Now that all of us are married to the idea that stocks are the best long-term investment, we have a problem. Where can we invest when we are scared to death of what rising interest rates will do to our stocks and stock funds? Is there a simple tool for reducing risk? The answer, I think, is a cautious “yes.” Small-capitalization stocks have been so thoroughly ignored that they are now selling at a substantial discount to large-capitalization stocks. One way to see this is to make a comparison of small-cap, mid-size and large-capitalization equity funds using a tool like Morningstar Principia. While the average fund that specializes in a blend of large-cap growth and value stocks has a portfolio price-to-earnings ratio of 35, mid-cap funds have a P/E ratio of 30, and small-cap funds have a P/E ratio of 26. So small-cap stocks, as a group, are cheaper. Are they cheaper for a reason, like slower growth? No. The trailing earnings-per-share growth rate for the small-cap funds was very close to the growth rate for the large company funds, 18.5 percent vs. 19.9 percent. Basically, you pay less for growth in small-cap companies than in large-cap companies. Another thing we learn in the comparison is that while large-cap funds blew away small-cap funds over the last three years with an annualized return of 21.1 percent compared to 15.5 percent, the relationship has reversed in the last 12 months. Now the average small-cap fund is doing better than the average large-cap fund. One reason may be that the valuation difference may have gotten too large to ignore. The best ongoing source for this kind of information is the institutional research of the Leuthold Group, the Minneapolis-based investment think tank for Weeden and Co. For several decades, Steven Leuthold’s research crew has dissected the stock market, looking for sectors that offer good relative values. Question: Like many, we have “lost” a small fortune with our investments during the past few weeks. I would like your opinion. I believe that since our total investments are still above what we put in, we haven’t lost anything until we actually sell. My husband, however, honestly believes that since our portfolio was recently $100,000 larger in value than it is now, we have lost $100,000. Is this factual, or is it simply a matter of attitude? B.B., Dallas Answer: The value of your investments is the price they could fetch today. It isn’t what they were worth last month, what you originally paid for them, or what they might be worth in the future if everything goes well and the party of your choice is in the White House. Failing to focus on actual current market value is an invitation to wishful thinking and denial it’s a very effective way to avoid recognizing a loss and commits many people to holding a stock until it rises enough to “break even.” The primary issue in all buy/sell decisions is your estimation of the future for the new investment vs. the existing investment. It’s a change of horses, no more, and you want to have the best horse at any given moment. Whether you have a loss or a gain in the existing investment is only an issue when you can use a loss to offset a gain realized elsewhere, or when realizing a gain will bring a tax cost. Another consideration is the relative size of the loss. If your portfolio is off $100,000, down to $900,000, you’ve lost only 10 percent of your money. You should expect such fluctuations in value because they are entirely normal events. If, however, your portfolio is off $100,000 and is down to only $100,000, you’ve lost 50 percent of your money and should be worried. Q: Reading your column, I am usually depressed at how much money people have invested. I only recently realized that retirement is around the corner, and I am not prepared. Divorced and remarried three years ago, I am a 58-year-old legal secretary with annual income of about $50,000. My husband’s income is in the $70,000 range, with a company car, but I am more concerned about what I can do at this point. We live in a four-unit condo complex, where I purchased a unit when I was single for $87,000. I presently owe $79,000. The unit next door is in escrow for $132,500. We also have a cabin in East Texas that my husband pays for. We plan to add on to it and move there after we retire. We both contribute the maximum in our 401(k) plans at our companies. I have all of mine in Janus Mercury, balance $21,000. I also have $20,000 in an Equivest IRA. After April 2001 I can remove these funds without a penalty. I have sent $20,000 to E-Trade to open an account, and I have around $40,000 in a money market account at a credit union. I have no idea what stocks to buy. Any recommendations? J.P., via e-mail A: Examine your current expenses and make a budget for the future based on that spending but assuming changes such as selling the condo and moving to the East Texas cabin. Assume that you have no mortgage debt. This will give you an idea of your target future income. The first thing you will learn is that after you net out your savings, FICA taxes and income taxes, etc., your future income needs will drop sharply. Contact Social Security and get an estimate of your future retirement benefits at full retirement age. Your husband’s will be about 25 percent of his current earnings, and yours may be about 35 percent of your current earnings but get actual estimates. Make a plan to pay off one of the mortgages in the next six years. You should be in a position to own your home free and clear by the time you retire it will reduce your required retirement income substantially. The difference between your Social Security income and your projected spending (including taxes) is the amount that will have to come from money you save between now and retirement. At 10 percent, your current $100,000 will double to $200,000 in seven years. Saving $10,000 a year and earning 10 percent will produce almost $100,000 more. This means that you, personally, could have $300,000 in financial assets by the time you retire. If you withdraw at a 5 percent rate, that means $15,000 of income in addition to Social Security. If your husband does a similar exercise, you can estimate how much he will accumulate by retirement. My bet is that it won’t be so bad. Where to invest the money? Unless one of you has a defined-benefit pension, I suggest a Couch Potato portfolio that is no more than 60 percent stocks, 40 percent bonds. It won’t give you fairy-tale returns, but it will give you most of the growth you will need. Questions about personal finance and investments may be sent to Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; or by fax: (214) 977-8776; or by e-mail: firstname.lastname@example.org.