*** In from Bloomington, I went to the Midtown Yacht Club last night — a local watering hole here in Baltimore — to catch up with some friends. After a few Budweisers and Miller Lites (not sure how many exactly), my buddy Mark starting talking about his 401(k).

“I don’t understand,” Mark said. “As it is, my 401(k) only made about 1% or 2% last year. That’s terrible. Heck, my savings account can make that much. What am I doing wrong? I have all my money in large-cap stocks and bonds — split 50-50.”

Of course, no question is too difficult to answer after drinking a few cold ones. So I started in…

“You are a young guy — in your mid-20s,” I said. “You have 30 years or more to make money. Unless you are really worried, there’s no reason to have ALL your cash in just big-name, large-cap stocks and low-yielding bonds. Over long periods of time (like 20- and 30-year spans), stocks rise — more than bonds (and savings accounts!) — and small-cap stocks outperform large caps. So you should take advantage of that. Time is on your side.”

I told Mark about this book I read yesterday on the plane from Indianapolis to Baltimore. It’s called Investing in Small-Cap Stocks, by Christopher Graja and Elizabeth Ungar. I happened to have the book in my briefcase…so I pulled it out and thumbed through until I found a series of asset allocations charts on Pages 26 and 27. (It’s a wonder why I am still single!)

Graja and Ungar recommend an investor in their mid-20s (like Mark) have 70% of their cash in stocks, 25% in bonds and 5% in cash.

“Wow, that’s great,” said Mark. “But what kind of stocks should I be holding?”

Your Penny Sleuth editor was getting there! Man, a few beers and everyone gets jumpy!

Graja and Ungar suggest that an aggressive investor with a steady stream of earnings and a stomach for some short-term risk have 20% invested in small-cap stocks, 20% in growth stocks, 15% in international funds and 15% in growth or value funds.

By contrast, an investor in his or her late 60s and beyond should typically have 60% of his money in bonds, 30% in stocks and 10% in cash. And there is no mention of owning any small-cap stocks.

So what’s the deal?

Time is a small-cap investor’s biggest ally. If you have 10, 20, even 30 years until you need to retire, you would be a fool not to invest in small-cap stocks. According to Graja and Ungar…

“Stocks outperformed bonds in every one of the 20-year periods from 1926-1995, and in 94% of those periods, the smallest stocks did better than larger ones.”

Heck, even if you are only willing to hold a basket of small-cap stocks for 10-year periods, they will outperform large caps 60% of the time.

The longer you are willing to hold a diverse portfolio of good small-cap stocks, the more your risk diminishes…

Graja and Ungar quoted Bob Barker — known as the Warren Buffett of the small-cap universe and the head of his own investment firm — who said, “If…half your companies are mistakes, and you lose everything in them, and the other half go up between five and 10 times, that’s all you need…. My father bought $700 worth of Frito in the old days. Frito got bought out by Pepsi. That investment turned into more than $6 million. Every other stocks he bought lost money, but that one made up for it.”

Of course, Barker’s dad did two things right. He invested in a basket of small-cap stocks — not just one or two. And he held for a long period — taking advantage of any small-cap investor’s largest ally…TIME.

By the end of my fourth or fifth beer, I had Mark thinking. In fact, he just stopped by my desk this morning and asked to borrow my copy of Investing in Small-Cap Stocks. He is going to restructure his portfolio more according to his risk and time frame. That’s not a bad thing to do — especially as we are only two weeks into the new year.

I strongly suggest you pick up a copy of Graja and Ungar’s book. (I think I bought it online for about $10). And if you are looking for another great site on asset allocation, check out http://www.russell.com/us/sitenav.asp. Click on “Individual Investors” and then “Education Center.”

The difference between being properly diversified can be the difference between making 1% or 2% or giving yourself the chance to turn a $700 investment in Frito-Lay into a cool $6 million. The ball is in your court!

*** In keeping with the theme of sharing our favorite investment books, Fleet Street editor Chris Mayer will now share his. And it’s pretty darn good stuff. In fact, if you follow the 10 simple guidelines he presents, you will be well on your way to making good money in this (or any) market.

Chris, whatcha got for us…?

Neuberger’s 10 Principles of Successful Investing

Roy Neuberger led a remarkable life. The co-founder of Neuberger Berman, the multibillion-dollar investment management company, had a long investing career. At the age of 94, he sat down and wrote his memoir, So Far, So Good — The First 94 Years, published in 1997. Over his 68 years on the Street, covering the meat of the tumultuous 20th century, he never had a losing year. The man knew something about investing. In his memoirs, he offers his 10 principles of successful investing. In today’s column, we’ll take a look at them.

1. Know Thyself

The first of Neuberger’s rules deals with understanding your own strengths, weaknesses and preferences. Are you a speculator, comfortable with taking some risks? Or are you a more conservative investor, willing to wait it out? As the old saying goes, if you don’t know who you are, the market is an expensive place to find out.

2. Study the Great Investors

Neuberger lists among them Warren Buffett, Ben Graham, Peter Lynch, George Soros and Jimmy Rogers. In my own letter, Fleet Street Letter, I regularly feature successful investors and entrepreneurs of the past. Many of them are not so well known — Cyrus Holliday, C.V. Starr and Augustus Heinze among them. There are great stories here, worthy of study. You can learn a great deal studying the unsuccessful investors as well. How great fortunes are lost can be even more informative than how they are won.

3. Beware of the Sheep Market

“The sheep market is a little like the fashion industry,” Neuberger writes. “When a great couturier makes a new style of dress or suit, the minor designers copy it. If the hemlines on a dress go up or down, millions of people follow the fashion. That is a sheep market.”

The herd instinct is strong with investors. Hearing the opinions of prominent analysts or media types, investors may find it hard to find their own path. The sheep market is basically one driven by crowd psychology, and it can be dangerous to your wealth to follow that market. Keep your own counsel.

4. Keep a Long-Term Perspective

What is one way to immunize yourself against the suggestions of the crowd? “Keeping a long-term perspective will keep you from being diverted by fads,” Neuberger writes. “There have always been fads on Wall Street, from the Stutz Bearcat autos of the 1920s to the bowling stocks of the late 1950s.”

Most investors spend far too much time worrying about next quarter’s earnings and fretting about day-to-day, or even minute-to-minute, stock prices. Neuberger advises keeping the longer-term trends in mind and also studying the past. “Be your own historian,” Neuberger writes. This bit of advice is particularly warming to me, because again, in my own letter, I often write about the past — it helps to keep perspective. In the past few issues, I’ve written about early 20th-century panics, the Swedish Match King and the founding of the House of Morgan.

All of these things make one realize that our collective financial experiences have covered just about everything. I remember reading somewhere that the only new thing in finance is the history you haven’t read. I think there is a great deal of truth in that.

5. Get in and out in Time

“Timing may not be everything, but it is a lot.” Neuberger is not recommending you become a market timer, but he emphasizes the notion that no investment is good all the time. “Everything changes,” he notes, “I just don’t believe you can have confidence in any industry for an infinite length of time.” He also writes that it is important to recognize and close out your mistakes.

6. Analyze the Companies Closely

Neuberger had a preference for tangible assets. “Check the company’s real assets,” Neuberger advises. Plant and equipment, real estate, natural resources and other assets get a big plus in Neuberger’s investing schema. These assets should be connected with the company’s business and its ability to generate cash flow. Again, I find myself aligned with Neuberger’s thinking. In the last few issues, I’ve recommended companies with piles of cash-generating assets — industrial properties, mines, hotels, airports and more.

7. Don’t Fall in Love

“People should fall in love with ideas, with people, or with idealism based on the
possibilities that exist in this adventuresome world. The last thing to fall in love with is a particular security.” Enough said.

8. Diversify, but Don’t Hedge Alone

It was Neuberger’s diversification and hedging strategies that allowed him to weather the collapse of ’29. He was short Radio Corp. of America, which was cut in half in the collapse and covered losses in other positions. The basic advice here is to be flexible and maintain some balance so you can pull through the unexpected dips and swirls of the market.

9. Watch the Environment

Neuberger maintained that investors should keep an eye on general market conditions. As he says, the joys of living and investing are enhanced with an appreciation for the shifting financial seasons.

10. Don’t Follow the Rules

“At least not slavishly,” Neuberger adds to this last principle. Be willing to change your thinking and to challenge the thinking of others. Succeed in your own way, Neuberger advises. And remember that we all make mistakes. “Always-right investors don’t exist,” Neuberger concludes, “except among liars.”

Signing off for Penny Sleuth,

Chris Mayer
Editor, Fleet Street Letter

January 18, 2005

Neuberger’s 10 Principles of Successful Investing was originally featured in the Penny Sleuth.