we’re also skeptical of claims that a certain amount of controlled market-timing was good for long-term shareholders. The e-mails and memos cited in the complaints paint a picture of a firm that knew it was pushing the boundaries of its own policies and of what was good for shareholders.

One June 2002 memo stated, “This type of activity is not in the best interest of the other fund shareholders.” Later, in a December 2002 memo, Invesco compliance officer James Lummanick wrote the trading policy exceptions “may be considered contrary to the prospectus disclosure. The level of market timing is not in the best interest of the non-market-timing shareholders, nor have they been provided notification of the change in policy 60 days in advance. Invesco Funds Group may be incurring business risk by continuing this market timing practice.”

Other documents in the complaint cast doubt on Invesco’s claims that it was able to control the market-timers it allowed in its funds. In a February 2003 e-mail discussing the activity of Canary Capital, Invesco Dynamics (FIDYX) manager Tim Miller groused, “These guys have no model, they are day-trading our funds, and in my case I know they are costing our legitimate shareholders significant performance. … This is not good business for us and they need to go.”

But despite the concerns, Canary didn’t go, according to the complaint. Invesco allowed the hedge fund to continue trading, albeit at a reduced level.

The charges have hit Invesco in a weakened state. The family that was one of the fastest-growing fund firms of the late 1990s has faltered in recent years. Eye-popping returns from aggressive-growth funds such as Dynamics and sector offerings, such as Invesco Technology (FTCHX) and Invesco Health Sciences (FHLSX) helped the family grow from $9 billion in 1995 to $39 billion by August 2000. By the end of the decade, its stature was gaining on cross-town rival and bull-market darling Janus. In 2001 Invesco paid $60 million for the naming rights to the Denver Broncos’ new football stadium.

The firm had started to lose altitude before Invesco Field at Mile High even opened, though. The bear market that began in March 2000 savaged the family’s stock funds and many of them have lagged their peers in this year’s recovery. Through Dec. 3, 2003, more than 85 percent of Invesco funds trailed their respective category averages over the previous 12 months. More than 80 percent lagged their typical peers over the trailing three years, and more than 70 percent plodded behind their average competitors over the trailing five years.

The fund family also has endured management turnover and corporate upheaval. Some departed managers, such as former Invesco Growth (FLRFX) manager Trent May, had dismal records and probably deserved to go. But the firm has also lost some veteran hands in recent years, such as Invesco High-Yield’s (FHYPX) Jerry Paul; and Invesco Core Equity (FIIIX) manager Charles Mayer, who had about three decades of experience.

Currently, the managers of two-thirds of Invesco funds have less tenure than their average category peers do. This year’s sweeping consolidation of Amvescap’s (AVZ) Invesco and AIM fund families, which merged 14 Invesco funds out of existence, adds to the confusion.

On top of all this, the expense ratios of many of the firm’s funds have also increased in recent years as assets have declined. The family opted to keep 12b-1 fees, which are supposed to pay for fund marketing and distribution, on the no-load investor share classes of its funds after those shares closed to new investors in March 2002 when Invesco transformed itself into a broker-sold fund family. Rising expenses and keeping distribution fees on closed share classes isn’t unique to Invesco, but it doesn’t make the family any more appealing, either.

Invesco has fallen so far that a screen of Morningstar’s fund database searching for Invesco offerings that meet a few basic qualities often used to describe good funds — above-average manager tenure and category performance rankings; and below-average expenses, turnover, tax costs, and volatility — currently eliminates all funds.

Invesco is the first fund company implicated in the scandal to stand up and mount a vigorous defense. It says market-timing isn’t illegal; that all fund families struggle with rapid traders; that regulations on the practice are murky at best; and that Invesco was helping shareholders by making exceptions to its trading policy. Further, Invesco officials say now that the firm is essentially part of the AIM Investments, AIM’s trading policies apply to Invesco funds.

We’re wary of these arguments. Several firms operating under the same regulatory structure as Invesco, such as Vanguard and First Pacific Advisors, have decided that while not illegal, market-timing isn’t in the best interest of their shareholders and have taken resolute stands against the practice. They may still struggle with timers, but they have decided it is better to establish and consistently enforce clear policies against the timing than to make exceptions on a case-by-case basis. We doubt doing otherwise helps long-term shareholders.

It’s also not clear if following AIM’s policies will make any difference. Invesco’s most recent prospectuses include new, more detailed language on market-timing, saying it will monitor trading, limit exchanges and use redemption fees and fair value pricing to discourage it. But the document seems to grant a lot wiggle room, stating the family “reserves the discretion to accept exchanges in excess of these guidelines on a case-by-case basis if it believes that granting such exceptions would be consistent with the best interests of the shareholders.”

Invesco will have its day in court, but in the court of public opinion it bears the burden of winning back investor trust. It isn’t clear Invesco sold market-timing capacity for sticky assets (an indefensible practice in our view), and the firm contends its “special situations” were technically legal. Still, there is evidence that the firm had something other than its fund shareholders’ best interest in mind when it allowed market-timing. Invesco CEO Cunningham himself admitted in an e-mail cited in the complaint that the firm was “constantly trying to balance revenue growth with an accommodation for this type of business.” In the same message CIO Miller is described as someone who “has always been willing to work with timers as a group.”

As it stands now, long-term investors have a choice between firms that are willing to man the battlements and fight the good fight against market-timing (they are out there), or an outfit that thought letting the Trojan Horse in the gate was a good idea. As long-term investors, we’d rather cast our lot with the former than with the latter.

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For comprehensive daily mutual fund and stock data, articles and news, or to find out more about Morningstar and its products and services, please visit http://www.morningstar.com.

(c) 2003, Morningstar. Distributed by Knight Ridder/Tribune Business News.

AVZ,

Dec. 8–Successful investing is hard, but it doesn’t require genius. As much as anything else, it requires something perhaps even more rare: the ability to identify and overcome one’s ownpsychological weaknesses.

Behavioral finance has become a cottage industry in recent years, spawning an array of academic papers and learned tomes that attempt to explain why people make financial decisions that are contrary to their own interests. Several mutual funds have even appeared, such as LSV Value Equity (LSVEX) and Undiscovered Managers Behavioral Growth (UBRLX), that seek to exploit faults in investor behavior.

The concept is not new, however. Benjamin Graham used to portray Mr. Market (and who is the market other than you and I?) as a fellow prone to mood swings, from wildly optimistic to irrationally pessimistic. The key for Graham — and for his disciple, Warren Buffett — is patience.

As Buffett said in a 1999 interview with BusinessWeek, “Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

His partner at Berkshire Hathaway (BRK.B), Charlie Munger, never misses an opportunity to recommend Robert Cialdini’s book “Influence,” which examines why people give in to pressure from others.

Yet, despite all the warnings, investors continue to exhibit several key behaviors that tend to get them into trouble. Let’s go over a few of these counterproductive activities, so that we’ll have fodder for the next round of New Year’s resolutions right around the corner.

1. Checking portfolios too often.

Let me be the first to say that I’m guilty here. I look at my stocks at least a couple of times a day, so I know firsthand what a psychologically painful experience it can be. The problem is that people are generally loss-averse — that is, they experience negative feelings from a $50 loss that are stronger than the positive feelings they get from a $50 gain. This concept formed the basis for prospect theory, developed by Nobel laureate Daniel Kahneman and Amos Tversky in 1979. Richard Thaler and Shlomo Benartzi went the next step and showed that frequency of evaluation was key to how well an investor could endure losses. Those who do their mental accounting over short time spans, even if they’re investing for the long term, earn lower returns.

Again, this is nothing new. Buffett has said that he wouldn’t mind if the market shut down for years at a time. For many of us, though, every day becomes another chance to suffer the agony of our investment decisions. Nassim Taleb, who runs a hedge fund (Empirica Capital) that makes its living by enduring short-term pain, points out in his book “Fooled by Randomness” that probability dictates that the market will show a positive return on only a little over half of the days it’s open. If losses hurt twice as much as gains, then people who check their portfolios daily will suffer much more than they’ll benefit.

Thaler and Benartzi calculate that the “psychic cost” of evaluating your portfolio on an annual basis is 5.1 percent per year, vs. 0.6 percent for a 10-year evaluation period, based on changes in the implied equity-risk premium. Measuring performance on a daily basis seems certain to drive the risk premium even higher, costing investors considerably more than 5.1 percent.

Do yourself a favor and try to resist the urge to calculate your portfolio value in real time. The quotes may be free, but the total cost can be huge.

2. Trading too often.

Frequent evaluation leads, naturally, to frequent trades. Terrance Odean and Brad Barber studied activity in 66,000 accounts at a large discount broker from 1991 to 1996 and came to this conclusion: “Trading is hazardous to your wealth.”

They found that individuals who trade frequently (with monthly turnover above 8.8 percent) earned a net annualized return of 11.4 percent over that time, while inactive accounts netted 18.5 percent. Trading costs, in the form of commissions and losses on the bid-ask spread, accounted for most of the difference. Those costs have likely fallen since 1996, as more discount brokers have pressured commission prices and decimalization has reduced spreads, but friction costs remain a drag on overall returns.

But surely investors got some benefit from trading less desirable stocks for better ones, right? Nope. In fact, Odean and Barber found that, excluding transaction costs, newly acquired stocks actually slightly underperformed the stocks that were sold! That bears repeating: By trading frequently, individuals hurt not only their performance net of fees, but they also hurt their performance before fees.

Why would this be? Odean and Barber believe that it reflects investors’ overconfidence in their ability to assess information. It’s clear that rapid traders are making unreasonable bets — one would expect that they would trade only when the benefit would offset at least the cost of trading, but that was clearly not the case in this data set. But does high turnover reflect self-assurance, or could it betray the lack of it?

Investors in Odean and Barber’s study were much more likely to sell winners. This appears to reflect the desire to “take some profits,” while not wanting to accept defeat in the case of the losers. (Philip Fisher writes in his excellent book “Common Stocks and Uncommon Profits” that “more money has probably been lost by investors holding a stock they really did not want until they could “at least come out even’ than from any other single reason.”) Such a tendency would be in keeping with myopic loss aversion: People may view losses as more likely in a stock that’s up than one that’s down. This attitude would also mesh with another common trait, framing evaluations on meaningless benchmarks, such as what price you bought a stock at.

Perhaps, then, investors aren’t confident in their understanding of their investments and simply worry that they could lose their gains. They may feel more comfortable jumping into an investment that others currently recommend.

3. Getting distracted by shiny objects.

There are thousands and thousands of stocks out there. Investors cannot know them all; in fact, it’s a major endeavor to really know even a few of them. But people are bombarded with stock ideas from brokers, television, magazines, Web sites and other places. Inevitably, some decide that the latest idea they’ve heard is a better idea than a stock they own (preferably one that’s up), and they make a trade. Unfortunately, in many cases the stock has come to the public’s attention because of its strong previous performance. When this is followed by a reversion to the mean, new investors get burned.

This is not to say that an investor should necessarily hold whatever investments he or she currently owns. Some stocks should be sold, whether because their underlying businesses have declined or the stocks simply exceed their intrinsic value.

But it is clear that many individual (and institutional) investors hurt themselves by making too many buy and sell decisions for too many fallacious reasons. We can all be much better investors when we learn to select stocks carefully and then block out the noise.

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For comprehensive daily mutual fund and stock data, articles and news, or to find out more about Morningstar and its products and services, please visit http://www.morningstar.com.

(c) 2003, Morningstar. Distributed by Knight Ridder/Tribune Business News.

BRK,