Now What?
So you have made your way through the first seven parts of Investing Basics, your brain hasn't melted and you're beginning to feel Foolish. You understand how to get your finances in order before investing and have mastered basic investment lingo. At cocktail parties or festive family reunions you can talk stocks, bonds, and mutual funds without looking at the cue cards, and most importantly, you know the basic approaches to valuing each one. Finally, you can select an affordable broker that will allow you to transact your investment decisions. You've learned the investing basics. Now what do you do next?

Building a Portfolio: Asset Allocation
Knowing how to analyze and select stocks, bonds, and mutual funds is only half the battle. How much of each should be in your portfolio? Complicated, contradictory, and confusing asset allocation models abound in the investment world. Many times these models appear to be designed by a committee of dueling economists who have agreed upon adding a small dash of every investment option imaginable rather than to give investors guidance in how to divvy up their investment pie. What is a poor investor to do?

The key to all asset allocation models is risk. What is "risk"? Well, when capitalized - it's a board game, but it's more than that. If you recall way back in Step 2. Investing Concepts, risk is the measurement of how willing you are to see the value of your investments decrease in the near term, even while you know the chances that they will increase over the long term. The higher the risk in an investment, the more likely it is to drop in the short term as well as to rise.

In modern finance, risk is defined as the variability of returns. If an asset jumps up and down a lot, it is deemed to be riskier than an asset that stays put or climbs slowly - even if the asset that jumps around a lot tends to outperform the slower moving assets over time. This is somewhat akin to young children. The ones who jump around a lot are deemed somewhat riskier to themselves than the ones that just sit and watch television all day. Many will find the jumpy ones ultimately more satisfying and successful, though they obviously require a bit more attention. When your returns are more variable, you have more of a chance of losing money. When investors adjust their returns for risk, they use some figure (normally the "beta," or volatility relative to the S&P 500) to adjust the returns. If your stocks were jumpier than average, your risk-adjusted returns get penalized.

The problem with this kind of approach is that it inherently has a short-term bias. Stocks, by and large, outperform everything else over long periods of time. Over more than ten or 20 years, if you invest in stocks, you are almost guaranteed to outperform anything else. Investors who use asset allocation models that are concerned about short-term volatility underperform over the long term because these models will inevitably take them out of stocks and put them into other investments like bonds.

When Will You Need the Money?
Risk sounds like a pretty serious problem. How can someone possibly assess his or her risk tolerance? Variability of returns does not seem to be the answer. If the main issue with risk is that stocks are riskier over short periods of time, how can you compensate for this without creating overly complicated asset allocation models? It is quite simple. Before you start buying, you need to assess how much risk you are willing to take on and then select investments based on that risk tolerance. This means deciding when you need the money.

If you need the money within the next five years, you are going to want to avoid individual stocks and stock mutual funds. If you need the money within the next three years, you are probably going to want to also avoid bond mutual funds and real estate investment trusts (REITs), which can drop if interest rates increase. For those who need the money within the next three years, you have a few choices left - buying individual bonds or certificates of deposit (CDs) with durations of less than three years, putting your money in a money market fund, or using a savings account. Each of these investment vehicles generates income while guaranteeing that you will get your principal back. If you need the money within the next three to five years, you can't really afford to lose very much of it, right?

Long-Term Returns
So, if you can lose money on stocks, stock and bond mutual funds, and REITs over short periods of time, why invest in them at all? Why not stick to the safe alternatives and let it lie? Well, if you look at the long-term historical returns that investment vehicles like stocks have generated, you should have second thoughts about sticking with the low-risk, low-return vehicles that serve as safe havens for parking your money.

Average Annual Returns
	1802-1995	1900-1995	1950-1995
T-bills	-	4.19%	5.35%
Bonds	4.97%	4.05%	4.15%
Stocks	7.79%	9.78%	12.42%
Data from Global Financial Data

As you can see, over three pretty significant periods returns from stocks walloped the returns from bonds or money market funds (in this case, T-bills can serve as a proxy for money market funds and short-term bonds). In spite of the fact that over all three periods measured stocks had several drops of 20% or more, with a few leaving stocks down 80% from top to bottom, the returns have still been superior to anything bonds have produced.

The difference in annual returns is magnified over long periods of time. Because of the miracle of compounding, each year you are left with slightly more money that is reinvested at a higher rate of return, and that extra money earns more money. Over the period from 1950 to 1995, an investor would have earned a total return of 19,300% in stocks versus 523% in long-term bonds - almost 20 times as much.

Let's try that sentence again, this time with some punctuation.

Over the period from 1950 to 1995, an investor in stocks would have earned a total return of 19,300%! This compared to 523% in long-term bonds - almost 20 times as much!! Didn't Einstein say something like, "The most powerful principle I ever witnessed was compound interest"? He did say that actually, which is a pretty ringing endorsement, since he discovered a couple other pretty powerful principles as well.

As you can see from the historical returns listed above, stocks have a place in every portfolio. The historical record stretching back to the beginning of the 19th century indicates that stocks will beat returns of other investments by a healthy margin. If you have the intestinal fortitude to stick with stocks even during the inevitable periodic downturns and you have money that you will not need for five years or more, you should consider putting that money in stocks (or REITs, the real estate equivalent of stocks). Of course, this is not a cut-and-dried asset allocation model like you might get from a full-service broker, but in the end the decisions about where to invest your money are so dependent on your individual situation that no one-size-fits-all model could ever work for each investor.

When to Sell
So you have bought some investments and you are wondering when might be an opportune time to sell? As bonds really end up selling themselves when they mature and you receive all of your principal back, the real selling issues come up when you own stocks or stock mutual funds.

Some investors believe they can "time" the market, meaning that they think they can tell when the market will go up and when it will go down. As a result, they counsel selling all of your stocks when the market is going to go down and buying them all back when the market is going to go back up. Unfortunately, if it were that easy these same folks would be sunning themselves on beaches in Acapulco and not trying to sell newsletters. Certainly when the overall economic scenario gets bad enough to hurt corporate earnings growth and companies start to flounder, you might consider selling some of the lower quality companies that are overvalued - but a system to consistently time the market as a whole has been about as actively pursued as alchemy, and at this point is about as realized.

If you have purchased a stock mutual fund, you have handed your money over to a professional money manager or you have handed it over to passively follow an index like the S&P 500. When should you sell a stock mutual fund? If you bought a fund because of the record of the manager and that manager leaves or turns out not to be quite what was advertised, selling might be a consideration. However, as it has been proven in several academic studies that people who jump from mutual fund to mutual fund tend to wildly underperform those that stay put, sticking with a fund even during bad times should be your default setting. If that great manager you have known and loved for years jumps ship to go elsewhere, you might want to consider following along. But just because you have not done so well over the past six months is never a good reason to sell a fund.

Selling a stock is slightly more complicated than selling a stock mutual fund. The two major reasons to sell a stock are 1) if the basic business changes in a way that was not anticipated, or 2) if the stock becomes overvalued enough that even after considering the taxes you would have to pay on the capital gains you still believe the company will underperform.

When the business changes or management proves inept at handling the business, all the patience in the world is seldom rewarded. Investors who stubbornly held on to shares of buggy whip makers and ice delivery services at the beginning of the 20th century saw their investments erode into obscurity as automobiles and refrigerators made their products obsolete. Selling might make sense if a company switches businesses to one you don't understand very well. Is the teenager taking your burger order asking, "Would you like a web-browser with that?" rather than the previous attempt at getting you to add some fries? The most important risk you run in owning a company's stock is that you don't understand the business.

Finally, if a stock becomes overvalued enough that the shares have a substantial risk of decline, you should consider selling to preserve capital. This is the "Sell high" portion of the "Buy low, sell high" cliche. Don't be too eager though. If it is a quality company and the overvaluation could be cleared up with a year or two's worth of financial results, you may actually be better off holding and avoiding the big tax charge on your gain. However, if the valuation is stratospheric and seems to assume that all the news between here and the end of the world will be good, selling could possibly be the better part of valor.

Bull, Bear and Volatile Markets
The media pays an awful lot of attention to the market, though quite often it only looks at a particular index (such as the Dow) and considers that representative of the market as a whole. The market is considered to be bullish if it is going up, bearish if it is going down, and volatile if it is going up and down in quick succession. Some investors, particularly those who use technical analysis, like to look at charts of the market in order to assess investor psychology to gauge whether or not the market can go higher.

Foolish investors believe that this is an exercise in futility and that focusing on individual companies and their businesses is the only way to go. Bull market, bear market, or volatile market aside, in order to get the kind of long-term returns on stocks that investors have seen for the last two centuries, the buy and hold mantra is the one that has served investors the best over time.

The Impact of Taxes
Investors need to keep in mind that the real return on their investment is the return they have left after they pay Uncle Sam and his cousins in the state and local tax collection offices. The difference between a 10% gain taxed at 36% (one of the highest income tax brackets) and a 10% gain taxed at 20% (the highest long-term capital gains rate) is quite significant. Waiting long enough to ensure that you get the most favorable tax rate possible when selling an investment can often make a big difference.

While tax consequences should always be something you consider when selling a stock, never let taxes be the tail that wags the investment dog. The decision whether you keep or sell a stock should never be made based on tax consequences alone.

Review, Review, Review
Most important of all to the long-term success of your investment portfolio is paying attention. Would you buy a plant and never water it? Would you buy a dog and let him keep eating the curtains after you've explicitly and patiently explained the reasons he shouldn't? Of course not. The same is true, to a lesser degree, for a portfolio of investments. Unless they are government bonds, any investment needs to be checked up on regularly to see if it is matching or beating the market and other substantially similar alternatives.

Reviewing your investments, particularly when you may have made mistakes, offers a crucial opportunity to learn from your mistakes rather than being doomed to repeat them. Everyone makes errors on occasion, but most successful investors avoid making the same errors more than once. Set aside time to review your portfolio at least once every three months, if not weekly. While you shouldn't be glued to the computer screen tracking your investments on a minute-by-minute basis, tossing them in a drawer and forgetting them is not a great idea either.

Conclusion
Congratulations! You've made it through all of Investing Basics. As you continue to build upon the foundation you have gained here, you'll discover the subtleties of building your wealth through investing. We encourage you to make use of the many investing tools and resources available here and add to your knowledge base.

Finally, we'd like to stress that all of what we've covered here -- from compound returns to inflation to bond yields to asset allocation -- is more than simply numbers and philosophies. Investing is what enables us to buy homes, pay for our kids' educations, retire early, take exotic vacations, and give our grandkids extravagant gifts. We wish you luck -- but we don't think you'll need it. You've got all the tools at your fingertips and a solid understanding of what it takes to be a successful investor.

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