By Michael Brush

MSN Money

It’s downright nasty out there. Jobs keep disappearing. Scared consumers have stuffed money under mattresses instead of spending or investing.

We’re all getting back to basics like friends, family and frugality. In the market, old hands have been forced to reconsider their basic assumptions, and newer investors wonder whether anything they’ve learned thus far still holds.

To help sort through the confusion, here are my answers to 10 simple (and not-so-dumb) questions we have to be able to answer before we can move ahead.

1. Should I own stocks?

This may seem like a candidate for Dumb Question of the Year in the midst of a precarious rally following an epic bear market that saw a fall of 50% from its high. But the answer is the same as it has always been: Yes, you should own stocks, assuming you are saving for a long-range goal like retirement or college tuition. Over the long run, stocks do better than other investments.

But here’s a good basic rule of thumb: Don’t put or keep money in stocks if you need it in less than five years. (Read "When’s the right time to invest?" for more on this.)

2. How do I know what a stock is really worth?

In the short term, what a stock is worth is exactly what someone will pay for it today. But that doesn’t help you invest for tomorrow.

The value gauge used most often by the pros is the price-earnings ratio. To calculate the ratio, take the current price of a stock and divide it by its earnings for a year. If a stock trades for $50 and is expected to earn $1 a share next year, it trades for a P/E ratio of 50.

Investing guru John Neff counted it as one of the key tools behind the 13.7% average annual returns he produced while he managed the Windsor Fund (VWNDX) from 1964 to 1995.

This ratio tells you whether a stock is cheap, meaning that it trades for a lower P/E than stocks of similar companies. But the biggest insight from the ratio, Neff says, is that it tells you what kind of growth other investors expect. If their expectations are too high, they’re willing to pay more, and the P/E ratio will be high.

For example: If one stock trades for a P/E of 50 and another trades for a P/E of 10, it means investors are willing to pay five times as much for a dollar of earnings at the first company. That’s usually because they expect earnings to grow much more rapidly at the first company. Neff reasoned that since investors have higher expectations for that stock, it runs a higher risk of crashing if it posts disappointing results, writes John Reese in his recent book "The Guru Investor."

Neff, as a value investor, favored cheap stocks of companies that were so disliked that people wouldn’t pay much for them. They had extremely low P/E ratios — often in the single digits. He knew that bad news wouldn’t drive them much lower and that any improvement would drive them much higher.

3. What’s a PEG ratio?

So-called growth investors prefer stocks in fast-moving sectors such as technology, which tend to have high P/E ratios because of higher growth expectations.

They compare a company’s P/E to its expected growth rate. Generally, a company is considered fairly valued if its P/E is the same as its growth rate. And it’s considered cheap if the P/E is below the growth rate. This ratio of P/E to expected growth is called the PEG ratio.

The PEG ratio helped one of the world’s most successful investors ever — Peter Lynch — produce 29.2% annual growth at Fidelity Investment’s Magellan Fund (FMAGX) when he managed it from 1977 to 1990.

4. How much do dividends matter?

Cautious investors love companies that send profits to shareholders. Companies that pay dividends tend to be in more-stable sectors, such as consumer staples or utilities, and they pay investors through good market times and bad. And with so many of us suspicious about Wall Street, dividends are real money you can trust more than forecasts or projections.

When shopping for dividend plays, though, avoid the trap. If dividend yields — dividend divided by stock price — are sky-high, it could be because the stock price has tanked or because of some serious problem not yet revealed. Troubled companies eventually cut their dividends. Be suspicious of a yield over 10%. (Read "Stocks that pay you to own them" for more.)

5. Should I buy individual stocks or mutual funds?

These days, some experts say single stocks are simply too risky for most investors. The real answer depends on how much time you have.

If you go with stocks, you’re going to need a portfolio of at least a dozen and probably more. A variety keeps you diversified, so that problems in one company or sector won’t wipe you out. You also need the time to understand and track those stocks; if you don’t, you’re speculating, not investing.

Mutual funds let investors pool their resources so that a professional money manager can invest for them. The problem here is that the returns posted by most mutual fund managers trail the market, partly because of their fees. (Read "Are fund managers worth their pay?" for more.)

You also get a tax bill as they buy and sell and, hopefully, collect capital gains.

A solution is to go with index funds that invest in a broad basket of stocks such as the S&P 500 Index ($INX). The fees are lower, and you get the diversification you need. Plus the stocks are traded less often, so the tax burden is usually lower.

6. What’s the difference between a mutual fund and an ETF?

With a mutual fund, you give your money to a fund company, which then invests it in such things as stocks or bonds. The fund’s value is calculated once a day, after the markets have closed. An ETF, or exchange-traded fund, is a basket of stocks, bonds or commodities that usually follows an index and that you can buy and sell throughout the day, just like a stock.

ETFs typically have lower expenses and fees, but, as with a stock, you have to pay a commission to buy them. Because you control sales, you have more control over when you’ll get a tax bill for taking profits.

7. Why can’t I time the market?

It looks easy because stocks go up and down so regularly. If you could consistently buy on the dips and sell into the rallies, you could retire in no time. Unfortunately, even most pros find it hard to time the market. Most hedge funds did horribly last year, for example.

There are two basic reasons it’s difficult. First, predicting what’s going to happen next at a company or in the economy is only half the problem. You also have to predict investor expectations, because they set market prices as much as anything else, points out Axel Merk of Merk Mutual Funds. Predicting what a large crowd is going to think next is virtually impossible.

It’s also tough not to get caught up in the emotion of the moment. When everyone is bullish and stocks are rising, you’re likely to do the same and stay in the market too long. Likewise, at market bottoms, things are typically so gloomy that you won’t want to put money into stocks. Because markets tend to move up over long periods, the best thing is to spend time in the market rather than try to time the market. (Read more in "The 5 biggest 401k mistakes.")

8. What is dollar-cost averaging?

A simple way to deal with the fact that you can’t time the market is to dollar-cost average. Put the same amount of money into the market at the same time every week, month or quarter.

True, you’ll rarely get the best prices. But you won’t always buy at the worst time either — at the top, when it is easiest to buy because you feel most confident. Instead, you’ll get an average of the prices of stocks over time, which is better than what would happen if you just followed your emotions. (Read "Wade into the market? Or plunge?")

9. What are bonds?

Bonds are loans — to companies or governments. They typically offer regular interest payments every quarter through what’s known as coupons. Then when the bonds expire, or reach maturity, you get your original loan back.

Bonds are generally safer than stocks. But returns tend to be lower, and they do carry risks. Bonds issued by companies carry credit risk. That means companies could do so badly that they go out of business and can’t pay you back.

Bonds also present interest-rate risk. Once a bond has been issued, its price in the market will move in the opposite direction of interest rates. When rates go up, the prices of existing bonds have to fall so that they offer a higher return to anyone who wants to buy them at that point.

None of this matters if you buy a bond outright and plan to hold it until the loan is repaid. Your gain is the interest — or coupon — that you signed up for at the start.

But if you buy bond mutual funds, it’s a different matter. The value of the fund is affected by the prices of bonds in the fund. If interest rates go up, the price of the bonds in your fund will sink, and so will the value of your fund. The fund value could then stay down for a long time, depending on how your fund manager reacts.

10. Should I own gold?

At its best, gold serves as a store of value for the times when things get so bad that all other assets, such as stocks, bonds and home values, are falling apart. Look at it as a kind of insurance.

But unless you are a gold bug or a survivalist who also keeps a year’s supply of food and water on hand at all times, it doesn’t make sense to have more than about 5% of your wealth in gold. The reason: Gold prices are extremely volatile, and it’s tough to predict where they are going next.

Historically, gold prices go up when the dollar sinks, when oil prices rise and sometimes when inflation heats up. But since predicting any of those trends is tough, it doesn’t make sense for most average investors to hold gold as a play on those themes.

How should you own gold? The survivalists like bullion buried in the backyard. But for most people, gold is costly to store, and commissions are high. The gold ETFs make more sense for a portfolio. ( Read "Why gold prices will keep rising" for more.)

And there you have it: 10 basic answers and some rules to hold on to at a time when nothing seems particularly simple. They won’t bring your portfolio back overnight, but they might help you get back on track.

Looking for other answers or have your own rules to offer? Post your questions or comments on the Your Money message board, and I’ll consider them for a future column.

At the time of publication, Michael Brush did not own or control shares of any fund mentioned in this column.

Updated Sept, 25, 2009

By Jim Jubak

When the financial markets experience a strong trend, investors tend to pass through five distinct emotional stages:

1. Denial. The trend isn’t real. Or it’s nothing an intelligent investor would put a dollar in.
2. Skepticism. OK, there may be something there, but it’s too risky.
3. Bargaining. The trend is real. I’ll invest, but only if the price is right.
4. Regret. God, I’ve missed it. The time to get in was three months ago.
5. Panic. This trend will go on forever. The risks were overstated. I’ve got to buy in.

We’re now moving to Stage 5 in the so-called collapse of the U.S. dollar, which means this trend is actually nearing an end. That doesn’t mean it’s going to end overnight. Trends always run to excess and beyond. It does mean we’re getting to the point where the easy profits are gone and that the risk is starting to rise.

And if you’ve been investing for a while, your portfolio has the wounds that show how dangerous it is to buy into a trend when everybody believes they must get in. (The smartest money is usually headed to the door at just about that point.)

It’s not necessarily time to abandon a trend when it reaches Stage 5, but it is time to start trimming rather than pouring in money. And it’s a time to think very, very carefully about what stocks and other vehicles you use to ride the last stages of this trend.

How far the dollar has fallen

The dollar is down about 9% against the euro since January and about 11% against a trade-weighted basket of currencies.

And the damage is even worse against what I’d call the world’s commodity currencies. So, for example, the dollar is down about 16% in 2009 against the Canadian dollar, 24% against the Australian dollar and 27% against the Brazilian real.

There are good reasons for the decline:

• The U.S. consumer is in a deep, deep hole. Households owed 127% of disposable annual income at the end of 2008, according to the Federal Reserve. To get that ratio down to 91%, the average from 1990 to 2000, households would have to shed $4.4 trillion in debt.
• Government debt has soared during the financial crisis, and the federal budget wasn’t in great shape to begin with, given huge unfunded liabilities in health care and retirement programs. The percentage of federal debt held by the public is projected to go from 41% of the gross domestic product in 2008 to 68% by 2019.
• The U.S. has been slower coming out of the economic slowdown than China, India, Brazil, Australia, France, Germany . . . well, the list goes on and on. Interest rates in many of those countries are already higher than in the United States, and in some — Australia, for example — central banks have already started to increase interest rates.

When a currency goes into a fall like the dollar’s recent plunge, the trend starts to feed on itself. The dollar goes down (or just threatens to go down), and no one wants to risk owning dollars, which makes the dollar sink further, which makes fewer people want to own dollars.

And it takes a pretty big shock to reverse this kind of self-reinforcing move. In an Oct. 14 post on JubakPicks.com, I laid out the case that the downward trend for the U.S. dollar will continue until sometime around mid-2010, when the Federal Reserve makes it clear that it is on course to start increasing short-term U.S. interest rates from today’s level near 0.25%.

How much more can it fall?

But it’s one thing to say the U.S. dollar is likely to slide lower over the next six to nine months and quite another to say that the dollar is going to fall an additional 50% or is worthless. That sounds like Stage 5 panic to me.

When I hear this kind of stuff, it makes me want to cut back on commodity-related and emerging market stocks.

I’m apparently not the only one to have these thoughts, an e-mail from reader Terry W. points out. Analysts who have cranked through Goldman Sachs’ (GS, news, msgs) recently released third-quarter earnings believe they detect signs that Goldman is getting less bullish on commodity prices just as competitors, such as JPMorgan Chase (JPM, news, msgs), are getting more aggressive.

I’m not taking any action yet, but I am becoming more vigilant and looking for the kinds of comments that send up red flags.

But what about the warnings?

It doesn’t bother me when analysts such as Bill Fleckenstein and Jim Grant call the dollar worthless. That’s been their position since they were old enough to feel cheated when the price of Batman comics went from 10 cents to 12 cents.

What smacks of dollar panic is when we get voices that are normally bullish — and remember that Wall Street is almost always bullish –jumping on the "dollar is worthless" bandwagon.

Such as these comments from Daisuke Uno, the chief strategist at Sumitomo Mitsui Banking: "The U.S. economy will deteriorate into 2011 as the effects of excess consumption and the financial bubble linger. The dollar’s fall won’t stop until there’s a change to the global currency system."

Uno finished by saying the dollar may drop to 50 yen next year and eventually lose its role as the global reserve currency.

Well, eventually is a long time, but 50 yen to the dollar? That’s a drop of about 45% from today’s exchange rate of about 90 yen to the dollar.

The yen? Really?

Against the yen? Japan is the most indebted developed economy in the world, with a government debt that at the end of 2008 ran to 170% of GDP. It has one of the oldest populations in the world and a country with a dysfunctional political system that pumps money into underproductive rural areas because they have disproportionate electoral clout. (The U.S. ratio, remember, was shocking at 41% last year and is projected to be a horrifying 68% by 2019.)

And the dollar is supposed to fall 45% against the yen? When the yen has remained essentially flat against the dollar during all the U.S. troubles in 2009? That feels like jumping on the bandwagon in panic, Mr. Chief Strategist.

I can hear the same panic in the current bidding to see who can set the highest price on gold. Not so long ago, the consensus was that $1,150 an ounce or so might be a top for gold. That’s been left in the dust. As has $1,200 an ounce. And you don’t have to look very hard to find analysts calling for $1,500. Next year. That’s a 50% climb in the price of gold. Think about it.

Looking ahead

So what should you do?

If you hold stocks or other assets that benefit from the rising belief in the falling value of the U.S. dollar, hold on. It wouldn’t hurt to set actual or mental stop-loss targets 8% or so below current prices for these volatile investments.

If you’ve missed the falling dollar rally to date, don’t do anything stupid. A prediction that the dollar will tumble 50% more isn’t a good enough reason to load up on anything. The dollar has months of decline ahead of it, but the decline is likely to be relatively gentle. When we’re talking about the big drop in the dollar in 2009, we’re talking about 11%.

You could have done way better than that by simply forgetting about the dollar and just buying a Standard & Poor’s 500 Index ($INX) fund or an exchange-traded fund that tracked the technology sector.

If you must buy something to play the falling dollar, try to stick with investments that have real fundamentals behind them. Buying the iShares MSCI Brazil ETF (EWZ, news, msgs) or the Market Vectors Brazil Small-Cap ETF (BRF, news, msgs), a Jubak’s Pick, for example, gives you exposure to a falling U.S. currency and, more importantly, a chance to profit from fundamental improvement in the Brazilian economy.

All market trends run to excess. But that doesn’t mean you have strap on your track shoes.

At the time of publication, Jim Jubak owned or controlled shares of the following funds mentioned in this column: iShares MSCI Brazil ETF and Market Vectors Brazil Small-Cap ETF.

Jim Jubak has been writing Jubak’s Journal and tracking the performance of his market-beating Jubak’s Picks portfolio since 1997 on MSN Money. He is the author of a new book, "The Jubak Picks," and writer of the Jubak Picks blog. He’s also the senior markets editor at MoneyShow.com.

By Michael Brush

MSN Money

Last year’s market madness didn’t just flush away $7 trillion in wealth.

It also washed away a lot of investors’ confidence and left them stumped about the best position to take now. "Somewhere between cash and fetal," quips one pessimist.

In such downbeat times, let’s consider a dose of optimism, wisdom and insight: the basics as taught by that perennial investing Yoda, Warren Buffett.

For new investors or those now starting over, there’s good news here because Buffett’s investment success comes from some easy-to-grasp human qualities as much as sophisticated expertise in balance sheets.

Buffett would be the first to say his homespun and positive philosophy played a big role in his becoming the richest person in the world (before he gave most of his loot away).

Changing your basic psychology can be tough, so new investors may have a leg up here because they don’t have ingrained bad habits. But for anyone, a psychological makeover is worth the effort if you hope to recover your losses in the market’s next leg up — and then make the right moves for the rest of your life.

My tour of the essence of Buffett’s wisdom starts with the simple psychological lessons taught by the master, many of which are applicable in life outside investing.

Lesson No. 1: Be frugal

If the economic downturn is forcing you to live simply, look on the bright side: It’s making you more like Buffett.

Buffett lives in the same modest house in Omaha, Neb., that he bought more than five decades ago. He drives his own car.

How does this make him a better investor? First, it gives him more to invest.

Second, a frugal investor will demand this quality from managers. Buffett is leery of corporate waste. Excessive executive pay or silly perks are red flags. Buffett once quipped that companies stack pay committees with "sedated Chihuahuas."

Third, frugal people don’t need fast returns to support extravagant lifestyles. This leaves them free to think more clearly about when to buy and sell stocks, making them much better investors, believes Stephen Shueh, a Buffett expert and managing partner of Roundview Capital in Princeton, N.J.

Lesson No. 2: Wait for the ‘fat pitch’

Resist the itch to constantly buy or sell stocks.

"Lethargy bordering on sloth remains the cornerstone of our investment style," quipped Buffett in his 1990 annual report to Berkshire Hathaway (BRK.A, news, msgs) shareholders. Have the patience to wait a long time until some market turbulence brings the "fat pitch," as Buffett calls it, or stocks of great companies trading at really cheap valuations.

Lesson No. 3: Be a contrarian

A great way to make money is to go against the crowd. "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful," Buffett explained in a 1986 letter to shareholders.

So be skeptical of the conventional wisdom. Not because the crowd is always wrong but because the crowd’s wisdom is probably already reflected in market prices, says Todd Lowenstein, a portfolio co-manager of the HighMark Value Momentum Fund (HMVMX).

When the investing public is extremely negative, it’s usually a good time to buy stocks. When investors are confident, be careful.

Lesson No. 4: Stick with what you know

One of Buffett’s basic rules is: If you don’t understand a company’s product or how it makes money, avoid it. He calls this "staying within your circle of confidence."

This isn’t always easy. During the late 1990s boom, Buffett famously avoided tech companies, confessing that he could not understand what they did. He looked dumb until the bubble burst. "Ultimately, when it came full circle, he was proven right," Lowenstein says.

Lesson No. 5: Don’t depend on others to say you’re right

If you are in need of constant affirmation about your investment decisions, particularly from the stock market, you won’t be able to invest like Buffett, points out Legg Mason (LM, news, msgs) money manager Robert Hagstrom in his book "The Warren Buffett Way."

That’s because Buffett makes outsized returns by purchasing disliked value stocks that are so beaten down they’re often virtually ignored by the talking heads. They won’t be on TV every week telling you that you made the right choice.

Lesson No. 6: Buy companies cheap

This is the essence of being a value investor. The first step involves calculating what Buffett calls an "intrinsic value" for a business — either by examining what similar companies sell for or calculating the present value of all the cash that will be generated by a company in the future. For more details on how to do this, you’ll have to consult books such as "The Warren Buffett Way" or "The Market Gurus" by Validea’s John Reese.

Next, build in a "margin of safety" by purchasing a stock well below its intrinsic value.

Buffett doesn’t pay much attention to earnings per share, a common measure of value. Instead, he likes to see companies with good return on equity, solid operating margins and reasonable or no debt. He also likes to see that companies generate a lot of cash and that they invest it well or return it to shareholders in the form of dividends or buybacks.

The key throughout this analysis is to look back over five years or more. Buffett wants to see a consistent operating history; he’s not into startup companies. He also prefers to gauge how well a company does in different kinds of markets, not just the good times or the latest quarter.

Lesson No. 7: Look for companies with economic moats

A key characteristic supporting consistent operating history is a sustainable competitive advantage. In other words, a company should have a barrier to entry — or a kind of moat — that keeps potential competitors at bay.

This could be a patent protection on drugs, high costs to get into a business or simple brand power, fund manager Lowenstein says. "Franchise" businesses like these can do well because they have the power to raise prices. In contrast, companies in "commodity" businesses have to take whatever price is set by a competitive market — which can crush profits during hard times.

BNSF Railway is a great example of a "franchise" business. It’s pretty hard for anyone to lay enough track in North America to start a competing railroad. Coca-Cola (KO, news, msgs), another long-term Buffett holding, has barriers to entry in the form of a strong global brand and distribution system that is hard to replicate.

Lesson No. 8: Buy big, concentrated positions

Most professional money managers protect against risk by diversifying. Buffett goes against the crowd here, too. When he finds a company he likes, he piles into it big time.

This is crucial to his success. Money manager Hagstrom calculates that if you eliminate a dozen of Buffett’s best investment choices over his career, he’s only an average performer. Buffett thinks his risk protection comes from understanding a business better than the market does and then being patient enough to buy it at the right price.

Lesson No. 9: Hold for life

Buffett quips that his favorite holding period is "forever." Embedded in this concept are two key Buffett tenets I’ve already alluded to. First, it’s worth investing only in companies that are good enough to outperform for decades. Next, you have to think on your own and avoid the madness of the crowd.

"Buffett believes that unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market," Hagstrom says.

This doesn’t mean buy and forget. Buffett tracks his investments closely and gets out when he thinks that they are fully valued or that trouble is on the way, points out Pat Dorsey, the director of stock analysis at Morningstar (MORN, news, msgs). A few years back, Buffett sold big positions in Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs), the home mortgage companies that blew up last year.

Buffett is not infallible, however. He still owns big positions in Gannett (GCI, news, msgs) and Washington Post (WPO, news, msgs) even though he forecast at his 2004 annual meeting that the newspaper business would see nothing but trouble for decades.

The price of his company’s stock — always a major part of his wealth — dropped 31% in 2008 and continued to follow the market down early this year. Since, it and the market have rallied strongly.

Lesson No. 10: Believe in America

Unlike most investors, Buffett doesn’t tweak his portfolio depending on which party is coming into office or where we are in the economic cycle. This may make him seen naive. But it also has him putting money to work now, when many others have lost faith in the U.S. economic system. It’s a move that will likely make him a winner down the road yet again.

After all, the current fears about the long-term prosperity of U.S. companies make no sense, he wrote in an October op-ed column in The New York Times. That’s why he was buying stocks before the current rally began.

"These businesses will indeed suffer earnings hiccups, as they always have," he wrote. "But most major companies will be setting new profit records five, 10 and 20 years from now."

At the time of publication, Michael Brush did not own or control shares of any company mentioned in this column. This article was updated June 17 2009.

By The Wall Street Journal

What was I thinking?

If there’s one question that investors have asked themselves over the past year and a half, it’s that one. If only I had acted differently, they say. If only, if only, if only.

Yet here’s the problem: While we know we made investment mistakes, and vow not to repeat them, most people have only the vaguest sense of what those mistakes were, or, more importantly, why they made them. Why did we think and feel and behave as we did? Why did we act in a way that today, in hindsight, seems so obviously stupid? Only by understanding the answers to these questions can we begin to improve our financial future.

This is where behavioral finance comes in. Most investors are intelligent people, neither irrational nor insane. But behavioral finance tells us we are also normal, with brains that are often full and emotions that are often overflowing. And that means we are normally smart at times and normally stupid at others.

The trick, therefore, is to learn to increase our ratio of smart behavior to stupid. And since we cannot (thank goodness) turn ourselves into computer-like people, we need to find tools to help us act smart even when our thinking and feelings tempt us to be stupid.

Let me give you one example. Investors tend to think about each stock we purchase in a vacuum, distinct from other stocks in our portfolio. We are happy to realize "paper" gains in each stock quickly, but procrastinate when it comes to realizing losses. Why? Because while regret over a paper loss stings, we can console ourselves in the hope that, in time, the stock will roar back into a gain.

By contrast, all hope would be extinguished if we sold the stock and realized our loss. We would feel the searing pain of regret. So we do pretty much anything to avoid that pain — including holding on to the stock long after we should have sold it. Indeed, I’ve recently encountered an investor who procrastinated in realizing his losses on WorldCom stock until a letter from his broker informed him that the stock was worthless.

Successful professional traders are subject to the same emotions as the rest of us. But they counter it in two ways. First, they know their weakness, placing them on guard against it. Second, they establish "sell disciplines" that force them to realize losses even when they know that the pain of regret is sure to follow.

So in what other ways do our misguided thoughts and feelings get in the way of successful investing — not to mention increasing our stress levels? And what are the lessons we should learn, once we recognize those cognitive and emotional errors? Here are eight of them.

No. 1: Caring that Goldman Sachs is faster than you

There is an old story about two hikers who encounter a tiger. One says: There is no point in running because the tiger is faster than either of us. The other says: It is not about whether the tiger is faster than either of us. It is about whether I’m faster than you. And with that he runs away. The speed of the Goldman Sachses of the world has been boosted most recently by computerized high-frequency trading. Can you really outrun them?

It is normal for us, the individual investors, to frame the market race as a race against the market. We hope to win by buying and selling investments at the right time. That doesn’t seem so hard. But we are much too slow in our race with the Goldman Sachses.

So what does this mean in practical terms? The most obvious lesson is that individual investors should never enter a race against faster runners by trading frequently on every little bit of news (or rumors).

Instead, simply buy and hold a diversified portfolio. Banal? Yes. Obvious? Yes. Typically followed? Sadly, no. Too often cognitive errors and emotions get in our way.

No. 2: Thinking foresight can be as clear as hindsight

Wasn’t it obvious in 2007 that financial institutions and financial markets were about to collapse? Well, it was not obvious to me, and it was probably not obvious to you, either. Hindsight error leads us to think that we could have seen in foresight what we see only in hindsight. And it makes us overconfident in our certainty about what’s going to happen.

Want to check the quality of your foresight? Write down in permanent ink your forecast of tomorrow’s stock prices. Do that each day for a year and check the accuracy of your predictions. You are likely to find that your foresight is not nearly as good as your hindsight.

As the market tanked, investors wondered where to put their money. Many are turning to advisers, but don’t know how to choose the right one.

Some prognosticators say we are in a new bull market and others say this is only a bull bounce in a bear market. We will know in hindsight which prognostication was right, but we don’t know it in foresight.

When I hear in my mind’s ear a voice that says the stock market is sure to zoom or plunge, I activate my "noise-canceling" device rather than go online and trade. You might wish to install this device in your mind as well.

No. 3: Being led by the pain of regret

Emotions are useful, even when they sting. The pain of regret over stupid comments teaches presidents and the rest of us to calibrate our words more carefully. But sometimes emotions mislead us into stupid behavior.

We feel the pain of regret when we find, in hindsight, that our portfolios would have been overflowing if only we had sold all the stocks in 2007. The pain of regret is especially searing when we bear responsibility for the decision not to sell our stocks in 2007. We are tempted to alleviate our pain by shifting responsibility to our financial advisers. "I am not stupid," we say. "My financial adviser is stupid." Financial advisers are sorely tempted to reciprocate, as the adviser in the cartoon who says: "If we’re being honest, it was your decision to follow my recommendation that cost you money."

In truth, responsibility belongs to bad luck. Follow your mother’s good advice: "Don’t cry over spilled milk."

Where am I leading you? Stop focusing on blame and regret and yesterday and start thinking about today and tomorrow. Don’t let regret lead you to hold on to stocks you should be selling. Instead, consider getting rid of your 2007 losing stocks and using the money immediately to buy similar stocks. You’ll feel the pain of regret today. But you’ll feel the joy of pride next April when the realized losses turn into tax deductions.

No. 4: Letting investment success stories blind you

Have you ever seen a lottery commercial showing a man muttering "lost again" as he tears his ticket in disgust? Of course not. What you see instead are smiling winners holding giant checks.

Lottery promoters tilt the scales by making the handful of winners available to our memory while obscuring the many millions of losers. Then, once we have settled on a belief, such as "I’m going to win the lottery," we tend to look for evidence that confirms our belief rather than evidence that might refute it. So we figure our favorite lottery number is due for a win because it has not won in years. Or we try to divine — through dreams, horoscopes, fortune cookies — the next winning numbers. But we neglect to note evidence that hardly anybody ever wins the lottery, and that lottery numbers can go for decades without winning. This is the work of the "confirmation" error.

What is true for lottery tickets is true for investments as well. Investment companies tilt the scales by touting how well they have done over a pre-selected period. Then, confirmation error misleads us into focusing on investments that did well in 2008.

Lottery players who overcome the confirmation error conclude that winning lottery numbers are random. Investors who overcome the confirmation error conclude that winning investments are almost as random. Don’t chase last year’s investment winners. Your ability to predict next year’s investment winner is no better than your ability to predict next week’s lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever.

No. 5: Putting fear or exuberance in control

A Gallup Poll asked: "Do you think that now is a good time to invest in the financial markets?" February 2000 was a time of exuberance, and 78% of investors agreed that "now is a good time to invest." It turned out to be a bad time to invest. March 2003 was a time of fear, and only 41% agreed that "now is a good time to invest." It turned out to be a good time to invest.

I would guess that few investors thought that March 2009, another time of great fear, was a good time to invest. So far, so wrong. It is good to learn the lesson of fear and exuberance, and use reason to resist their pull.

As the market tanked, investors wondered where to put their money. Many are turning to advisers, but don’t know how to choose the right one.

No. 6: Basing happiness on wealth ups and downs

John found out today that his wealth fell from $5 million to $3 million. Jane found out that her wealth increased from $1 million to $2 million. John has more wealth than Jane, but Jane is likely to be happier. This simple insight underlies Prospect Theory, developed by Daniel Kahneman and Amos Tversky. Happiness from wealth comes from gains of wealth more than it comes from levels of wealth. While gains of wealth bring happiness, losses of wealth bring misery. This is misery we feel today, whether our wealth declined from $5 million to $3 million or from $50,000 to $30,000.

We’ll have to wait a while before we recoup our recent investment losses, but we can recoup our loss of happiness much faster, simply by framing things differently. John thinks he’s a loser now that he has only $3 million of his original $5 million. But John is likely a winner if he compares his $3 million to the mountain of debt he had when he left college. And he is a winner if he compares himself to his poor neighbor, the one with only $2 million.

In other words, it’s all relative, and it doesn’t hurt to keep that in mind, for the sake of your mental well-being. Standing next to people who have lost more than you and counting your blessings would not add a penny to your portfolio, but it would remind you that you are not a loser.

No. 7: Losing sight of your goals

Another lesson here in happiness. Mental accounting — the adding and subtracting you do in your head about your gains and losses — is a cognitive operation that can regularly mislead you. But you can also use your mental accounting in a way that steers you right.

Say your portfolio is down 30% from its 2007 high, even after the recent stock market bounce. You feel like a loser. But money is worth nothing when it is not attached to a goal, whether buying a new TV, funding retirement or leaving an inheritance to your children or favorite charity.

A stock market crash is akin to an automobile crash. We check ourselves. Is anyone bleeding? Can we drive the car to a garage, or do we need a tow truck? We must check ourselves after a market crash as well.

Suppose you divide your portfolio into mental accounts: one for your retirement income, one for college education for your grandchildren and one for bequests to your children. Now you can see that the terrible market has wrecked your bequest mental account and dented your education mental account, but left your retirement mental account without a scratch. You still have all the money you need for food and shelter, and you even have the money for a trip around the country in a new RV. You might want to affix to it a new version of the old bumper sticker: "I’ve only lost my children’s inheritance."

So here’s my advice: Ask yourself whether the market damaged your retirement prospects or only deflated your ego. If the market has damaged your retirement prospects, then you’ll have to save more, spend less or retire later. But don’t worry about your ego. In time it will inflate to its former size.

No. 8: Ignoring the benefits of dollar-cost averaging

Suppose you were wise or lucky enough to sell all your stocks at the top of the market in October 2007. Now what? Today it seems so clear that you should not have missed the opportunity to get back into the market in mid-March, but you missed that opportunity. Hindsight messes with your mind and regret adds its sting. Perhaps you should get back in. But what if the market falls below its March lows as soon as you get back in? Won’t the sting of regret be even more painful?

Dollar-cost averaging is a good way to reduce regret — and make your head clearer for smart investing. Say you have $100,000 that you want to put back into stocks. Divide it into 10 pieces of $10,000 each and invest each on the first Monday of each of the next 10 months. You’ll minimize regret. If the stock market declined as soon as you invested the first $10,000, you’ll take comfort in the $90,000 you have not invested yet. If the market increases, you’ll take comfort in the $10,000 you have invested. Moreover, the strict "first Monday" rule removes responsibility, further mitigating the pain of regret. You did not make the decision to invest $10,000 in the sixth month, just before the big crash. You only followed a rule. The money is lost, but your mind is almost intact.

Things could be a lot worse.

Meir Statman, a professor of finance at Santa Clara University in Santa Clara, Calif., wrote this piece for The Wall Street Journal.