As Fed Tapers Stimulus, It's Time to Change How You Invest

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Investors are well aware that the past two years have been kind to the markets. All of the major U.S. indexes are pushing through new highs, corporate earnings have rebounded sharply from their Great Recession lows, and many of the go-to economic measures (unemployment, durable goods, GDP) have shown consistent signs of improvement.

But much of this has been due to "quantitative easing" from the Federal Reserve -- a policy that will likely soon reverse. That means you'd be wise to prepare for a change in how you invest.

A Lesson in Greek

Fund managers often cite two factors when evaluating their stock market performance: alpha and beta. Simply put, an investor achieves alpha when their stock pick performs well due to improvements in that specific business or some internal catalyst -- better earnings, management actions, activist intervention and the like.

The complement to alpha is beta, or stock performance dictated by movement of the overall market. For example, if the Dow Jones industrial average (^DJI) rises 3 percent in a month and your personal stock portfolio rises around that level, without any major company-specific developments, then that performance is due to beta.

The two aren't always mutually exclusive -- a healthy economy helps a well-run business increase its earnings -- but lately, investors have enjoyed more profits from beta than alpha.

In the coming months and years, that pattern may change quickly.

Be Prepared to Adapt

Last week, Federal Reserve Chairman Ben Bernanke said the Fed may ease up on quantitative easing, the bond-buying program it has employed since the Great Recession. What that means for many companies is a slowing of all of the cheap money that has helped fuel growth in the face of a tepid economy and a nervous consumer base.

In the program's most recent iteration, the Fed has been buying $85 billion in bonds every single month. Whether one agrees with the Fed's quantitative easing policy, it's hard to argue with the market performance. The S&P 500 (^GSPC) is up more than 140 percent since its March 2009 low. Since the beginning of this year, the Dow is up more than 14 percent.

What if the quantitative easing program ends? How can you structure your portfolio to earn alpha instead of beta?

Choose your stocks more carefully

We have been playing the most fun game in the market: Everyone's a winner. But what happens when the game skews toward rewarding skill? The diligent and cautious prevail. As Warren Buffett famously says, "Only when the tide goes out do you discover who has been swimming naked."

It's more important now than ever to buy great companies at reasonable (preferably cheap) prices. This might mean avoiding the high-profile, sexy investments -- such as Apple (AAPL) and Google (GOOG). There is an army of analysts following these stocks, and you may not find any bargains.

Instead, use your role as a retail investor to your advantage. Look at smaller, under-followed companies. Niche manufacturing companies, business leasing companies and franchise-heavy businesses are examples of less interesting and often rewarding investments.

Choose a company with a solid management team and stable earnings growth over the past couple of years. Avoid stocks that have taken on large amounts of debt without boosting performance. When rates rise, some of these companies might be in a pinch if cash flows aren't enough to pay creditors. Don't obsess over the big winners; protect your downside instead. This seems obvious, but the best thing you can do in the stock market is not lose money.

Without turning this into investing 101, take a look at what you are paying for a stock versus the value you receive. Take Netflix (NFLX), for example. Sure, it's a great company with a market-dominant position. We can safely say that streaming on-demand content over the Internet is the future of the industry. But at today's stock price, you're paying $75 for every $1 the company is set to earn in 2013, with the expectation that the company will pay you back (with interest) over the coming years. Regardless of the innovation and strengths of Netflix, that's a hefty premium with a lot of to-be-determined risk factors. The market may not continue to carry Netflix higher and higher. At some point the company's intrinsic value will dictate the stock price.

Overwhelmed?

It may sound a bit daunting, but there are infinite resources at your disposal via the Internet for finding great stock picks. You just need to do the homework. Investors can continue reaping the benefits of stocks, but it won't be like shooting fish in a barrel.

Work on your aim, and by the time the Fed shuts off the faucet completely (don't expect this for quite some time), you'll have a well-protected portfolio that is beta-irrelevant and (hopefully) earning that alpha.

Motley Fool contributor Michael Lewis has no position in any stocks mentioned. You can follow him on Twitter @MikeyLewy. The Motley Fool recommends Apple, Google and Netflix. The Motley Fool owns shares of Apple, Google and Netflix.

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As Fed Tapers Stimulus, It's Time to Change How You Invest

Warren Buffett is a great investor, but what makes him rich is that he's been a great investor for two thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.

Most people don't start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That's unfortunate, and there's no way to fix it retroactively. It's a good reminder of how important it is to teach young people to start saving as soon as possible.

Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That's really all there is to it.

The dividend yield we know: It's currently 2%. A reasonable guess of future earnings growth is 5% a year. What about the change in earnings multiples? That's totally unknowable.

Earnings multiples reflect people's feelings about the future. And there's just no way to know what people are going to think about the future in the future. How could you?

If someone said, "I think most people will be in a 10% better mood in the year 2023," we'd call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.

Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97% return by the end of 2012. That's great! And they didn't need to know a thing about portfolio management, technical analysis, or suffer through a single segment of "The Lighting Round."

Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7% of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96% total return -- still short of an index fund.

Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it's not like golf: The spectators have a pretty good chance of humbling the pros.

Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time -- every single time -- there's even a hint of volatility, the same cry is heard from the investing public: "What is going on?!"

Nine times out of ten, the correct answer is the same: Nothing is going on. This is just what stocks do.

Since 1900 the S&P 500 (^GSPC) has returned about 6% per year, but the average difference between any year's highest close and lowest close is 23%. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring.

Someone once asked J.P. Morgan what the market will do. "It will fluctuate," he allegedly said. Truer words have never been spoken.

The vast majority of financial products are sold by people whose only interest in your wealth is the amount of fees they can sucker you out of.

You need no experience, credentials, or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he'll receive, even though it makes him more likely to be wrong.

This is perhaps the most important theory in finance. Until it is understood you stand a high chance of being bamboozled and misled at every corner.

"Everything else is cream cheese."
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