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Creating Your Discretionary Stock Portfolio
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You're a baby boomer who just inherited $50,000. You are a young executive who finally has saved $10,000 from his paycheck. You just got married and you want to make some money in the market, not just watch your retirement index fund grow. You want to build a portfolio of stocks. You want to manage it yourself. How do you begin? Do you just grab a couple of stocks that are top rated from some broker or that score well on some quantitative tracker and let 'er rip? Or is there more to it?

If you are like most people, jammed to the gills with work, not a spare hour of time to be had in a week, let alone a day, and you still want to pick individual stocks, I've got some bad news for you. I won't play. I won't endorse your owning stocks or building a portfolio. You can't do the homework necessary to do it yourself. You don't have the time or inclination. Period. You will lose too much money. Hand over your money to the mutual fund manager.

I have spent the better part of the last five years doing repair work for individuals in your shoes who built their own portfolios during the heyday only to see all their hard-earned work immolated in a pyre of Commerce One, Internet Capital, and Lycos. Money just shredded into cold coals and burned out sparks. Fizzled to nothing, because people didn't know the basics, they didn't do the homework, and they ignored the cardinal rule to diversify to minimize the risks of single- sector annihilation.

I know the pushback. I can read your mind right now: The professionals didn't do it any better, either, most of them lost big, too. So I can do it better and it will cost me less. Here's the problem: Managing money is difficult, time-consuming, draining, and a totally alien experience for almost everyone who has come out of the educational system of the United States , where, if you are lucky, you may have learned the difference between a stock and a bond. You most likely figured out how to balance a checkbook on your own, but beyond that, handling money is tough for you. And now you want me to endorse your setting up a portfolio? Dream on. You'll be like all the other callers I talk to every day on my radio show who have crushed their own nest egg with reckless purchases based on bogus investment tools and advice that made them feel more confident about buying than they should have been.

But you've paid for the book, you've gotten this far through my basic training, you've digested my Miranda warnings against doing it yourself, and you won't take no for an answer. You insist that you can take control of your finances, that you are not going to let some broker churn you or some mutual fund rip you off. Your confidence that you can do better is unshaken. I will help you, but only on the following conditions:

1. You will do the time-consuming, sometimes tedious homework that I described earlier in the book. No shortcuts. You have to do it all. Remember, in my world it's buy and homework, not buy and hold. Take it from me, I speak to dozens of people who bought and held crummy stocks that they never should have purchased, let alone held. You have to listen to the conference calls—they are very timeconsuming and dense—read the articles, get the annual and quarterly statements and reports and understand them. If you don't, I will mentally buzzer you as I had to do to Dorothy from Queens, New York, who called me on my radio show last year claiming she had done all the homework that was necessary to buy International Game Technology and was "ready to pull the trigger." Just one thing, though, she said; she wanted to know why the stock was down 3 points, given that everything was so hunky-dory. I asked her, "Did you listen to the conference call on the quarter?" She said no way. I said had she listened she would have heard management say that contrary to the last few years of great consistent earnings, this year was going to be "lumpy." You pay up for companies with consistent growth, as I have demonstrated. You slaughter consistent growers that suddenly turn lumpy in their earnings generation. Now the stock will have to go from growth to value hands, and that takes many quarters and takes off many points. Dorothy was all set to be fleeced by the process because she thought she had done the homework after reading some articles about the potential of Indian gaming. Turns out she hadn't done anything substantive to merit her opinion. Thank heavens she called; the stock got obliterated shortly thereafter. Most of my callers, when asked if they did even the most basic level of homework, admit that they haven't when I define the homework substantively. Don't be a casualty; do the kind of studying that you would have done for a social studies test in seventh grade. You would do the work if you set out to buy a new car; stocks are even more expensive and don't come with warranty protection. No money-back guarantees here! Caveat emptor still lives in the stock market, despite the attempts by the tort lawyers to change it.

2. Which brings me to the second caveat that you must agree to before you get my blessing to run your own money instead of turning it over to others. You must promise to spend a minimum of one hour per position per week doing the research. I know this commitment sounds onerous. It isn't; it is commonsensical. There's a lot to do to maintain a portfolio, and I find myself routinely spending at least an hour a week staying on top of each of my positions. That's why I arbitrarily cap my positions at twenty-five; I have only about twenty-five hours each week free to do research because of my various commitments. When I have more positions than that, I fall down on the job and can't stay on top of things. And I am a very fast researcher and fact-gatherer about my companies. The difficult thing about this rule is that you can't be diversified to my liking unless you have five stocks in your portfolio, which means that you need to have five hours free a week to run your own money. Don't freak out; it takes five hours to watch an afternoon of football. It takes about five hours to go to a baseball game. You go to the movies, it's about a four-hour experience. Are those activities more important than your money? I didn't think so. If you don't have the time, skip to page 198, because you are not going to be a good enough portfolio manager. You just don't have the time. If you have only four hours, give the money to one of the fund managers I recommend. You can be a great client in four hours.

•  You must be interested in business, in what makes a business
tick, to do it yourself. You must be curious about how a business
makes its money, what its metric is that has to be beaten—gross mar
gins, revenues, seat miles, average selling price per unit, etc.—and how
much growth you think a company 'may have. If you don't have that
inclination to find out these things, you won't know whether a decline
in a stock is a buying opportunity or a time to puke up the stock—and
if you don't know that, I guarantee you will lose money. If you can't
explain to me in thirty seconds what a company does and what you are
expecting out of that company, go be a great client; you won't be a
great investor. I am not asking you to be a stock junkie, like me; I am
asking you to have some authority and curiosity about companies be
fore you buy them.

•  You must have someone, not necessarily a broker, you can
bounce an idea off of, someone whom you trust, so you can get a sec
ond opinion on the stock before you buy it. I didn't use to believe this,

5. Finally, I can't have you get discouraged and quit. The whole process is a game of endurance. Think long-distance running. There are periods where you want all your discretionary money in cash, and there are periods where you want every dollar on the board wagering for you. Remember, I'm not talking about the retirement account. That's too sacrosanct to play with; you need to keep that with others unless you know already that you can beat the market. As I have said elsewhere, I am a rank conservative when it comes to retirement: I want the money as diversified as possible into high-quality equities as defined by an index fund or a mutual fund that acts as an index fund with a brain. We aren't fooling around here. As you get older, you need to have fewer stocks and more bonds. But that's not the kind of investing we are talking about here. What I am talking about here is the notion of setting up the portfolio and then having the discipline to stay with it, to review it, and to cull it and revise it. I will give you very spe­cific advice later in the chapter how to rank things like a pro. We know that no asset class has beaten high-quality stocks that pay dividends over a twenty-year period. But we also know that many people get fed up during the tough times and blow their stocks out either because they can't take the pain or their stocks aren't of high enough quality to meet the test. Sign on for the long term, not a couple-of-years hitch. That will solve a lot of your problems.

Okay, now you have gone through the warnings and you have checked off on all five preconditions. You are now ready to build a portfolio to augment your paycheck. I am going to assume that you can build up to ten stocks, that you are willing to give it ten hours a week. If you can't do ten, cut it back to five and just take my top five from the Chinese menu I have prepared.

I am not intentionally trying to steer you to any one company. I have come up with a menu that makes it so you can get involved with a portfolio and stay involved, and use your expertise (which you may not even realize you have) to pick stocks. I want you to feel free to deviate from the list, but if you pick from it, I know you will be diversified in areas and types of stocks, and that will keep your risk to a minimum and your rewards to levels you are not used to achieving. I present it in menu form by sector or by risk-reward. You have to choose the stocks because, after all, it is your portfolio. This way, with this menu, I know you won't just own five tech stocks. I know you will be diversified and not get clobbered on the down days. I know you will stay involved because you are doing the picking, not me. I can't be your guru; who knows when I won't be there to hold your hand. You need to be your own guru, but I can give you the parameters, the guard rails so to speak, to be sure you don't plunge off the bridge into the sea of red ink that awaits so many who try to do it themselves.

Please be careful when you work this hometown advantage. I bought the stock of a company once that had a factory that made precision instruments for aircraft dashboards. The local paper kept talking about how the division was hiring like crazy and getting big orders, but it was part of a larger company that at the same time was imploding under a mountain of debt. My method doesn't absolve you of homework; it is just a way to be able to get a feel beyond what you might get by just buying shares in some tech company that you know nothing about that could be slaughtered as you continue to buy down for no good reason.

There used to be a toy and novelty store down the block from where I lived in Brooklyn. I went by it every day to pick up a little trinket for my kids, something my dad used to do for me when I was growing up. Each day I heard the "boys" who ran it talking about what was hot and what wasn't. From them I had a very nice hit in Mattel, a comeback story. But one day I heard them cursing about the stock market. They had no idea who I was. One had bought Seagate, the other Daisy Systems. I told them at the register that I was always interested in stocks and that I was intrigued by what they knew about Seagate and Daisy, both of which I happened to have been shorting for my fund. They freely admitted they knew nothing; they had just heard these were hot stocks from someone on TV. I laughed and told them to get out now. Seagate was cut in half soon after; Daisy filed for bankruptcy. Classic—they were making me money with their inventory and they were buying stocks they knew nothing about.

Having trouble finding a local company or local news about one, like Mattel? Check the business pages of your local paper. They usually have a good read on the companies in and around town. Of course, you need to be able to stay current beyond reading that paper. All of the rules of homework apply, but that is a nice way to start. Many papers have beefed up their business coverage these last few years, and I always found them—still do—to be of tremendous value in finding new ideas. The best papers are the real local papers, the weekly local paper that covers just your area, your suburb, your neck of the woods. That's where the really great ideas come from.

2. Your next pick should be an oil stock. I almost never see a portfolio with an oil stock in it and it drives me crazy. These are some of the most consistent performers, with high-dividend yields, great cash flows, and businesses that do well in times of tension. I am a huge believer that we are going to see continual increases in demand for oil worldwide, and until a better fuel is found you should own shares in one of these companies. Exxon, British Petroleum, ChevronTexaco, ConocoPhillips, and Kerr-McGee all could be great for many, many years. They will be boosting their buybacks and raising their dividends as their cash flows have increased faster than any other sector. Oil is in what we call a "secular bull market," meaning that it has characteristics of longevity that counteract the traditional cyclical nature of so many businesses. Strong or weak economy, it seems, oil's staying up there as a valued commodity. Can't come up with a stock? What brand of gas do you buy? That will probably be fine. Yeah, it is that simple.

Oil used to be 20 percent of the S&P 500 when I got into the business of stocks. It subsequently went all the way down to 5 percent two years ago. As I write it is only at 7 percent. I think that it belongs at 10 percent. When you see it there, you are free to take a profit if you want to. Not until then, though. These stocks have fallen well behind the price of crude; that will change over time and you will be the beneficiary.

•  You need a brand-name blue chip that currently sells at a 2.5
percent yield or greater. At any given time the market's putting on a
sale of one of these and you just need to find which one is right. Why
2.5 percent yield? That's above average for the S&P and it affords you
protection if the stock gets hit. I don't find a lot of 2.5 percent yielders
getting crushed because they have a floor. The floor will be lower
when the Fed finishes raising rates, but I think that it is nice to know
that the worst thing that happens is you are getting an even bigger
yield as the stock goes down. Consider one of the major chemical
companies or conglomerates if you are having a hard time choosing.
Try to get one with a history of raising dividends when possible.
Please, please, don't buy the stock of a company that is borrowing to
fund the dividend. I know I can count on you to spot that, because you
agreed to my Miranda warnings earlier in this chapter. Remember to
use the weakness in the market to buy a high-quality dividender on
your terms.

•  You need to own shares in a financial, one of the largest portions
of the S&P 500.I like to own local. I have had phenomenal success
over a twenty-year period owning a local bank or a savings and loan.
One of my biggest hits came from Commerce Bancorp. When it
opened near me I was attracted to its seven-day-a-week service, and
we decided to bank there. About three months after we put our money
in CBH, I told my wife that I was going to be attending a conference

5. No other financial writer in America is going to tell you what I am about to tell you next and frankly, I could not care less. I know you crave speculation and I know that some speculative investments can be rewarding. I am not willing, like so many others who write and talk about the market, to deny you that feeling. It is too ascetic and unnatural. I know you will speculate anyway. It's human nature, in the same way that gambling and lottery tickets attract so many takers, no matter how many times you tell people it is a sucker's game. That's why to round out your top five investments I am blessing an investment in some risky, on the come, next Microsoft, Home Depot situation. You can choose something that is being recommended by the Stocks Under $10 newsletter, perhaps, which I have a hand in. Or you can choose a tech or a biotech company that has some potential to be a huge company. I am blessing this because I have found that investing is a lot like parenting; if you don't give your kids a little room to do something daring, to break a few rules, then they will break all of the rules and cause tremendous heartache. I am telling you, go, with 20 percent of your money, and buy something that you think could be a terrific investment, a hunch, a potential home run. But if you do, please, I don't want you to put one penny more into speculation than that. You are taking a pledge. You must swear to me you won't put more into the speculative portion of your portfolio even if it is crushed and you want to average down. This is the portion of the portfolio where you can expect to lose your investment, and you should accept that. I don't want you losing more than your 20 percent, though, because you can't make it back with the consistent growers you own elsewhere in your portfolio. The math's just too brutal.

Mind you, if you have the time and the inclination, you might use this slot, again keeping in mind it is only 20 percent of your invest­ment, in a pooled fashion. Some of the best investments I have ever made are in baskets of down-and-out stocks that can either go to zero or make you a fortune. In October 2002, for example, I recommended a basket of telecommunications stocks, all of which sold under $2: Lucent, Nortel, JDSU, Corning, and Qwest. With the downside factored in—thank heavens stocks can't go to negative 4—1 watched as some of these stocks doubled and doubled again. Each time I took some of the investment off the table but let the rest run. I did a similar field bet in 2003 with the merchant energy companies like Dynegy and El Paso that were down on their luck and trading under $7. These kinds of field bets can serve as the speculative portion of your portfolio just as well as if you are trying to hunt for the next Arngen. Typically, in a field bet, one of the five will go to zero, another one or two will do nothing, but the others will create profit enough to make the whole thing worthwhile. I make these bets whenever a sector falls so out of favor that even if the stocks fall from where they are, the loss will not be of great magnitude. Again, you can't let the speculative portion of your portfolio exceed 20 percent of your invested capital or you are taking on too much risk. By the way, I am always making field bets in distressed areas, so stay close to what I'm up to for ActionAlerts PLUS.com, my private account where I send out e-mails to you telling you what I am going to do before I do it. I play with an open hand. For a trial simply log in at www.thestreet.com/actionalertsplus, another special URL for readers of the book only.

You have now selected five stocks from a list of diversified sectors. You can stop there or, if you have the time and inclination, you can diversify further, adding something from each of the next five items as you get more capital.

6. Rotations of the type I have described—where market players flee safety for aggressive cyclicals because the Fed is about to ease rates aggressively—often create tremendous buying opportunities in the staid and true, the Procter & Gambles, Kelloggs, the Colgates, BUDS, General Millses and Gillettes, the so-called medicine chest and fridge stocks. As you have already selected your diversified five stocks, why not wait to add the sixth, a soft-goods secular growth stock, until the market deems it out of fashion. You have a long-term time horizon; be smart and pick the stock up when nobody likes it. Use the rotation to pick it up much cheaper than you would otherwise. Use the decline to win, not lose, for once, with your portfolio. Lots of times these stocks go down hard after a particular quarter because some fund or funds get disappointed. But it is a tribute to the high quality of these branded companies that they almost always snap back. So don't be afraid to buy the most dislocated of the companies that have big shelf space in the supermarket. That's how I gauge it—with my eyes.

•  Now, to augment that soft-goods play, I want you to buy one
high-quality cyclical stock when it is clear that the economy is going
to go bust and the smokestack stocks are being trashed repeatedly. My
favorites: Dow, Deere, DuPont, Caterpillar, Boeing, Ingersoll-Rand,
United Technologies, and 3M. These stocks, like those of the category
above, always get slammed if you wait long enough, and the slamming
will produce value for a long period of time. Again, you have to regard
the rotation as your chance to pounce on the proverbial straw hat in
winter or snowshoes in July. You are not affected by the "inventory"
concerns that plague so many professional money managers. No one
is looking over your shoulder, no one is reviewing your portfolio daily,
so use that advantage to snap up the stocks that the lemmings have to
get rid of to show they were "in the know.'' These are great American
companies that, several times a year, get thrown into the discount bin
or are marked down by market hysteria. You have to be ready when it
happens.

•  Technology companies are risky; but not to have a technology
company has proven to be a terrible risk for all but three of the last
twenty years. That's why I think you have room for one after you have
selected the other seven stocks. Me, I am so conservative, I like tech
companies with yield. That means they are mature enough to be
steady growers and you haven't necessarily sacrificed double-digit
growth. If you think that I am being too stodgy, you have an easy
choice: Make your tech stock your speculative stock. I have seen so
many portfolios with the same old poorly performing bunch of techs
that I can't bear to see you load up with too many of them. I would
hate to have to buzzer you if you called me on a Wednesday when I am
playing "Am I Diversified?" I know that tech can be considered the
lifeblood of the economy, but so many have put tech at the first, sec
ond, and third portions of their portfolios, much to their own ruination, that I need you to deemphasize the sector. It is too dangerous to overweight until all the others have capitulated. And remember, that comes from me, an Intelaholic.

9. Add one young retailer that hasn't yet expanded to the majority
of the country, and has preferably saturated only one region of the na
tion on a march to national status. People are always saying that the
retailers are great investments, but they don't understand that it is not
"the retailers" in general, but the retailers that are still expanding geo
graphically around the nation. In fact, once the companies are every
where they tend to be pretty poor investments, as anyone who has
owned May or Federated or even Wal-Mart can attest. I like to buy re
tailers when they are just getting started and they have a concept that,
if it works in one place, can work all over the country. That's how I
discovered and owned so many great retailers, including great one
time growth stocks like the Limited, Gap, Wal-Mart, Kohl's, and even
Lowes and Home Depot. Once they were everywhere, though, I sold
them and never looked back. Currently I like Cabela's because it is a
high-end camping and hunting store that could go for years before it
saturates the landscape. Be careful, though, you must check them out
firsthand.

10. Finally, buy a "hope for the future" nontech stock, perhaps a
biotech company or another kind of company from the S&P 600,
which is the mid cap index. Many of these companies will turn out to
be the Amgens and Starbucks of tomorrow. You have to be a legit com
pany to get into the S&P 600, and it is the proving ground for the S&P
500. It's a natural place to hunt for some good names. That's a great list
to choose from; if you can't come up with something, pick a holding
from the New America index of Investor's Business Daily. They have a
phenomenal track record for selecting these kinds of medium-stage
companies. Again, do your homework. IBD is no substitute, just an
other terrific starting point for ideas that you can use to find the next
big stock.

Now that you have picked your stocks, you have to learn how to buy and sell for your portfolio.

I am a huge believer, as you know, in my own fallibility. I also like to make the market work for me. It puts on sales all the time. I like to use those sales to buy my stocks cheaply. That's why I have urged you to set up your portfolio to take advantage of the sales. Rotation sales are like post-Christmas sales. You know they are going to come. Unlike Christmas, you don't purchase a stock for someone else; this is for you. So wait for the sale and take advantage of it.

I also don't believe in putting too much money to work at one level. I know that the market tends to fool the most people it can. So why be faked out? Why not accept that your first buy may not be your last buy and build in the weakness? That way you are never top- ticking, something that's incredibly important if you are going to stay in the game. I know most people think that the market is rigged against them. That's because they buy a stock and it immediately goes down. Heck, if so many people complain about this—and they do on my radio show all of the time—let's do something about it.

So, let's say I want to own 200 shares of Cabela's as part of a retail bet because this retailer is only in a small part of the country and it can grow forever. It will take a decade before Cabela's has saturated any­thing. That means anytime it dips it could be a terrific buy.

What I like to do is buy my first 100 shares and then wait. If the stock goes down a buck or two, I will buy it; if it goes up, oh well, the worst that happens is I have made a little less money than I would like. That's how I buy everything. I like to buy weakness. Similarly, I like to sell strength. When I have decided to take something off the table I wait until a day when my stocks are running and I offer them out. I never like to exit all at once; I pare back. That's the best way; don't let your broker press you into being the big man and selling all at once.

At any given time I maintain a wish list of stocks to buy and to sell as part of my portfolio. I don't know when the sell-off is going to take place; I just presume it will happen and then I pounce. I am so religious about not buying stock all at one level that I actually sketch out the levels I will pull the trigger at, and I will widen or narrow the scale of the bids depending on how well or badly the market might be doing at the time. If I believe, for example, as I did in 2000-2002, that the market itself would serve to hinder my buys, I use a wide scale. If the market was poised to make a move because, as a whole, it seemed cheap and was ready to roll higher, I would use tighter scales. I let the market throw its sales to get my merchandise at better prices.

Of course, there will always be situations where you have been too aggressive and the market becomes brutal. There will always be situations where you simply misjudge the market. I don't care about misjudging it too conservatively: The worst that happens is you make less money. I care about being too aggressive when the timing is bad and getting your head handed to you. Again, those lunds of misjudgments come with the risky assets we are accumulating. My insurance against my own fallibility, besides the use of scales to buy on the way down, is to rank my stocks, perform a sort of battlefield triage for the moments when it seems as if the world's coming to an end and all of my stocks are getting killed. That's why I rank my stocks every Friday on a scale of 1 to 4. It helps me make judgments in a cool moment that can then hold up during the hurly-burly of the trading day. (I don't like to make these rankings during the trading day because that influences my fears more than it should. Fear is too powerful when the market's open.) My four-part scale makes the process much easier. You can easily employ the same strategy with your portfolio. A 1 is a stock that if I have capital handy—some sidelined cash or new money—I want to apply it right now, that's how good it is. A 2 is a stock that if it pulled back 5-7 percent, or a couple of points, I would buy more. A 3 is a stock that if it were to go up 5-7 percent, or a few points, I would begin to sell it. And a 4 is the mirror image of a 1, it is a stock I want to get rid of ASAP, either because it has gone up enough or because I think it could be a real bone-crusher in an ugly tape. Because I have ranked my stocks, when things get nasty I circle the wagons around my 1s and 2s and I let go of my 3s and 4s. I would be willing on the fly to whittle my positions down to my top five from ten if I felt that I was in danger of getting crushed by the market. I also know that if there are stocks that I wouldn't buy right now, then I don't have the conviction I need, I am too heavily invested, and I will panic out of my holdings when the tape turns really ugly. (If this is all foreign to you, take a trial of my ActionAlertsPLUS.com where I run my own money publicly. Lots of good ideas there, and I use this identical ranhng system to make all my buy and sell decisions.)

Ranking stocks is a tremendous way to test your discipline and your conviction. If you don't want to buy more of a stock right now, right here, that says something. That says when things get tough you will jettison it in a heartbeat. What we are looking for, what ranking does, is make it so that weakness is welcomed. It stands the psychology on its head and turns fear into a method of buying your stocks on terms you want, instead of selling them on terms the markets dictate.

I love the flexibility, by the way, of selling a quarter or even half of my shares as a stock goes up. Selling strength is another of my trade­marks. If you want to buy on a sale at a store, wouldn't you like to return some of the merchandise at a higher price if possible? When I put it like that, I'm sure you understand my "scaling out" on the way up. If the stock falls back, I can always repurchase it. If it keeps rallying, I just make a little less money than I would like. By selling partially into strength, I don't violate my bulls, bears, and pigs adage. But I also let my winners run, which is vital, particularly because I often see people sell really good stocks that are going higher where they have done a giant amount of homework, only to reinvest the money in a loser.

Ranking stocks, making sure not to defend everything because then you really are defending nothing, and waiting for broad market sell-offs that have nothing to do with the companies you are buying but are knocking down the stocks you like anyway are the disciplines necessary to maintain your portfolio in tip-top shape. They are the key to implementing a disciplined approach that allows conviction to make you money but limits the losses during the inevitable vicious markets that we have all become so fearful of. You must feel emboldened by sell-offs, not paralyzed by them. You must recognize that a sale in the market is no more frightening than a sale at Macy's. If you do that, you will prosper when others are beside themselves with pain or throwing up their hands with resignation.

You don't have the time or the inclination to build and maintain a portfolio with your discretionary savings. What can you do instead? I've got a couple of options, none of them optimal, but all of them acceptable. First, you can get your diversity and beat almost every single mutual fund manager simply by buying shares in stock index fund. Almost every major firm has them; the key is to find the lowest fees possible as these are commodities. Vanguard pioneered the S&P 500 index fund and is the cheapest and best one I can find.

Why do most managers fail to beat index funds? Because it's a lot harder to manage a lot of money than it looks. If you manage a tradi­tional mutual fund and you do well, you will soon be inundated with money, which will cause you to change your style and, over time, unless you are incredibly good, you will begin to mirror an index fund, except you will be charging your investors higher fees.

John Bogle, the most honest money manager in the business, and the creator of the index fund, once appeared on one of my TV shows after I had run money professionally for about ten years. He said that no successful manager, over the long run, can beat an index fund. I told him that was just untrue, that I was a living, breathing example of someone who consistently beat index funds. He then asked me, "Do you limit the amount of money you take in?" I told him that not only did I limit the amount of money that I took in but that I was almost always closed to new investors.

He then asked me how much I ran. At the time I had about $200 million under management. He said that as long as I stayed under $500 million and was closed to new investors—relying only on capital appreciation for more money under management—I would be able, if I continued to be really good, to beat the market. But once I got above those levels and changed my exclusionary policy I would eventually become a glorified index fund with high fees. I never forgot that and I never went bigger than $500 million. I also never got beat. That's why.

Most mutual funds, which have a different incentive structure from a hedge fund, can't be so exclusionary. Hedge funds take a percentage of the gains—realized and unrealized. I took 20 percent. Mu­tual funds take a percentage of the money under management, usually about 1 percent. Given that everyone on Wall Street wants growth, the way to grow your fees is to take in more money. So the natural ten­dency is to get big fast, particularly after you have a hot hand. That's just the recipe for underperformance that Bogle sketched out. Nevertheless, there are some managers, individual managers, who are so good that they have been able to overcome the Bogle problem. Unfortunately, they are few and far between. Consider the game like the NBA; 99.9 percent of the basketball players aren't good enough to get in the NBA, and even when you get there, only a handful are bona fide superstars.

Before I give you the names of the great managers, let me just add that I hate giving mutual fund recommendations. As an experiment five years ago I put $2,500 into each of fifty mutual funds to see if I could keep up with who was good and discover some stars, some people worth writing about. Only three of the funds made me money, and none made enough money to get mentioned here. Bogle's right.

Still, there are some managers I recommend because they are truly world-class stock pickers. Notice, I am giving you the name of the manager, as well as the fund. If the managers were to leave or retire— and the industry is notorious about not telling you if they do, so you have to stay on top of it—you will have to pull your money out pronto because you only buy a manager in this business, not a fund.

The first is Will Danoff of Fidelity Contrafund. Danoff worked with my wife in the 1980s, and it always burned me up that she said he was as smart as I was. I always figured that if she weren't married to me she would be telling people that he was smarter than I am. I am a jealous guy. The only way to get even is to give the guy you think might be better than you some money, which is why I have a lot of my personal retirement money with Contra. Danoff's the real deal. He's had the fund since 1990. While his five-year performance is not a knockout at 1.69 percent, he's your index fund with a brain, as the S&P returned —2.30 percent during the same period. I like to use Danoff's Contra as a substitute index fund because it always does a little better with less risk. You can't ask for more than that from big money.

My second pick is Richie Freeman of the Smith Barney Aggressive Growth Fund. Freeman's fantastic; a stock picker par excellence, some­one who lives and breathes stocks the way I do. He's incredibly focused and driven to beat the averages. You want him in your corner. Freeman's always good, but I particularly like to give him money after he's had a rough patch; he's so competitive that that's when he is most bankable. Richie's been in the game since 1983. In the last five years he's averaged 5.83 percent, with terrific recovery from a very tough 2002.

My third pick is the John Hancock Classic Value Fund, run by Rich Pzena. Rich got in the business about the same time I did and has always been a fantastic value guy. I'd entrust him with any amount of money because he picks stocks with the lowest risk and highest reward of anyone I know. Always has. Rich has chalked up a 13 percent annual return over the last five years. Wow!

Lawrence Auriana's been a guest numerous times on my CNBC show. He and his partner Hans Utsch have been running the Federated Kaufmann Fund for almost two decades. They are driven to find new names, great health-care and tech companies. They are wild-card players, but they play those cards more consistently than any managers I know. These two have shot the lights out over a long period of time, notching 12.5 percent annually in the last five years.

Finally, the only manager I don't know personally whom I will recommend is Clyde McGregor, who runs the Oakrnark Equity and Income Fund. Unlike all of the other funds, this one has a heavy bond exposure, so consider it the most conservative of the lot. Given this fund's risk aversion, the 11.76 percent return is just plain stellar.

Remember that mutual funds are already diversified, so you don't need to own a whole bunch of them. I am always getting phone calls and e-mails from people who own ten or twenty mutual funds, which is absurd. Who can keep up with that? I would invest in the Oakmark Equity and Income Fund if you are conservative, Federated Kauf- mann or Smith Barney Aggressive Growth if you want to have some risk with big reward, and the Contrafund if you are somewhere in the middle like the vast majority of folks out there. If you just had to own one fund, I would make it Contra. I don't want to overthink this process. I bet all of these managers are going to beat the index funds simply because they are better than 99 percent of the managers.

What happens if you say, Hold it, I want to be in a hedge fund, not a mutual fund. I want some of the service that Cramer gave to his partners at his firm, where he talked to his clients whenever they wanted and told them what they owned and consistently outperformed. (Mutual funds tell you nothing about what they own in real time, so you just have to trust the manager.) I have bad news for you. I have no recommendations for you. First of all, hedge funds can take only "qualified" investors, meaning rich people. Second, I don't know anyone I would like to recommend to you. I can tell you, though, that you need to interview the manager personally and be sure that he has done well in good and bad times. It is incredibly important that the manager give you two references whom you can call. If he can't do that, don't bother. He also has to have an outside accountant who works just for the partners. That accountant works for you, gets all of the confirmations and documents, and can tell you where you stand. Without such an arrangement, I would be scared to have my money with that fund, because hedge funds aren't regulated by the SEC in the same way that mutual funds are.

Should you be worried about shenanigans at the mutual funds, after the terrible disclosures that some made about selling the net asset value of the individuals to the hedge funds to take advantage of pricing discrepancies? Not any more. The regulators have cracked down. But far worse than the chicanery, frankly, is the poor management and the return after the fees are taken. The managers I recommend above all charge fees, but the net return of their funds after fees is still much better than the averages, and only the net matters.

If instead of giving your money to a hedge fund or a mutual fund you want to give it to an individual broker, all I can say is good luck. My experience is that no really good broker, who has made money consistently for his clients, can service you if you have less than $250,000. Of course, there will be thousands who disagree, so here's what I suggest. Find someone with your size nest egg who can recommend a broker. It is a total word-of-mouth business. The firm itself means nothing to me, only the broker, because at any firm there are hundreds of ideas and ways to make money. You need someone who can harness the best and cull the worst. Only a word-of-mouth recommendation is going to cut it for me, because, again, I have no recommendations. I don't mean that meanly, I am just saying that it is a one-to-one business, like health care, and you have to find the broker you would be most comfortable with.

If you have less than $250,000 and you want a broker, I don't think I can protect you from being treated poorly. So you either have to learn to do it yourself or you split up the money among the managers I have highlighted here.

I know I sound cynical, but just call me skeptical. Having worked as a commission broker, an investment adviser, and a hedge fund manager, and having taken and answered literally tens of thousands of calls and e-mails from investors, I know the business's limitations. I am not going to sugarcoat them. If you care about your money and you want to see it grow and you don't want it screwed up, you must take the time and develop the inclination to do the things I say here. Together we can do it; otherwise everything else is just, well, settling for less than you deserve.

Oh, one other thing: please be wary of hot funds. One time, while I was working with my wife, a decade before I talked with Bogle, I opened my fund after a fantastic quarter. I took in almost the same amount of money that I was running. What happened? Well, when I was a kid there was a game show called Supermarket Sweep. In the show contestants would have a couple of minutes to run through a supermarket with a cart, gathering as many expensive goods as they could. Whoever grabbed the highest-priced merchandise won the game—"Look, he's going for the hams!"

That was me. I had to put that money to work. Fast as possible. They didn't give me the money to sit on the sidelines, I rationalized. I went for the hams! Sure enough I got the market's equivalent of trichinosis. As soon as I spent the money I knew I had done the wrong thing. Within two weeks the fund had dropped 10 percent. I spent the rest of the year making up for the decline.

Why does this happen? Couple of reasons. One is that you feel the responsibility of the new money. You feel that you have to justify why you took it in. The only way to justify it is to invest it.

Second, the size that you use to buy, your deployment tactics, change when you run twice as much money. You don't know how much you should put to work at one level. You don't how you should buy things. If I used to buy 5,000 shares at a time should I now buy 25,000? I blew my head off because my usual method, 5,000 shares at a time, seemed too slow to me. I started committing capital too aggressively.

Third, what works for $20 million may not work for $50 million or $500 million or $5 billion. Maybe the secret of your first-quarter success was finding precisely the right small cap stocks. Now that you took in all of this money you feel like you have to invest, but you can't find the right small caps to meet your rigorous criteria. So you force things. That's how you make even bigger mistakes.

Eventually the stress of the money cascading through the door becomes too much for any mortal to take. The job becomes managing the input, not picking stocks, and the great stock pickers get sacrificed. The fund managers I recommend have dealt with this issue, confronted it, and have the tenure and power to tell the marketing depart­ment, "Look, I can't handle the money right now. That's why I feel so confident about them and so nervous about the new ones I don't know."

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