THE TAO OF THE DOW

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THE TAO OF THE DOW

A Philosophy of Financial Securities Investing

By R.S. Heyer

1993


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PREFACE

This little book distills the results of 35 years of investment experience, crystallized and

conveniently expressed in terms of principles expressed in the Tao, but reached independently. The pun

in the title is my own proclivity, but the idea of combining these two elements was inspired in part by

such examples as the Tao of Physics, the Tao of Leadership, and the less serious Tao of Programming.

The reader need not conscientiously peruse every line of this book to make use of it, although

every author hopes that every reader will benefit from every word written. The plan of the work

consists of four principal parts, each of which provides its own value and can be read separately.

The first part presents the fundamental principles of the Tao, as I construe it. My approach

differs from that of others, but that is not unusual or surprising. This part contains chapters I-III. Those

mainly interested in the Tao, in an analytic way, but not in investment, might read only this.

The second part details the application of these general principles to the particulars of

investment problems. This is the longest part, containing chapter IV, parts A-D, and chapter VII. Those

interested only in the investment practicalities might concentrate on this part.

The third part contains a lighter, more sloganeering, less analytic approach to investment

philosophy. It consists of appendices I and II. Appendix I relates to investment ideas suggested by each

verse or section of the Tao, arranged in the poetic order in which the Tao itself is known rather than any

analytic order. Although this is a verse-by-verse approach, it is not a translation by any means, but a

sort of correlation, numbered to correspond to the verses of the Tao. Appendix II is a set of modern

aphorisms (some old, some new, some revised) which are or might appropriately be applied to

investment. Some readers may prefer this part to any of the others. It was the most fun to put

together.

The fourth part consists of the remaining appendices, which provide additional information

which may be useful to the investor, especially a new one, for reference only. Appendix III contains

acronyms and other odd abbreviations which help a new investor in reading or listening to the financial

news media, and Appendix IV lists formulas used by fundamental analysts, as suggested by Graham and

Dodd, and their successors, Cottle, Murray, and Block.

It is hoped that the reader will enjoy and find useful this little book. It is of course too short to

be complete in any of its aspects, certainly not in the summary of financially pertinent reality. For

greater detail the reader may consult other sources, a few of which are suggested in the bibliography

included after Appendix IV. Suggestions for corrections, clarifications, and additions are welcome.

Taoism refers to the doctrines expressed in a concise ancient book, the name of which is usually

spelled Tao Te Ching in English, following the Wade-Giles spelling system for Chinese (Dao De Jing in

Pinyin). It is pronounced dow duh jing referring to the concept of the Tao (pronounced Dow), the Way

of nature and of sensible human behavior. Hence The Tao of the Dow is a play on the identical sound

of the two words, Tao (or Dao) and Dow. Some observers regard the Tao as emphasizing mere passivity,


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but it was intended as advice to government in a tyrannical time; therefore, a more plausible and useful

view is that the Tao is a guide to action, allowing for more patience, more forbearance, more reason and

self-control, more liberalism of spirit than the actual tyrants of the time displayed.


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THE TAO OF THE DOW

Table of Contents

Preface 2

Table of Contents 4

I. Introduction 6II. Harmonious Balance 9III. Cosmic Harmony in General 12IV. Financial Securities Investing Defined 14

A. Investing 14B. Financial Securities 14

V. Harmonious Balance in Investing 17A. Psycho-Strategic Balance (Appropriate Goals) 17B. Emotional Balance (Reasoned Action) 17C. Market and Selection Balance (Independence, Avoidance of Extremes) 18D. Chronological Transactions Balance (Averaging) 18E. Portfolio-Holdings Balance 19

1. Asset Allocation 202. Diversification 203. Geographic Balance 204. Risk Balance 20

F. Balance in Approach (Adaptability, Flexibility) 20VI. Cosmic Harmony in Investing:

A. Initial Comments 22B. Background Environment 24

1. Economic Environment 24a. Nature of Economy 24b. Financial Securities 25c. Classic Economic Laws 25d. Effective Demand 29e. Organizational Flexibility and Social Inclusivity 30f. Economic Cycles 32g.

Interest Rates 34

h. Geographical Scope of Economic Environment 362. Politics 363. Resources 374. Trading System 39

C. Fundamental Analysis 401. Objectives and General Principles 40


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2. Valuing Debt Securities 413. Valuing Stocks 414. Compound Interest 425. Rule of 72 436. Reading an Annual Report 437. Primary Factors 448. Accounting Concepts 46

a. Earnings Report (profit) 46b. Balance Sheet (equity, book value) 47c. Cash Flow 47

9. Ratios 47a. Measures of Progress 47b. Measures of Value 48c. Measures of Safety 49d. Measures of Profitability and Stability 49

D. Technical Analysis 501. Trends 502. Dow Theory 513. Averages and Indices 514. Patterns 525. Support and Resistance 526. Volume 537. Sentiment 538. Seasonality 54

VII. Conclusion 55Appendix I. Interpretation and Application of Each Verse 56

Appendix II. Aphorisms 64

Appendix III. Acronyms 67

Appendix IV. Formulas 74

Bibliography 81


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I. IntroductionPrinciples of good sense and sound behavior long endure and widely apply. A truly sound

philosophy can provide valuable guidance in a surprisingly wide variety of times and circumstances.

Much of life turns out to consist of finding ways in which lessons learned in one context often apply to

other contexts as well.

For example, 25 centuries ago in China a man known simply as the Old Master wrote a poem

to guide his people and especially the rulers through troubled times. The Chinese call that poem the

Tao4 Te2 Ching1 (pronounced Dow Duh Jing), which can be translated as Guidebook to the Way of

Virtue (more commonly as the Classic of the Way [of both reality and wisdom] and of its Virtue

[human application]).

The Old Master (Lao Tzu, pronounced Loud-zz) wrote in a time and for a culture far separated

from ours, but I believe his ideas fit everyday life here and now. Some people call this poem mystical,

but I believe it is clear and eminently practical common sense. Lao Tzu never heard of capitalistic

financial investing, much less the Dow-Jones Average of stock prices of major American industrial

companies, but I have found that his principles assist in stock market investing. That application is what

I call the Tao of the Dow, i.e., a Way to invest.

The Tao Te Ching basically enunciates two primary principles which I will call Cosmic Harmony

and Harmonious Balance. Flowing from these are the corollary principles of careful, open-minded

examination of past and present, imaginative and prudent foresight, patience, self-control, economy of

action, independence of analysis and decision, modesty, generosity of spirit, honesty, steadfastness in

plan, and agility and adaptability in application.

A. Cosmic HarmonyBy Cosmic HarmonyI mean external harmony between the self and the outside world. This

comes, not from mere lazy passivity or fatalism, but rather from closely observing reality and

purposefully adapting ones own behavior to that reality. This examination of reality looks for truth, in

the manner of a scientist, a judge, or a financial analyst.

This adaptation is like that of the old-fashioned rag sailor, who depends on his sails to propel

his vessel. He cannot get out and push the vessel; he has no engine on which he can turn up the power.

Yet he does not passively drift wherever the wind takes him. Instead, he quietly and constantly

observes the wind, the current, the waves, and the shore, and fine-tunes the position of his rudder and

the trim of his sails to harmonize his vessel with the uncontrollable forces of nature to navigate his

intended course.

In a similar way, the prudent investor observes closely the geographical, political, economic, and

psychological realities, the progress of particular products and companies, the trends of prices, interest

rates, and so on, and acts accordingly.


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Professional investors have a saying, The trend is your friend. Successful investors watch for

trends and use them like a favorable wind. They dont fight the trend, even if it is only caused by a mere

fad in the mass psychology of the market. Yet they keep attention on their goals and longer time

periods, and remain ready to adapt to new information.

B. Harmonious BalanceThe other major principle of the Tao Te Ching or Taoism is that ofHarmonious Balance, or

internal harmony. The ancient Greek Stoics called this same idea the golden mean, but most of us

would call it the happy medium. The idea here is like the experience of Goldilocks (in the childrens

story of the Three Bears), who tried food that was too hot, too cold, and then just right. The basic idea

is to maintain personal balance. The most obvious investment applications flowing from this principle

include:

1. First, the prudent investor tries to keep emotions in balance, because success depends onavoiding impulsive actions resulting from extremes of overconfidence when things are going

well and of panic and despair on each setback.

2. Second, and related, the investor must position the individual portfolio as a balance to themarket, buying what the market has neglected and selling what the market has

overemphasized. This is called buying straw hats in the winter, when prices are low.

3. The portfolio itself needs to be balanced, as discussed below. Market terminology usesdifferent terms for different aspects of this balance (asset allocation, diversification, cost

averaging, etc.).

At the opposite end of the civilized or developed world in the ancient classical period, the

Greek Stoic philosophers also emphasized essentially the same guides to human internal and external

behavior: harmonious balance and harmonization with the real world.

The differences between the modes of expression of these two groups of philosophers do not

represent real differences in the underlying ideas. The Stoics used the term Golden Mean, conceived

as a middle ground between extremes, as the term for the goal of harmonious balance. The Taoists, by

contrast, refer to the union or complementarity of opposites, but the idea is similar.

Similarly, the Greeks tried to analyze and reason out the fundamental nature of the world, while

the Taoists sought to be in harmony with nature, with the flow of natural events in the world. As any

scientist or sailboat skipper knows, these two processes are essentially the same. One must be aware of

and attentive to the principles or persistent tendencies of the real world (the scientific laws) and set

ones mind and body in step in tune, in harmony with them to make effective progress.

The Greek version of this principle of close attention to the real world has grown into the

modern scientific method. The Taoist version has traditionally been associated only with a certain

mental state sought for the sake of inner peace. Yet a few modern Taoist scientists have recognized the

essential identity of the single principle underlying the two modes of expression of the importance of


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close attention to the real world, undiverted by prejudices, preconceptions, labels, or opinions. We may

briefly refer to this principle as that of cosmic harmony.

These two guides to action can profitably apply to investment strategy as well as to other

aspects of life, with effectiveness arising from the same qualities which make them so valuable in the

phenomenological sciences and for psychological health, even though the earlier formulation of theseguides did not specifically have securities investment in mind.

Readers interested only in the practical application of this approach to investing in financial

securities (stocks, bonds, cash equivalents, and derivatives of these) may skip chapters II and III, which

refer to the general philosophy suggested here.


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II. Harmonious BalanceA. The Unity of Harmonious Balance with Cosmic Harmony

One quality of cosmic harmony is conformity to the real nature of the world, implying common

sense attention and adherence to reality. That quality clearly arises from the principle of attention to

the real world and the effort to conform ones own thoughts and action to the pattern of the outside

world. This does not mean passively going along, like the proverbial sheep; it means trying to learn

what is real and to act in recognition of that reality.

One of those realities is that people, like all forms of life, function best in a certain range of

conditions. Outside that range come various degrees of discomfort, reduced effectiveness, and, at

extremes, disaster. The middle of that range is the Golden Mean. If we are too hot, dry, stuffed, or

oxygenated, we die. If we are frozen, submerged, starved, or suffocated, we die. Near those extremes

we are uncomfortable and inefficient. Near the Golden Mean we are healthy and able.

B.

Harmonious Balance in General

Thus, harmonious balance itself arises from cosmic harmony. Yet harmonious balance does not mean

finding some middle ground and calcifying there. Staying in one situation at all times is also a kind of

extreme. We need exercise for mental and physical health, but not to the point of exhaustion. We need

mental concentration to develop our minds, but not to the point of utter frustration. We need a variety

of kinds of food for health, and a variety in many aspects of life to make it interesting and enjoyable, and

to maintain our ability to cope with changing circumstances and make the most of opportunities. In

these respects, too, a human being needs balance not necessarily perfect equality of all aspects of life,

because people differ in their need for and enjoyment of various aspects but sufficient variety to

maintain interest, health, effectiveness, and adaptability.

A human also needs a certain amount of stability in certain aspects of life, but the search for

unchanging stability often leads to unfortunate rigidity, forcing oneself or others into unreasonable,

even unbearable courses of action or experience, or to inability to cope with change. What one needs is

not a single, immobile, rigid, dogmatic straight line, perfectly poised between unbearable extremes, but

rather a dynamic equilibrium constantly correcting tendencies to excess.

The chemical processes which characterize, maintain, and perhaps constitute biological life

illustrate such a dynamic equilibrium. A living body cell is not limited to being able only and always to

produce various chemicals at one rate. Instead, it has a variable capacity, and in practice produces more

or less of each under varying circumstances. If some chemical which it needs and produces is, forwhatever reason, being used up too fast or is still in inadequate supply, the cell will increase the supply.

If some chemical is in excess supply, a healthy functioning cell will reduce its production. Thus, not by a

rigid inability to change, but instead by constantly adapting to the actual situation, the cell maintains its

balance.

The Wright brothers may illustrate the same point in a different way. In the early years of

experimentation with vehicles intended for flying, the principles of lift from air flow and the


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consequences on the design of the shape of flying machines led to some fairly successful gliders. The

invention of the internal combustion engine provided a light enough source of power. Yet early

experimenters died in the attempt to build an aircraft stable enough to avoid tipping over and crashing.

The important contribution of the Wright brothers was that they had learned from making bicycles not

to think in terms of stability, such as a rail car gains by having four wheels, but in terms of continuous

balancing, as a cyclist does. A bicycle is inherently unstable, but in motion is easy to keep balanced by

positive balancing action.

By observing birds they learned about steering a flying object, and used that learning to find

ways to achieve a dynamic balance instead of static stability. From this finding they put together all

these elements to make an airplane that not only flew but initiated an entire new and important aspect

of human life in this world.

These are illustrations of the goal of harmonious balance. In subatomic physics the nature of

reality appears to consist in the interactions of discrete bits or packets of whatever composes the world

and these appear to have a number of opposite characteristics. Electric bits are positively and

negatively charged, different spin categories are recognized, etc. On a larger scale we are familiar with

the north and south poles of magnets. These all seem to be opposite, or at least different, yet they are

compatible they act together to make our world what it is. We do not need, and we would not want,

to eliminate, say, all the negative charges in the world. A world of protons would not provide an

adequate place to live. The harmonious balance of these opposites constitutes the core of reality and

a healthy environment.

A biological example was given above. Another is the presence of males and females in a wide

range of species. The sex differences provide advantages to a species in adapting to changing needs.

That advantage is so great that sex differences are fundamental throughout most of the more complex

and even some of the simpler parts of the biological world. The mean or balance is not achieved by a

single average form, but by a healthy dynamic balance between two (or sometimes more) rather

different forms.

The same principle applies as well at the psychological level. The stress of immediate problems

may at times seem overwhelming. We may then rail against reality, but that behavior achieves nothing

useful. Instead, we may retreat from reality. Yet a total and permanent rejection of reality usually also

does not succeed, and often only worsens the problem. A brief retreat from reality may however be

healthy if it means accepting the basic truth of reality but turning the mind briefly to other pursuits in

order to regain ones mental balance and perspective, and rest it from discomfort. Hereby we can

regain an internal harmonious balance.

Similarly, the push of urgency or necessity or responsibility sometimes may make us push too

desperately on others, passing on our tensions and emotional pain. If we can try to regain some of our

own internal balance, and think about our effect on the world in which we live, we can make it better

for ourselves and others. If we all or most of us do that, we shall all live in a world more like what we

prefer.


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We cannot eliminate emotion from our nature, and could not get much joy from life without it.

Yet we can try to balance our emotions, so that we do not lose control and cause harm from venting an

excess of anger, sinking to an excess of grief or despair, taking unreasonable risks in a fit of euphoria,

losing the power to function in a paroxysm of fear or a cloud of depression, exhausting the body or

psyche in some manic enthusiasm, or losing sight of crucial considerations in life through some narrow

and obsessive fixation. Balancing activity and balancing thoughts can help to restore a degree of

balance in emotion. The object is not a straight line of emotional death, but a damping of extremes and

a balancing of the humps and swales toward a range of reasonable emotional health.

At still more complex levels, the goal of harmonious balance is crucial for societies, of whatever

size and complexity of organization. The modern invention of consciously written national, state, and

association constitutions and charters attempts to apply some of what we have learned about this

principle to social organization. (The same is true of statutes creating and constituting local and special

governmental agencies, city and county charters, corporate charters and articles of incorporation and

partnership agreements.) Power is centralized for certain purposes but with balance to prevent is

monopolization and consequent abuse by any one element (or limited group of elements) within thesociety. We have not yet mastered this process fully, which should not be surprising since we have not

yet fully mastered it at the simpler level of psychology of the individual human being. But we have

learned much.

The particular techniques of achieving the goal of harmonious balance in particular types of

situation are the proper subjects of consideration by particular sciences and arts. The fundamental

principle of seeking such a goal, and what we mean by such a goal, is a main constituent of the Way (i.e.,

the Tao).

From harmonious balance flow patience, self-control, economy of action, modesty, generosity

of spirit, steadfastness in plan, and agility in actions.


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III.Cosmic Harmony in GeneralThe practice of paying close attention to reality and of acting in accordance with what one

learns is practical, and is what successful, healthy, and intelligent beings do naturally, whether they are

human or not. Sometimes, however,

1. Their emotions make them forget what they have learned, or2. Their circumstances become too complex for them to fathom, or,3. If they are human, they are taught misleading and unhelpful ideas.

The Tao attempts to return to basics, restore the common sense perspective, and deal with these

problems. The goal of seeking harmonious balance is the attempt to overcome the first problem. The

practice of observing reality closely and directly is the attempt to overcome the last problem and to

cope with the second one step by step.

Observing reality attentively does not mean merely looking at sunsets and rivers and mountains

and other aspects of what we sometimes narrowly call nature. Everything that really exists is part of

reality. Nature includes the tendencies of physics, chemistry, biology, astronomy, and geology, but it

also needs to be recognized as including human nature (psychology), the nature of group behavior and

of ideas (sociology), and the nature of reasoning and philosophy itself. We learn about reality from

looking at all of these things, and from thinking carefully about (not their essence, as the Greeks tried to

do, but rather) what consistent tendencies appear in their behavior. We seek to know, not what they

are, but what they repeatedly tend to do.

Trying to act in accordance with reality does not mean passively blending in, following the next

person, accepting foolishness and cruelty, insensitivity and selfishness, or any other form of meanness

of spirit, as ones own method merely because many others seem to regard that course as realism. Itmeans looking at the capacities and needs of the real world and seeking to adapt ones own course so as

to utilize these toward building an ever better life for us all.

Cosmic harmony means fitting ones methods to the tendencies or laws of nature, including

human and societal nature, to achieve ones individual objectives. That does not mean fatalism, saying

nothing can change, for history shows that the most repetitive of all human and societal tendencies is

to change. It does not mean following the current fads of diet or thought, for history shows that the

most repetitive of societal tendencies is for such fads to change. (Such fads sometimes go to foolish and

even unconscionable extremes.) It does not mean blindly following societys current direction, even if

bad, under the excuse that I cannot make a difference among so many, because society is only madeof individuals, and thus every continuity or change in the behavior of a society consists in what each

individual human does.

The push or urgency or necessity or responsibility sometimes may make us push too desperately

to achieve some short term, highly personal or narrow-group objective, struggling to overcome nature

or the natural processes. Western civilization tends to describe its successes as coming from such

behavior. In fact, successes more often come not from opposing but from utilizing some natural law


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IV.Financial Securities Investing DefinedA. Investing

Investinghere means setting aside a little of todays resources to increase tomorrows

opportunities. It includes acquiring or improving some natural resource, creating or acquiring some

tool, forming or obtaining an interest in some enterprise, acquiring some object or substance or right,

lending something, or otherwise making some contribution to society or to the development of

something which will be of value to society or some person. In current local usage it includes creating,

buying, or lending some property.

(The terms used here are to be considered in their broadest meaning. A tool includes

anything of use to humans [buildings, clothing, roads, ideas, machinery, crockery, holding tanks, heating

and communications systems, vehicles, etc.] A property includes both physical things and rights,

i.e., privileges which society grants for some social purpose to its members and which they can

individually buy, sell, lease, or otherwise use to increase their claim on the total benefits of society.)

Some people characterize investing as gambling, but this is not an accurate perception.

Investment always involves risk, as does all of life, but a sound investment is based on a careful and

realistic analysis of actual information about the subject, including awareness of direction, velocity, and

consistency of trends. In other words, in investing, we try to minimize the risk aspect. By contrast, the

essence of gambling is maximization of risk and minimization of information on which logical judgments

can be made. Indeed, possession of such information is considered cheating in a gambling situation,

whereas failing to provide it is considered cheating in an investment situation.

The original reason for the distinction was that all life involves risk but an effort to control it

through knowledge, while gambling was specifically invented to make choices uninfluenced by

knowledge, either to resolve conflicts without taking sides, or to learn the will of the gods. Only later

did gambling become a conscious game. As a game it has the advantage, in theory, of making all

participants equal, so that the weak or the foolish have as much chance as the strong or the wise. Now

it is to a considerable extent a business enterprise by large organizations, which deliberately set the

odds in their favor. In this form, what is gambling to the individual is sound business to the gambling

house, the manufacturer of gaming machines, and the insurance company, because these businesses

are able to play the averages and win. For them, that activity is economic. But in this sense they are

not gamblers anymore they know what result to expect over time. The prudent investor takes risks

but never gambles.

B. Financial SecuritiesBy financial securities is meant interests in ownership, debt, money, their equivalents, and

derivative interests. The basic securities are (1) shares of stock of business corporations and (2) tradable

long-term debt of those corporations. A buyer of debt becomes a creditor of the company, and thus

entitled to interest and principal payments from the company. Technically, tradable long-term debt

consists ofdebentures, which represent unsecured debt, and mortgage bonds, which are secured by


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the right to foreclose on certain property, such as land, buildings, machinery, aircraft, ships, railroad

cars, etc., if the debt obligations are not timely paid. In looser usage, the term bonds often includes

both types of debt paper. Stock includes both common stock, ownership of which may result in receipt

of dividends and usually entails a right to vote for the board of directors and proposals to change

drastically the nature and organization of the company, and preferred stock, which usually involves

dividends of a specified amount out of profits, but no voice in most corporate decisions.

Derivative securities include shares of mutual funds, which are companies, called investment

companies, which invest in the shares or debt of other companies. Investment companies may be

closed-end, meaning that they issue their own shares once at the establishment of the fund, and

rarely after that, and trade in the market like any other stock shares (e.g., General American

Investments, traded on the New York Stock Exchange under the symbol GAM). Open-end investment

companies, on the other hand, continuously sell shares in themselves to the public and buy them back in

(called redeeming them); owners do not sell these shares to other individuals; and the number of

shares outstanding thus constantly changes.

Options are also derivative securities. In this sense an option contract is effectively an

enforceable promise by one person, the option writer or seller, to obey anothers (the option

buyers) demand to buy or sell a certain amount of the underlying security (say, 100 shares of stock) at a

specified price. The writer is willing to make such a promise in return for a payment of cash (called a

premium) at the time the promise is made. This premium payment is completely separate from any

payment that must be made if the underlying stock is actually bought or sold. The demand is called

exercise of the option contract, and must be made, if at all, only within a time specified by the original

option contract.

Option sellers do so mainly for the premium, hoping that exercise will not occur. Option buyers

do so either for speculation to take advantage of price movements or for insurance against adverse

price movements. The level and movements of the stock (or underlying security) during the life of the

contract (between its open and its close) determine whether exercise of the option makes

investment sense and hence which contracting party gains and which loses. The two types of option

contract are named puts (buyers right to sell and writers obligation to buy the underlying security)

and calls (buyers right to buy and writers obligation to sell the stock or other underlying security). An

intermediary company sets the terms of the option contracts, but supply and demand determine the

premium at which each trade occurs.

Other derivative securities also exist. Warrants and stock rights resemble options, usually

conferring a right to buy stock at specified prices, or to buy stock below market value, but their termsare usually set by the company which issued the stock. Indices are averages of various groups of stocks,

weighted in various ways. Index options are option contracts similar to those mentioned above, but ties

to the level of the pertinent index rather than to prices of individual stocks. Futures and commodity

options may also be considered securities, but lie outside the scope of this manual.


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Other categories of financial securities also exist. Unit investment trusts are like mutual funds,

but differ in keeping essentially the same portfolio throughout the life of the trust. Partnership shares

are sometimes traded like financial securities, but for reasons too complex to discuss here, I would

generally avoid them, whether limited or general. My experience with them has not proven

satisfactory. Real Estate Investment Trusts (REITS), which also trade like stocks, attempt to profit from

real estate ownership or lending. These instruments will not be specifically discussed further in this

manual.


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to buy when prices are high and sell when prices are low exactly the opposite of a successful investor

who, by definition, buys low and sells high.

Of course high and low are relative, and in retrospect may seem very different from how

they seemed at the time. The important point, however, is that emotions tend to motivate us to do

exactly the opposite of what is prudent and sensible. An important principle in investment buying andselling therefore is to keep the emotions in balance, or at least exercise self-control over actions: avoid

manic (reckless) and depressive (panicky) actions. Do not become overconfident no one and nothing

can climb to the sky; do not become overly discouraged the world is not yet about to end. In either

case, the market will turn.

There are times when a recent price rise implies a future price rise, or a fall suggests further

falls, but these must be evaluated by reason and not by emotion.

C. Market and Selection Balance (Independence, Avoidance of Extremes)For the same reason as outline in section B, the market (the general tendency of prices) tends to

go to extremes. Prices will rise farther than is reasonable, then fall farther than is reasonable. This

tendency creates risks sometimes prices are too high for a purchase to work out well, sometimes too

low to permit a reasonable gain from a sale but it also creates opportunities (buy when prices are too

low, sell when too high). Essentially, the principle of balance dictates avoidance of extremes, whether in

ones own psyche or in price levels.

The exception is the investor who is doing the opposite of the markets tendencies, because

here another kind of balance is in play: the market will ultimately balance itself by swinging back and

the individual investor can gain by balancing out the market extremes. Great caution is needed in doing

this, however, for there are risks to going against a current trend. Thus it is important to recognizeextremes. The reasonableness of a price depends ultimately on fundamental analysis (see below), but

the technical analysis is particularly valuable for determining trends, extremes, and likely turning points.

For example, when everyone seems overoptimistic and prices (or a particular price) are

unreasonably high, or when prices (or a price) rise at an accelerating rate, it may be time to stand aside

or even sell; and vice versa. This principle applying to the market in general, also applies to individual

securities, especially stocks, mutual funds, and options.

D. Chronological Transactions Balance (Cost Averaging)Partly to avoid the excessive effect of emotions and partly to avoid the pitfalls of unexpected or

unforeseeable market-trend shifts, a wise procedure is a measured pace of gradual change of

investment stance: if an investor wants to buy (expecting a sustained rise in the whole market or in a

major part of the intended investment portfolio), gradually buying in over a period of time (months or

years) is often prudent (called cost averaging); likewise in selling, expecting a major market decline, it is

sometimes useful to sell a little at a time, gradually over time.


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These procedures require self-control and patience, do not suit everyone, and are not always

appropriate (especially where the particular item is to be only a small part of the total investment

portfolio), but I believe they produce superior results when an investor is trying to time a primary

(relatively long term) market change or moving into a particularly risky investment area.

When buying of a single security is done at exactly equal intervals of time and in exactly equaldollar amounts, purchasing in this measured, balanced way is called dollar cost averaging, and is

common in acquiring substantial holdings in mutual funds, but it is just as sensible in moving into an

industry and moving between different major asset-type allocations. When it involves buying more

shares when a stock falls, it is called averaging down; when it involves buying smaller amounts as a

stock rises in price, it is called pyramiding. In selling, it has no name, but all of these examples are

applications of the same idea, which is balance in the timing of major changes in the investment

portfolio.

E. Portfolio-Holdings BalanceBecause no one can forecast the future with absolute certainty, some allowance must be made

for the unforeseeable. The solution is not a search for the absolutely safe investment, like the search

for stability in early aeronautics; as in the case of the Wright brothers, the solution instead is a dynamic

balance. Viewed another way, balance in the portfolio allows the investor to gain from one class of

investment to offset potential losses in another.

There is no safe investment. Stocks can grow more than most investments, but call fall

rapidly, and do so at irregular intervals they tend to be volatile. Bonds vary less in dollar value, but

may lose in purchasing power when inflation occurs. They also change value depending on prevailing

interest rates. Money-market funds are liquid and retain dollar value essentially unchanged, but deal

with inflation even less well. Several kinds of balance are needed in a sound portfolio. The appropriateproportions of each element of the balance varies according to the needs, resources, and personality of

the investor. The various facets of such portfolio balance are outlined below, with their customary

names as used in the market.

1. Asset allocation: shifting trends among:a. Equity (participation) in enterprise for profit (=stocks), which also come in severl classes,

among which a portfolio should be properly balanced:

(1) Cyclical (rise and fall with economy);(2) Growth (tend to grow at most or all times);(3) Growing income (utilities);

b. Debt (=bonds) provides fixed income, sometimes capital increase; one must vary maturitydates;

c. Cash equivalents (=money market funds, etc.)Provide liquidity for emergencies or opportunity or allow waiting in time of uncertainty;

provide limited interest;

d. Physical assets, which protect against massive inflation:


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(1) Real estate(2) Gold, etc.

2. Diversificationa. Different types within each asset allocation (growth, cyclical, emerging, yield stocks; or

bonds of different degrees of credit risk, different maturities, different debtors, etc.)

b. Different industriesc. Different companiesd. Contra-cyclicals, i.e., companies whose individual cycles tend to offset each others cycles

(for example, gold mining companies versus interest-rate sensitive companies, heating

supplies with warm-weather products, etc.)

3. Geographic balancea. Different localities for local public utilities and regional banksb. Different global regions for world-class stocks

4. Risk balance: foreseeing the unforeseeable (because the future is never fully foreseeable, it isprudent to balance obviously riskier investments entered for their greater potential gain

with apparently less risky investments, and keep the former to a limited percentage of the

latter.) It is also prudent to provide protection against each of the major risks:

a. Market or volatility risk (prices rise and fall);b. Credit risk (debtor doesnt pay);c. Interest rate risk (interest rates may rise, reducing value of existing long-term bond);d. Currency rate risk (risk that currency in which the purchase is denominated [e.g., marks or

pounds] will fall relative to that which the investor must use to live [e.g., dollars]);

e. Inflation or purchasing-power risk (prices for particular goods and services used by theinvestor may rise more than the value of the security);

f. Quality risk (investment may simply prove less valuable than expected because the issuingentity is not as economically sound as expected).

F. Balance in Approach (Adaptability, Flexibility)Whatever approach the investor or trader takes in all of the above mentioned respects,

occasions will still occur when a change of direction or portfolio proportions or methods will be needed.

Balance in approach means avoidance of rigid attachment to a single approach. An investor needs a

consistent, basic strategy, but must maintain adaptability and flexibility in details, making

reapportionments from time to time (especially in different phases of the economic cycle or of company

development), and dealing with new circumstances as they arise, whether in the nature of new

problems or new opportunities.

The Tao Te Chingand other Asian scriptures speak of avoiding attachments to things. In the

mundane practice of investment, the prudent investor avoids falling in love with (becoming

emotionally or habitually attached to) one stock or tactic, to the point of using it at an inappropriate

time.


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Balance in tactics implies modesty about previous positions and expectations, patience coupled

with adaptability, self-control, generosity of spirit toward trading partners (the other side in the

contract), economy of action, and a balanced plan steadfastly applied.


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VI.Cosmic Harmony in Investing, ContinuedB. Environment

1. Economic Environmenta. Nature of Economy

The nature and current status of the general economy in which investment is under consideration is

obviously a crucial aspect of the investment environment. Ours is a mixed economy, in which several

types of organization operate:

(1) Individual autonomous subsistence activities (such as hunting, fishing, gathering berries androots, etc.) which may involve sharing (within the family unit), but do not involve formal

exchange this form of organization, unlike all the others mentioned here, is disregarded in

virtually all national economic statistics and is not subject to the laws of economics taught in

the schools (all others below are);

(2) Individual and family enterprises, in which one person or family provides all the labor andcapital, but the product or service is exchanged for money or barter;

(3) Cooperatives, in which several humans participate as approximate equals, with various kinds oforganizational structure;

(4) Sole proprietorships, in which one person owns and manages the enterprise, though oftenborrowing funds for capital and hiring employees for labor;

(5) Partnerships and joint ventures, in which more than one person operate the enterprise jointly,sharing profits, losses, investment, management, and liability to lenders, suppliers, employees,

and customers, operating otherwise in a manner similar to a sole proprietorship;

(6) Limited partnerships, in which one or more partners have management and liability, and othersmerely invest for a share in profits;

(7) Corporations, which have the status of separate legal persons functioning like sole proprietors,but operated like a sort of subsidiary state, with a ruling group (board of directors) elected by

the investors (shareholders) overseeing officers and a general manager (chief operating officer

or CEO);

(8) Associations (such as clubs), a form of little interest here;(9) Trusts; and(10)Public entities, such as governments of national, state, and local jurisdiction, schools, libraries,

hospitals, research institutes, etc.

Think tank futurists now argue that future enterprises will be characterized by more equalityamong the humans comprising the enterprise; more individual autonomy and initiative; flexibility; more

widely distributed decision making; and perhaps a more responsible approach to the common good

than has generally characterized business enterprise in the past.


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b. Financial Securities: Relationship to Organization FormsFinancial securities generally arise from the activities of business corporations owned by groups

of individual humans, usually in considerable numbers, and by retirement funds, trusts, and other

corporations.

c. Classic Economic LawsIn our society, some classic economic tendencies have been noticed. These were largely

described by Adam Smith or others in the period (though some of these principles were known before

that) when physicists were discovering the gas laws and atomic theory, and are therefore phrased in

language and concepts similar to those scientific laws, i.e., they assume a perfect system with no

friction, composed of elements of infinitely small size. Just as Boyle and Charles described how the

atoms in a gas act, treating the atom as having no size (a point moving in space), Adam Smith describes

an economy on the assumption that no individual enterprise or source of economic activity or resources

is large enough for its size to matter, with each able to move infinitely far in a trivial time. This approach

sufficed for his time, because his purpose was to ameliorate the economically stultifying restrictions

imposed, and the special privileges and favoritism granted, by royal governments. For our time this

simplicity in theory hides some defects in the analysis, but, keeping the limitations in mind, we must

remain aware of the fundamental observations of classical economic theory:

Law of Supply and Demand: In a totally free, equal, and competitive economic system, the price

of a commodity, service, or other economic good depends (in part) on the supply (wide, easy availability

tends to reduce price) and (in part) on effective economic demand (the desire to have it, coupled in the

same person with the ability and willingness to pay for it). Demand, in this instance, depends not only

on human needs, perceptions, and desires, but on the presence and distribution of buying power,

which in turn depends to a considerable extent on the preservation and distribution of the results ofprior production.

The extent of price variability differs, however, from one type of economic good to another,

depending on the flexibility or elasticity of supply and of demand. For example, in a hot country salt

may be a necessity; therefore demand will always be relatively high; the amounts of salt obtainable are

limited to some degree by mother nature; and therefore the price is unlikely to fall too far. On the other

hand, some fad item or more discretionary purchase may have a great elasticity of demand,

commanding a very high price at one time and place and an extremely low one under other

circumstances.

Each potential buyer has a series of prices at which that person is willing to buy certain amounts

of something, and each seller similarly will sell different amounts at different prices. At some prices the

seller may be unwilling ever to sell any, because the cost of production to the seller is too great to allow

such a sale to be worthwhile or even acceptable, and at some prices the buyer will not buy. These series

can be represented graphically as a series of points (or a curve in algebraic language). Sales occur,

theoretically, at prices and in quantities revealed by the intersection of these curves. These intersection

price levels are called the equilibrium prices because at these levels the supply and demand are in


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equilibrium with each other. Different prevailing price levels may cause different amounts of a good

with high demand elasticity to be sold.

Actually, Adam Smiths idealized, atomic economy differs from reality. To some extent,

custom, regulations, subsidies, tariffs, discriminatory taxes, waste, uneven economic policy, frictions and

distortions in the market, market power such as monopoly or oligopoly (limited suppliers available) ormonopsony or oligopsony (limited customers, such as only a single user, e.g., a unique business or a

government) will also influence prices, as will a government requirement of having that good (such as

automobile public liability insurance). In fact, any actual substantial size of any market participant

distorts to some extent the operation of the market, as does geographical distance, local licensing, and

other factors.

Allocation of Resources: The existing price levels tend to influence the use of the resources of

an individual customer or worker or investor, of an enterprise, of a country, of an economy, particularly

where less expensive substitutions may be made. Of course quality of a potential purchase item also

plays a part.

The supply and demand curves may be analyzed in terms of value from the viewpoints of

buyer and seller. The buyer must consider how much he or she has available to spend, what other

demands there are on those limited resources, how much is likely to come in the future and at what

rate, whether prices are likely to rise or fall or stay the same, how urgent the purchase is, what benefits

it will provide, what opportunities are lost by spending the money or other resources on this purchase,

etc., in light of the marginal utility to the buyer of both the purchase and the wherewithal to make that

purchase, The seller must consider the costs of production (or acquisition by the seller from the

producer), how urgent the sale is, what is likely to happen to price in the future, the cost of carrying the

item in inventory (if it is carried), etc. Each must seek to obtain the maximum utility available to that

party from the transaction. The trade can be mutually beneficial, and is likely to be consistently

repeatable only if it is mutually beneficial.

Trade versus Subsistence or Autochthony: A system of specialization and exchange increases

productivity and prosperity over a system of self-sufficiency. Hence wider free-trade areas commonly

lead to higher prosperity. When internal tariffs kept China, France, and Germany backward a few

centuries ago, their absence helped Britain to lead the world economically. The unification of Germany

in 1870 brought it ahead of Britain, and when the U.S. grew larger, it became the leader. The European

Economic Community and China today are making strides from their more recent movements toward

internal economic unity. Inclusion pays.

Exchange of ideas, too, leads to more efficient advancement of more useful ideas. Where ideas

from different cultures cross at some country, whether because of trade, exploration, or education from

other kinds of impetus, that country often becomes the dominant culture of the time. Such has

happened many times in history. It also happens in business and science. Persons from different

scientific disciplines or different industries often find ways to make a company or a field of research

prosper from the interaction of these divergences and exchanges.


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For this reason, attempts to monopolize or corner the market sometimes backfire. Open

architecture in computers led first Commodore, Apple, IBM, and later Sun to prosper, because of the

wide range of software which outsiders quickly provided to operate on machines produced by these

companies. Texas Instruments attempt to corner the market in TI software effectively killed the sales of

the previously popular TI home computer and drove TI from the industry.

Elements of Production: Economists generally recognize that production of goods, or even of

services, requires the input of human effort (labor), natural resources (land), and capital, but not all

define these terms in the same way. Many say that capital is, effectively, money, because money can

often be exchanged to obtain real capital. Accountants treat money as capital, so that both long-term

borrowing and saved profits, as well as initial investment in a company, are lumped together as capital

structure.

Other economists mean by capital the means of production saved from prior production,

which for most businesses means the machinery and other equipment, special rights and privileges

(such as patents, franchises, buildings, roads, electronic systems, information, etc.), and similar things

used to aid labor in accomplishing the goals of the enterprise. This is, economically, probably a more

useful definition. A whole country can only slowly convert money into usable capital equipment,

although a single company may be able to do so fairly rapidly.

Some economists include natural resources as capital, because certain systems allow them to

be bought, and also because prior work may alter the immediate practical availability of some natural

resources, but other economists distinguish irreplaceable natural resources as a third separate element.

Since the other two elements can be changed by economic activity, and natural resources, in this sense,

cannot, the separate treatment of this element is probably a sounder approach.

A few economists list entrepreneurship as a fourth factor of production, but this conceptseems to mean merely the investment of time, effort, initiative, leadership, and control exercised in

varying degrees by some business owners, which are all forms of service, i.e., labor; investment of

money or land or capital, which are already included in the other factors; and assumption of risk if the

enterprise does not do as well as planned. But all participants experience risk, so this is probably not

really a separate factor.

In economic theory, the factor payments are termed rent if for natural resources and sites

(land), interest if for capital lent with a promise of return, profit if for capital contributed as part of

ownership, and wages if received for any form of service. Common usage slightly alters the applications

of these terms, but in economics each must be taken into account. Each of these interests, if paid for,constitutes a part of business expense, and therefore helps determine the prices at which a seller is

willing to sell.

Law of Diminishing Returns: Because a number of factors affect each part of the economic

process, an increase in one may often result in higher production, but this effect will be strongest when

the increase is in the production element which is currently the most limiting factor. When there is a

surplus of one of the three elements of production, increasing that one will not increase production


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much. Thus, if labor is in short supply, but there is plenty of equipment and natural resources are

plentiful, one more worker (if healthy, intelligent, and properly educated and motivated), will increase

production considerably. But if capital or resources are in short supply, one more worker will not add

much production. Thus, if the one element of production is increased and the other two are held

constant, there comes a time when each further addition to that one element will add less production

than did the previous addition. This is the law of diminishing return.

It leads to the Law of Marginal Utility or Cost, meaning that at some point a further increase in

the surplus element of production will add so little production as not to be worth doing it the point of

marginal utility. Some companies find a way to sell a significant part of their products at prices sufficient

to cover fixed and variable costs, and in addition sell some (in a different market) at a lower prices,

determined by the law of marginal utility, usually the variable cost without regard for fixed costs, which

are unaffected by how many units are sold.

Scarcity: Economists say there is scarcity because reality is always finite and human desires tend

to be infinite, especially so in an advertising society. Hence, total wants tend to outdistance current

availability of whatever people want.

Bad money drives out good: If two forms of money both suffice as legal tender and one is less

valuable, or holds its value less well, everyone will pay bills in the less desirable form and hoard the

other, driving it out of circulation. This was more important when gold and silver, though having

variable values like any commodity, served as money, at a set ratio. Now it is replaced in importance by

currency-value ratios. A rising economy and higher interest rates will tend to make one currency more

attractive and therefore rise in value relative to another (say, the mark versus the dollar versus the yen

versus the pound, etc.). The weak currency is sold to buy strong currency to invest in the stronger

economy or at the higher interest rate, further draining money from the weaker economy. The

devalued currency, however, then effectively makes the prices of goods produced in the weaker

economy less expensive in international trade terms, which may tend (usually only temporarily) to

improve sales of such goods and thus improve the weaker economy. Inflation usually increases in the

economy with the weaker currency.

Economic Stages: Since humans have considerable capacity to recognize improvements in

methods, a common historical sequence of development of manufacturing in a country or region is from

primary industries derived from and immediately dependent on natural resources and crops (such as

textiles, wood products, metallurgy, processing of food, fiber, and fossil fuels), through secondary

industries (like vehicle, chemical, and other more sophisticated manufactures) to tertiary industries

with most advanced technologies (currently electronics and gene-splicing, but later something nowunforeseen). Commercial activity often garners better profits than manufacturing and the latter more

than agriculture per person engaged in them and per acre devoted to them, but in each case only if a

large enough hinterland or market area is accessible, in which the other, more basic industries still

prevail.


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International specialization: In an ideal economic world, i.e., one without wars, national

subsidies, and obstacles to international trade, each nation, like each individual, would, according to

economic theory, fare better trading freely with all others, producing what it produces most efficiently,

and buying from others what they produce most efficiently, because that arrangement yields the

highest productivity and efficiency, coupled with the lowest prices. The major obstacles to such an

arrangement, however, are (1) inertia, because current change from a different arrangement creates

current disturbances and dislocations during the adjustment process; (2) the perennial effort of each to

gain advantage over others, urging others to open their markets while restricting or skewing its own; (3)

the inability of workers to move about to get work or access to resources, as easily as money and trade

move; (4) the lack of effective international monetary and regulatory standards; and (5) the threat of

interruption of supply, particularly from wars. If a group of nations can agree on avoidance of war

among themselves, and provide a mechanism to assure that arrangement, and to protect them all from

outsiders, they could then dare to trust their economies to one shared economy. The world slowly

struggles toward this goal.

Private Enterprise: The value of so-called private enterprise lies primarily in allowingcompetition of methods and relatively objective measurement of efficiency by profit. Yet its social costs

(damage to workers, neighbors, sometimes customers, environment) become excessive if government

policy fails to assign those costs to those competitors who create those costs. Hence this system only

produces a consistently satisfactory result if government performs that assignment adequately.

Workers compensation programs, product-liability and environmental lawsuits, health and safety

regulation, and similar programs constitute attempts to accomplish that assignment.

Common Observations Outside Classical Economics: Honesty and fairness in administration

yield higher efficiency in the economy. Where governmental or company officers abuse their position

for personal gain at the cost of the society or the enterprise, the latter loses efficiency. Irrational andunjust discrimination hurts perpetrator, object (intended victim), and bystander. Those societies and

companies which have not learned this are less promising places for investment than those which have

learned and consistently applied these principles. This paragraph may sound idealistic, but history

proves its serious practicality, and investors often rue having ignored these commonplace ideas.

d. Effective DemandThe environment in which a company operates obviously can affect the success of the company,

and the most obvious pertinent aspect of the environment is the economic. Markets, meaning demand

for products and services are particularly vulnerable to the current general health of the economy. A

maker of factory machinery will sell more when other businesses expect to expand their sales andtherefore need new machinery; a builder will sell more houses when people are able to buy them; a

seller of clothing and entertainment will make more sales when more people are able to buy them.

When times are bad, these kinds of sales will fall drastically.

Ability, desire, and confidence among buyers are not precisely constant in respect to those kinds

of purchases which can conveniently be delayed. The rise and fall of economic demand largely


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extremely chauvinistic, selfish, or socialistic. An unbalanced system, which tries to force all group

projects into one kind of organization, becomes unnatural, oppressive, inefficient, and ultimately

insupportable. A one-legged stool is unstable.

Some needs of society are best provided, as experience has shown, by public institutions: (1)

military, police, and other regulatory organizations, because those not under public control cannot betrusted with power to coerce their fellow citizens; (2) at least a certain level of education, because it is in

the interest of society that all citizens reach their maximum potential, regardless of whether individually

and unaided they have the means to do so; (3) public roads and other facilities, because everyone must

have access to them, because establishing them involves the power to take or spoil privately owned

land, and because the taking of tolls impedes the flow of traffic. Public assistance to the destitute and

other unfortunates has become necessary because those most able to help them tend not to do so

voluntarily on an individual basis to a sufficient degree, perhaps partly because our competitive system

tends to penalize them for doing so.

Still, some social needs are best provided by separate, competing enterprises. Competition,

where it stays within the bounds of efficiency, quality, service, or even educating the customer to the

value of a product, provides an objective measure of the success of techniques, and thereby can reduce

excessive bureaucracy, correct inaccurate judgments and forecasts, reward initiative and perception,

and thus improve the economy generally.

The danger is from the short sighted, who seek quick profit through fraud, overreaching,

shoddiness, planned obsolescence, and dangerous practices; from the narrow viewed who injured their

neighbors, their environment, their employees, or their society through disregarding the interests of

these; from the vicious, who abuse for other ends the power granted them to operate enterprises; the

dishonest and unpatriotic who injure their society by shirking their tax, regulatory, and other social

responsibilities; and the grasping who abuse their power, acquired for management purposes, to garner

an excessive part of the returns from shared enterprises.

Some of these separate enterprises are actually private, one-person projects, but most

economic activity in industrial countries is carried on through large-group organizations such as

corporations and cooperatives, often with many employees, many stock holders, many bond holders,

many customers, and many suppliers: a team requiring teamwork.

A society needs to protect itself, its citizens, and its valuable institutions from enemies and to

provide its members a sense of self-worth, but some societies are excessively narrow and domineering,

too exclusive of other societies, or even of various segments of the society itself, whether on a genetic,religious, linguistic, or other physical or cultural basis, or just on the basis of some more trivial definition

of ins and outs.

All of these tendencies in societies have their useful, worthwhile side, but any society which

tries to press every aspect into one of the three extremes (of excessive public enterprise, excessive

private enterprise, or excessive regulation) falls ultimately on hard times and creates great, needless

misery in the interim. Every society needs all of these, mixed and melded in suitable proportion civic


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organization, privately owned (but often shared) enterprise, volunteer organizations, individual activity,

working in harmony, each in its proper sphere. Wholeness comes only from the union of divergence;

health comes only from the balance of multiple functions. An unstable or unbalanced society will not

provide a secure investment milieu.

Hence, a prudent investor will tend to invest more in societies with these various favorablefeatures and even consider them in evaluating the effectiveness of the internal organization of a

business corporation.

f. Economic cyclesFor financial investment purposes, then, the prudent investor must examine the state of the

economy at any given time, look for the direction in which it is moving, as a whole and in its principal

parts, up or down, and for its health or soundness, its balance, and whether it can continue to progress

as it has.

If the economy is rising and sharing the rise broadly, building soundly for the future, investmentin stocks for growth may be profitable. If the economy is declining, then investment debt may be

sounder. If inflation has become, or is likely to become, rampant, investment in land and physical

objects may be best. If the economy is superficially doing well, but its benefits are flowing into

increasingly narrower channels or growth comes only by enlarging debt faster, or economic growth is

exhausting a crucial resource like forests, soil, a mineral, or the good will of its own people or its

neighbors, then the prudent investor knows a time of retribution and tribulation lies ahead, and plans

for it.

The prudent investor also looks for how to utilize the observable trends in the economy. If

interest rates are about to fall, buying bonds may produce substantial and prompt returns. Ifproductivity is rising and depressed conditions are about to improve, stocks may be better. If inflation

and recession are to be combined, physical assets may be needed. If a quick and temporary drop in

prices is about to occur, cash may be best. If leisure time, disposable income, number of households or

children, accessibility of resources or tourist locations, or something else is increasing rapidly, an

industry able to utilize that change to its advantage may offer appropriate investment opportunity. If

one industry is making another, or a part of it, obsolete, prudence suggests avoiding or deleting the

loser from the portfolio. Generally, at any given time, some parts of the economy will be growing while

others shrink.

In general, three major price cycles overlap in our current economy: those of stock prices, of

bond prices, and of physical assets. When economic activity is rising, or is soon expected to rise,

business enterprise profits are generally expected to rise. People therefore invest in ownership of those

enterprises. For most of us, that means buying stock. This causes the prices of stocks to rise, as demand

for stocks increases faster than supply. In practice, the stock price rise tends to begin an average of six

months before the actual economic rise, because investors are trying to forecast the future of prices.

Individually they make many mistakes, but en masse their combined transactions function together like

a massively parallel computer, which forecasts reasonably (but far from perfectly) well.


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If the economic recovery or up-swing actually materializes, stock prices usually continue to

rise for some months or even a few years. The rise in activity normally results in more employment,

producing more wages and hence more buying, leading to further economic improvement. If company

managers expect this improvement to continue, the traditional response was the build new factories,

improve technology, or otherwise make real capital investments, which often produce still more jobs,

or longer hours, with further economic improvement following. If company management has not saved

enough cash beforehand, or they want to preserve cash, they borrow money for this purpose. At the

same time, improving economic conditions tend to induce companies and individuals to be more

optimistic and therefore become willing to take on larger debt than previously.

As more borrowing occurs, interest rates are pushed up, increasing costs to both corporate

borrowers and individual consumers, as well as government. The rise of interest rates pushes down the

value of existing bonds, so bonds fall as stocks rise. The prospect of this tendency in turn induces

investors to sell bonds and buy stocks, thereby accelerating the tendency.

As increasing economic activity causes the more rapid spending of money, the effect is to

increase the availability of money. If this availability grows faster than the availability of goods and

services, or if some companies selling goods and services are able to raise their prices in the improved

economic climate (through monopoly, oligopoly, conspiracy, or other friction in the system), then

these higher prices make other things cost more, and this more general inflation, plus more demand for

workers, induces workers to try to raise their wages to make up for the lost ground. The prospect of

rising prices encourages people to buy sooner, before the price goes up, thereby adding still further to

the rise of prices. All these factors, also, tend to reinforce each other and lead to further inflation, which

in turn tends to increase interest rates.

Inflation increases the value of physical assets such as existing factories and machinery, gold,

and land. In addition, inflation is to some extent built in by substantial control of some products by a

few holders. OPEC, for example, keeps energy prices far above the actual cost of producing oil, as de

Beers does of diamonds. Thus, in the later part of an economic cycle, gold has usually been rising,

because people buy it to hedge against inflation.

Finally, if interest rates rise too far, or debt grows too high, debt payments may choke off

purchases of large items like homes, automobiles, factories, and other buildings; this is usually

temporary, but produces a recession for some months, often more than a year.

If the general population does not get back enough of the yield of the increased economic

activity, they become unable to continue buying at the same rate; thereupon demand for goods andservices declines, or fails to grow fast enough to pay the interest required for the new factories or office

buildings. Declining economic activity follows, and leads to layoffs and further decline. Where this is

the reason, depression follows, lasting until the situation is forcefully corrected or government primes

the pump, or some external and fortuitous event temporarily solves the problem. For example, small

countries are sometimes rescued by economic activity created by wars among other countries. This kind

of rescue is not very effective for very large countries.


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subsidization, transportation, education, income distribution, resource access, care of the needy,

collection and provision of information, fostering of order and harmony, freedom to think, learn,

comment, and create, relations among humans, communities, states and provinces, nations, and global

regions, as well as other such matters can seriously affect the economy and other critical aspects of life.

Wars and revolutions can destroy property or business or whole economies, in addition to individual

humans, and national policies may affect the probability of such events.

Governments may foster citizen participation and equality of opportunity, or stifle opportunity

and suppress certain classes or castes of people. Governments may engage in wars or international

economic disputes, or foster peace and cooperation with other countries. Governments may try

counter-cyclical spending, or ignore economic cycles, over-borrow or over-inflate the currency, or their

opposite, and may engage in huge projects, such as military expansion or special perquisites for those in

power, so extensive in proportion to a national economy as to crowd out more productive activity,

either by devoting too much money to these projects, or by diverting too much of the nations talent to

them. The prudent investor considers these possibilities, not only in deciding in which countries to

invest or disinvest, but also in deciding when to do so.

It is probably also useful to consider the political organization of the individual enterprise in

which one considers investing or to which one considers lending. While the activities of partnerships

and corporations are supposed to further economic goals, the structure of the organization which does

this is more a matter of politics than economics. That structure effectively constitutes a form of

government, often more intrusive into and significant in the lives of individual employees, investors,

customers, and suppliers than elected government.

A prudent investor will not invest too heavily in a single enterprise over whose governing,

directing, and acting that investor can exercise no effective control. Limited partnerships, therefore,

often prove to be disappointing investments, and many corporate rulers grossly abuse their powers in

ways deleterious to their stockholders as well as to their employees, neighbors, etc. Such conduct can

ultimately damage the value of an investment, so a prudent investor learns the terms of his or her own

authority in the company and the attitudes and past conduct of those who will lead it. The law which

created the form of the enterprise is important to this structure, as is the responsibility to which the

members of its board of directors are held.

3. ResourcesResources available to a company, industry, country, or species also influence its success and

prospects. A shortage of water seriously limits the agricultural productivity and the population of aregion, as do certain climate and weather extremes.

Mineral resources most importantly, soil are valuable to the economies of some countries,

and to the species as a whole, but can be exhausted. Petroleum in the U.S. now has been so seriously

depleted that this country cannot long operate in an economically competitive way on the basis of its

own deposits alone. Hence it continues to drill and pump oil, but imports oil heavily from other

countries. Increasing internal production can only be done by degrading other aspects of the nations


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life, substantially increasing the cost of oil production to obtain less accessible reserves, and reducing

the remaining actual reserve supply.

No company can sell to more people than the world contains, or use more of some resource

than is available. Some physical resources are simply disappearing, and will be unavailable in

economically usable amounts or quality after a time if not reclaimed in some way.

There are also renewable resources, like forests. Those who simply destroy them will exhaust

their (and maybe everyones) resource base, while those who replace in some rational way will have this

resource to use again indefinitely. Government policy may encourage destruction or maintenance,

either by regulation or, probably more effectively, by taxation practices. If the cost of maintenance

exceeds the cost of destruction to the company, destruction will occur, but the company and its entire

industry may then have a limited future. Exhausted soils, fisheries, mines, and former forests litter the

world, and grow more extensive and more numerous through lack of foresight. Ultimately the destroyer

destroys itself.

Besides (1) physical resources, which can be effectively increased only by either finding new

ways to utilize existing resources more efficiently or by discovering a way to use different resources for

new purposes, there are (2) financial resources; (3) physical and economic access; (4) suitable sites for

various purposes (harbors, crossroads, damable river sites, suitable places for roads, factories, etc.); (5)

natural routes for travel, trade, and communication, often with critical strategic bottleneck points like

mountain passes, harbors, river mouths, and natural crossroads; and (6) human skills and (7) good will.

More than one company and nation have fallen on hard times because of poor treatment of citizens,

employees, customers, or neighbors, and others have prospered from more considerate and humane

behaviors. These need to be considered, not only for sound ethical reasons, but for sound practical ones

as well.

Information, understanding, and methodology knowledge, science, and technology are also

crucial to the success or failure of business enterprises. The enterprise using the best techniques,

whether of production, personnel management, coordination, or whatever, will have advantages over

its competitors. To achieve the best methods requires scientific research, perceptive conceptualization,

data collection, and communication. Either the enterprise must develop these itself, or must be able to

buy, rent, hire, or otherwise obtain these from others, and will normally not be long able to do so unless

the firm allocates enough of its resources to promoting them.

Some companies may conduct their basic, scientific research, but even so the scientists must

normally be recruited from somewhere, which means that, one way or another, directly or indirectly,the firm will have to pay for the costs of educating these people and of collecting the data (often by

government). If insufficient allowance is made for this, a company may get by through effective subsidy

(having someone else bear the burden) for a while, but its continuance of free-loading is unlikely to be

allowed to persist.


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The quality of the science, of the public information sources, of the communication and

transportation system, of the technicians, managers, and other employees, subcontractors, suppliers,

and services all are crucial resources.

4. Trading SystemBoth common experience and academic simulation experiments show that the trading system itself

affects the behavior or markets. Such a system is really a part of the economic system, which in turn is

part of the social system. Even so, it deserves special note here. Experiments show thatposted offer

pricing (retailer sets prices and potential customers decide whether and how much to buy) is less

efficient than other methods in setting prices and facilitating sales volume, though it reduces direct

negotiating costs.

By contrast, the continuous double auction, assisted by a computerized and centralized

intermediate service communicating all bids and offers to all participants, as in the stock and

commodities exchanges, is far more efficient in time and in arriving at prices most conducive to high

trading volume. A third and less familiar system,periodic, sealed bids and offers, as used on the new

Arizona Stock Exchange, is the most efficient.

Academic experiments also show unreasonable, speculative price movements in the first two

types of market, even when all participants have the same data, but that the valuations tend to become

more realistic near market closing times (Experimental Market Economics, December 1992, Scientific

American, p. 116 ff.).

These studies tend to refute the efficient markethypothesis or theory of rational expectations,

according to which the market price at any one time tends to discount (=allow for) all pertinent

information on the value of a stock. The evidence of experience confirms these experimental studies.


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VII. Cosmic Harmony in Investing, Continued.C. Fundamental Analysis1. Objectives and General Principles

The object offundamental analysis is to discover the basic, long term relative value of a financial

security in some objective manner. Because actual prices fluctuate daily in a manner which may reflect

mass psychology and even less predictable factors, more frequently than events that imply any real

changes in underlying value, it is inferred that todays price is not necessarily the best measure of real,

underlying value, and that future prices eventually will approximate (or at least oscillate around) that

underlying value. Experience and academic experiments agree in indicating that prices do tend to move

toward theoretical value over time, although often surprisingly slowly.

Because investors buy (and sell) stocks primarily on the basis of their expectations of future

profits in most cases, and future dividends in a smaller number of cases, these are what fundamental

analysis primarily attempts to forecast for stocks. With respect to future profits, important

considerations are levels (especially per share), direction, and velocity of change; riskiness or confidenceof projections; and timing of various parts of the income stream. The primary factors affecting future

dividends are individual company dividend policy and profits.

For example, a growing company may pay out only a few percent of its profits, as dividends to

its stockholders, or none at all, to enable the company to reinvest profits for future growth. A more

mature company may pay out 30-60% of profits to its stockholders in the form of dividends. A company

might even pay dividends exceeding profits for a year or two (usually in order to maintain a dividend

level previously established, or to sustain the value of the shares), but obviously cannot long continue

such a practice.

From these factors the investor can estimate at least a real value relative to competing

investments, and some also attempt to calculate a precise value, on the basis of certain assumptions

about interest-rate levels and trends. These real or fundamental values are then compared with

actual prices to discover the best buys and the most urgent sales.

(More precisely, an analyst may compute current value on the basis of the expected future

stream of profits or dividends by adding the annual expectations for a few years, offset by the current

prevailing interest rate:

V = _E_ + _E_ + _E_ + etc.

(1+k) (1+k)

2

(1+k)

3

Where V = initial value, E = expected earnings or dividends, and k = current interest rate. After a few

years the terms become too small to affect the result very mu

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