(MONEY Magazine) – ANYTHING GOING ON IN THE FINANCIAL MARKETS LATELY? OH, NOT much. . .unless you consider the Dow's 121-point plunge the week of March 21. . .and the 7.4% slide in the price of 30-year Treasuries since October. . .and the double- digit tumble in share values in many emerging markets this year. Clearly, this is one time when it's easy to make investment mistakes -- especially if you are a novice like singer Norma Roberts, 57 (at right). Fortunately, she has done well so far -- turning a 20% profit since January 1993 -- as have the other beginners profiled in "Today's New Investors" on page 80. Says Roberts: "I follow up my intuition and my broker's suggestions with research." But even the most experienced investors have to watch their steps to avoid today's seven biggest pitfalls and to prosper in the '90s and beyond.

1 FEARING THE WRONG RISKS QUICK -- WHICH IS RISKIER: NUCLEAR POWER or alcoholic beverages? Odds are you picked nuclear power, as did most ordinary Americans surveyed by Eugene, Ore. consulting firm Decision Research. But 15 risk-assessment experts said alcohol is actually far more risky, in part because you're more likely to suffer from its ill effects on health. What does this have to do with investing? Lots. Many people tend to exaggerate the likelihood of sudden catastrophes such as nuclear accidents -- or stock market crashes. So they plunk their life savings into "safe" bank certificates of deposit, which guarantee their principal. But over time, warns financial planner Victoria Felton-Collins of Irvine, Calif., market setbacks are not the greatest threat to your wealth. "Although there is a chance that you will lose money in stocks," says Felton-Collins, "thanks to the bite taken by taxes and inflation, there is a virtual guarantee that you'll lose money in CDs and money funds." Someone in the 36% bracket with $50,000 in a 3% six-month CD, for example, will lose $585 in spending power a year to taxes and 3% inflation. Stocks, in the long term, are likely to return that same investor at least $1,950 a year after taxes and inflation. Consider Boston chemist Gary Sigai, 49. Ever since he was laid off in December 1992, he has kept all of his IRA cash -- $107,000 -- in money-market funds paying roughly 3% while the Dow Jones industrial average advanced 16.1%. "I know I should be more aggressive, but I keep reading that we might have a correction in the stock market," says Sigai. "I don't want to take a big hit." Fear of the wrong risk also leads investors to put too much of their money into long-term Treasury bonds or U.S. Government bond funds. Treasuries, with their government backing, are practically free from the risk of default -- "the only risk that many bondholders focus on," says John Markese, president of the American Association of Individual Investors. But so-called market risk is a far greater danger. While the feds are unlikely to fail to pay off their bonds in 30 years, the value of these securities can fluctuate wildly in the meantime as interest rates rise and fall. You may have to sell at a sizable loss, as did many investors who bought long-term bonds in the high-inflation years of the late '70s and sold them in the early '80s. Their principal fell by roughly 45%. The market risk in long-term bonds is especially acute today. MONEY's Wall Street editor Michael Sivy believes long-term rates could surpass 7.5% by year-end -- causing 30-year issues to lose about 4% of their value. Fullerton, Calif. financial planner Carl Camp says that income investors should get out of long-term bonds and into solid short-term, no-load bond funds such as Vanguard Fixed Income Short-Term Corporate (current yield: 5.1%; 800-851-4999), which would lose only 1.2% of its value if short-term rates rise to 4% by year-end, as Sivy predicts.

2 MISREADING FUNDAMENTALS UNDENIABLY, VALUE STOCKS -- THOSE THAT LOOK cheap relative to earnings, dividends and other fundamentals -- or funds that buy them belong in every investor's portfolio. A 1992 study by University of Chicago finance professors Eugene Fama and Kenneth French shows that value stocks outperform growth stocks over time and hold up better in a market correction. But many investors seeking value stocks fail to look at the fundamentals properly. For example, you may figure that the best values are stocks whose price/ earnings ratios are now lower than they have been historically. "If so," says Gregory Forsythe, president of Chicago Investment Analytics, "you're making an implicit assumption that the company's outlook is the same today as it was five years ago. But often it's an IBM situation: The company's prospects may have changed dramatically." Forsythe's firm studied 2,000 large stocks from 1982 to 1992. It found that 400 whose P/E ratios sank the lowest compared with their own median P/Es during the previous five years went on to underperform the market by nearly 1.5 percentage points over the next 12 months. The better way to hunt for value is to find stocks whose current P/E is at least 25% below that of similar companies in the same industry. George Long, manager of the Quest for Value mutual funds, suggests two financial service companies trading on the New York Stock Exchange that now have P/Es well below the industry average of roughly 14: Exel (ticker symbol: xl; recent price: $40.75; 8.7 P/E)and Transamerica (ta; $52.50; 10).

3 TRUSTING THE TOUTS YOUR STOCKBROKER CALLS TO DANGLE AN UP-and-coming company that she says 10 analysts predict will grow 30% annually over the next five years. Do you bite? You probably shouldn't. That's because companies that analysts expect to grow the most are often among the worst market performers. When Prudential Securities surveyed the stock market performance of 405 small companies from 1982 to 1993, the firms that Wall Street analysts expected to grow 30% or more returned only 14.6% a year, on average, compared with 17.6% for all 405 small- company stocks in the study and 19.5% for those in the more modest 10%-to- 15% estimated growth range. "When expectations for a stock are very high, they are often unrealistic," explains Prudential small-stock research director Claudia Mott. "And investors who buy into those inflated expectations are apt to become disenchanted and dump the stock en masse if it doesn't come through, thus driving down its price." That's not to say, of course, that you should shun growth stocks altogether -- just those that are overhyped. "Everyone wants to find the next Microsoft -- it's human nature," says Gregory Forsythe. "But if what you're looking at is a highly touted issue, perhaps a biotechnology or drug company, the odds are stacked against you." Forsythe offers this method for spotting bad apples: First, check the company's expected earnings growth rate, which you can find in the Value Line Investment Survey in your local library. Then calculate its internal growth rate, essentially a measure of how much the firm is spending to build future profits. The internal growth rate is a company's return on equity multiplied by its earnings reinvestment rate; data for these are also listed in Value Line. If the expected earnings growth exceeds this internal growth rate, the buzz on a stock is probably too optimistic. For those who don't feel like digging out their calculators, Forsythe offers two stocks that now pass the test: furniture manufacturer Bush Industries (bsh; American Stock Exchange; recent price: $25.50) and IDEX (iex; NYSE; $38), which makes industrial products.

4 GOOFING UP GLOBALLY MOST FINANCIAL PROS AGREE THAT INVESTORS should keep 10% to 30% of their portfolios in foreign stocks or funds to improve their returns and lower the overall volatility of their holdings. But in an effort to do that, plenty of investors buy the wrong kind of funds. One common mistake: failing to & understand the difference between global funds and international funds. Unlike international funds, which hold only foreign stocks, globals invest in the U.S. as well as overseas. Consequently, many investors have much less foreign exposure than they think -- or need. "A client came in not long after buying the Merrill Lynch Global Utility A fund," says Robert Steffen, a fee-only financial planner in Bloomington, Minn. "I had to tell her that only 14% of its assets are in foreign stocks." (The percentage has since risen to 21%.) If you want a fund that will buy foreign shares, stick with one listed in our February 1994 rankings as an international fund. Two diversified international no-load funds with strong records: T. Rowe Price International Stock (average annual return for the three years to March 1: 13.8%; 800-638-5660) and Warburg Pincus International Equity (up 19.4%; 800-257-5614). Many investors are also caught unaware by the volatility of single-country funds. From Jan. 1 through March 25, for example, the closed-end Mexico Fund (MXF; NYSE; $31.25) fell 19.9%, partly in response to rising U.S. interest rates and political uncertainty after the assassination in Mexico. To lessen the risk, make your first international foray a diversified international fund and don't keep more than 5% of your total portfolio in single-country funds.

5 REACHING FOR EVERYTHING 'FESS UP: YOU'RE TEMPTED TO GRAB FOR EVERY tantalizing new investment you hear about. "People are always chasing today's top mutual fund," says Morningstar Mutual Funds publisher Don Phillips. "But when you pick from the annual leaders list, often all you've identified are the most volatile ones -- those run by managers who took a lot of risks that happened to pan out." Tell that to Christopher Keith, 28, a trainee mortgage broker from Glendora, Calif. Recently, he was planning to sink $3,500 into United Services Gold Shares. "A friend of mine doubled his money in it," he says excitedly. True, U.S. Gold Shares was the No. 2 fund out of the 3,105 that Morningstar tracked last year (1993 total return: 123.9%). But that glittering performance was a flash in the pan: The fund lost 50.9% in 1992, and this year's performance to March 1 is a woeful -22.2%. It's just as risky to buy a hyped stock. By the time an individual issue achieves media stardom, its price has usually run up significantly. A study by the Institute for Econometric Research in Fort Lauderdale shows that the prices of 1,977 stocks recommended by guests on TV's Wall Street Week from Dec. 12, 1980 through Sept. 11, 1992 steadily gained in the days before the Friday night show and spiked on the following Monday. (The upcoming guest's name is announced at the end of the previous week's show, giving investors time to scout out the pro's recent picks.) But 12 months later, the average recommended stock had actually lost 1.6 percentage points relative to the market. Impulse buying not only leads to poor investment choices, it can also leave you with a bloated and unwieldy basket of holdings. Financial planner Steffen tells of the man who walked into his office last year with a $450,000 portfolio spread among a mind-boggling 114 different mutual funds. "People like this may think they're spreading the risk," says Linda Barbanel, a New York City psychotherapist and money expert, "but they may actually be increasing the chances they'll lose money. They wind up with more investments than they can follow." Holders of individual stocks can be adequately diversified with just 10 issues in different industries, says Tom Howard, a finance professor at the University of Denver. Indeed, investing superstar Warren Buffett limits the major holdings of his Berkshire Hathaway parent company to just nine stocks, according to Berkshire's 1993 annual report. And most experts agree that you need to own no more than three to 10 mutual funds, no matter how big your portfolio. Lynn Ballou, an investment adviser in Lafayette, Calif., suggests that you look for mutual funds that have remained in the top third of their categories for the past 10 years -- such as growth fund AIM Value (5.5% load; average annual return for the three years to March 1: 22.1%; 800-347-1919) and growth and income fund Washington Mutual Investors (5.75% load; up 11.5%; 800-421-0180).

6 DIVING FROM TAXES WITH 1993'S NEW 36% AND 39.6% TAX BRACKETS, many upper-income investors are frantic to cut the IRS' take -- even when that means leaping headlong into unsuitable investments. Says planner Steffen: "People sometimes become so enamored of the concept of tax-free income that they don't calculate whether they're really better off in a taxable alternative." A prime temptation: variable annuities, which are investment contracts issued by insurance companies that amass tax-deferred earnings in mutual-fund- like accounts (see "Money Ranks the Best Variable Annuities," Money, January). Variables have been soaking up money lately; last year they attracted $40 billion, up from $29 billion in 1992. But they make no sense for short-term goals. That's because you'll usually owe a surrender charge of as much as 9% if you withdraw your money in the first seven to 10 years. You'll also owe income taxes plus a 10% tax penalty on money you take out before age 59h. And an annuity's annual expenses will carve two percentage points or so out of your return each year -- double the bite for ordinary mutual funds. The added expense alone means that an annuity earning 10% a year could require roughly 15 years to earn as much after taxes as a taxable fund with the same return. Similarly, although the double- and sometimes triple-tax-free status of single-state municipal bond funds makes them sound awfully appealing, they may be unwise for you. These funds can make sense for high-bracket investors in states like California and New York that have sizable state and local income taxes. Even if you live in a high-tax state, however, you can pass on them if you're below the 28% bracket; you'll probably earn more after taxes with a taxable bond fund. And though you're subject to default risk with any municipal bond fund, the risk may be higher than you'd like in states like Arizona, New Jersey and New Mexico that have a thin supply of top-rated munis, says James Lynch, editor of the Lynch Municipal Bond Advisory newsletter. Finally, be extremely cautious about limited partnerships that invest in low-income housing. These purport to offer huge tax breaks that can amount to effective annual returns of 10% to 14%. "But there are hidden risks," warns New York City tax attorney and C.P.A. Gideon Rothschild. "Your money is locked up for the 15-year life of the partnership and your return could easily sink to 3% or so a year if the tax laws change." A wiser tax-cutting strategy is to contribute as much as possible to retirement plans such as 401(k)s and IRAs. If you're in the 36% or 39.6% brackets, put taxable income-producing investments such as bonds into these plans and do your growth investing elsewhere. Earnings from income investments are taxed at your regular rate, while the most you pay on capital gains is 28%. But a new study by Steve Norwitz, a vice president at the T. Rowe Price fund family, shows that investors in the 31% bracket or below are probably better off putting stocks in tax-deferred vehicles. That way, they get full value of the stocks' reinvested dividends. Reinvested dividends are more valuable than reinvested bond income, he says, because in the long run stocks outperform bonds.

7 NEVER GIVING UP SAY YOU BOUGHT A STOCK AT $50 A YEAR AGO, IT soon sank to $44 and has hovered there ever since. Would you sell it or hold on for a while longer to see whether it will come back? If your immediate reaction is to cross your fingers and wait, says Olivia Mellan, a Washington, D.C.-based money therapist and author of Money Harmony (Walker, $19.95), you may be making the mistake of letting the past dictate today's decisions. "People never want to admit that they've made a bad investment," adds finance professor Tom Howard. "We all kid ourselves that we haven't lost money on a stock until we sell." Hanging on in hopes of getting even can cost you better opportunities elsewhere. Barbanel blames loyalty to investment dogs not only on ego but also on our natural resistance to change. "Sometimes an investment you've chosen gets to be like an old friend," she says. "People who have received presents of stock from a parent, in particular, often feel they can't sell them." The importance of weeding out your stinkers is underscored by a recent study of 1,387 mutual funds by finance professors Ravi Shukla of Syracuse University and Charles Trzcinka of SUNY-Buffalo. They found that if a fund has been in the bottom quarter of funds with a similar investment strategy over the past two or three years, its chance of staying there for the next three to four years is 46% greater than average. So look for mutual funds that consistently surpass their category mates, such as Lindner Dividend (no load; average annual return for the three years that ended March 1: 18%, vs. just 13.3% for other equity income funds; 314-727-5305) and Fidelity Magellan (3% load; up 18.6%, vs. 13.7% for other growth funds; 800-544-8888). If your stock has dropped, take a clear-eyed look at whether the company's fundamentals have changed for the worse, suggests Barbanel. If they have, get out. (Another reason to sell: Your own investing goals have changed.) To limit losses caused by excessive loyalty to bad investments, you can also place stop orders with your broker, setting a specific price at which the broker should sell the shares. After all, sometimes what we most need to protect our investments from is ourselves.