Investing Essentials – A Primer

Investing Essentials
A Primer


Dedicated to those investors trying to make sense of it all


Who is writing this primer? I am a self-taught investor who began by learning the basics from other knowledgeable, dedicated investors. I have now been enthusiastically studying investing for 12 years. My mission here is to pass along what I have learned, and hopefully to ultimately help you become a wise investor. It turns out that all of the investing research I’ve studied ends up with the same essential recommendations for the average investor, and this is what the primer is all about. I’ve also included some insight into what I’ve observed about average investors from 12 years participating on investment forums.

The Guide Will Enable You To:
Implement the six essentials of investing
Understand and manage risk
Evaluate and select mutual funds
Recognize and control the devastating effects of cost
Develop and write an Investment Policy Statement
Recognize and avoid behavioral mistakes
Evaluate and choose an Investment Advisor
Locate a large collection of reference material

You may read the book by simply scrolling down through the text, or you can go directly to a specific chapter by clicking on the chapter links.

CHAPTER 1: The Essentials
CHAPTER 2: Understanding Risk and Asset Allocation
CHAPTER 3: How Diversification Works
CHAPTER 4: Diversifying A Portfolio With Asset Classes
CHAPTER 5: Costs are a BIG DEAL
CHAPTER 6: Building Your Portfolio – A look at the Options
CHAPTER 7: Rebalancing
CHAPTER 8: Formalize Your Investment Plan
CHAPTER 9: Behavioral mistakes
CHAPTER 10: On Your Own Or Hire An Advisor
CHAPTER 11: Final thoughts and References


In the past thirty years, there has been a dramatic shift in retirement funding. We have moved from defined benefit plans to defined contribution plans. The difference is in the past an employee could go to work for a company and remain there for an entire working career, and on retirement receive a monthly pension and health benefits, and no worries about the future. Now, for most workers, the responsibility for a secure retirement is entirely up to the employee. Under the old system you did not have to worry about accumulating or managing a large amount of money to secure your retirement, now you do. This is a formidable challenge for workers who now must become not just investors, but smart investors.

Unfortunately, our educational system has not kept pace with the changes in retirement funding. Investing fundamentals are not taught at the high school level as they should be, and even college does not address investing fundamentals unless you take an economics course. When it comes to knowing what to do, you’re pretty much on your own.

Depending on where you work, your defined contribution plan might be called a 401(k), 403(b), 457, or something else. The numbers refer to the part of the IRS code that covers the plan regulations. Although your employer may match all or part of your contribution amount, you probably won’t receive the information you need to get the most out of your retirement plan. Education on the plan level and from the oversight agencies has been painfully lacking. What little education you might get comes from those selling the product.

Many plans are provided by insurance companies that charge very high fees and offer poor fund choices. Others have more reasonable fees and better choices, but that doesn’t help much if you don’t know the difference. Beside company related plans, you also have IRAs, Roth IRAs and taxable accounts for accumulating assets. The challenge before you is clear: you must make retirement savings a top priority and take charge of your future by becoming an educated investor.

A General Perspective on Saving and Investing for Retirement
While this book is about investing, a few comments about saving are in order because the two are so closely tied together. Before you can invest, you have to save. Your investment money can come from money you have put aside in your savings account, or it can bypass that and simply go directly to an investment from your wages. Saving is the real key to future wealth. No one is going to make you save, but no one is going to hand you a nice check every month after you retire either.

For some of you, serious saving may require a new perspective. Think for a minute about why you work. The answer is easy because the goals are readily apparent – you work so you can provide the necessities for yourself and your family, and earn enough to enjoy a better life.

Now, you have to add another goal that isn’t quite as apparent: saving for a better life when you stop working. Saving for something so far away doesn’t seem too important because more immediate goals appear to take priority. But preparing for that time is a very big part of your job now. You can’t afford to ignore it.

Where do you think your income will come from after retirement? It will come from the money you have saved and the money you have invested. You have to save (pay yourself enough while you’re working) to be able to support yourself after you no longer receive a check from someone else. Want to pay yourself well and enjoy a comfortable retirement? Then you have to continuously save and invest a portion of your earnings. With each paycheck, pay yourself first. Do it automatically and you won’t even miss it.

How much will you need for your retirement nest egg? The general guideline is that you need to set aside 25 times the amount you plan to withdraw each year. This amount has a high probability of lasting 30 years without depleting the original principle.

This is where investing comes in. To accumulate what is needed is going to require higher returns than you can get by simply saving your money in a bank. Investing in the stock market has provided those higher returns. In addition, you want to start as early as possible in order to have the power of compounding those returns work for you.

The stock market has provided higher returns than savings accounts and bonds, but the reason is there is more risk involved. And the risk does show up—Investing is a bumpy road. Individual companies can go bankrupt and the stock market as a whole can crash as it has done several times. Also, the stock market can go a decade or more without providing the expected higher returns. It is important to understand this so you can make intelligent decisions about how much of your savings you are willing to expose to stock market risks.

The probability that the businesses you buy will reward you in the future is high. The value of all companies (the stock market) has an upward slope over time, but no one can guarantee the market or your investments will provide what they have in the past. On the other hand, you have to take some market risk to have a good chance of reaching your goals. The need to have enough money for retirement offsets the risk you have to take. Remember, you’ll need to accumulate total assets of about 25 times what you intend to withdraw in retirement. So, if you want to retire with an income of $40,000 a year at age 62, you need to accumulate one million dollars (today’s dollars).

Assuming an average annual return of 8%, here is what you need to save each month starting at different ages in order to draw down that $40,000/year. Note that the 8% used is an attempt to represent a portfolio of approximately 75% stocks and 25% bonds. Since future market returns are unknown, the 8% and the associated savings/investing rates should be viewed only as an example. Actual returns will vary.

Beginning at age 22, you’ll need to save $300 per month.
Wait ’til age 32, and you’ll need to save $670 per month.
At age 42, you’ll have to save $1,800 per month.

The catch is you can’t get an 8% return on your money if you put it into a savings account. In the above example, if you start saving at age 22 but only earn a savings account rate of return, instead of $300, you’ll have to set aside $1,000 per month. That’s over 3 times more than if you invest some of your savings in the stock market. Also notice that waiting until age 32 requires you to save more than double the amount of age 22. Waiting until 42 requires six times the amount. These big increases are due to the power of compounding investment returns over longer time periods.

But no one actually receives all of what the market returns because you lose what you pay in costs. You can’t control what the market returns, but you can control costs and there is a proven relationship between the costs you pay and the returns you get. If you pay 1% higher costs, you lose 1% in returns. And over time, that 1% can cost you more than $200,000. The example demonstrates four things:

    1. The need to take some stock market risk.
    2. The big advantage of time and starting to save at a young age.
    3. The power of compounding returns.
    4. The relentless stranglehold costs have on returns.

Nothing can be guaranteed—risk is real. Smart investors do not forget this, and that is why they use every means at their disposal to minimize the elements of risk by investing in the most efficient way. The idea is to get the maximum return for the amount of risk taken and each dollar spent. Or actually, for each dollar unspent. That is what this book is all about.

The secret to investing and achieving higher than average returns is simply the elimination of mistakes most investors make. The stock market provides returns everyone hears about, but the truth is that investors as a group net substantially less than those returns. With the aid of this guide, you will learn how to protect yourself from throwing away returns due to behavioral mistakes, unnecessary costs, and the more serious risk of bad advice. If you are considering an advisor, or already have one, you should find chapter 10 on evaluating and choosing an advisor very helpful.

The investment guide begins with an examination of the risks associated with investing. Then we move on to creating an investment portfolio that targets your goals and matches your desired risk exposure. Chapter 8 covers the differences between active funds and index funds and how to use them in the most effective and efficient ways. Chapter 9 takes a close look at behavioral problems. Throughout the guide you will find many links to additional information that you may want to explore. The final chapter provides many additional links and references in the final chapter.

No matter if you manage your own investments or decide to hand the job to someone else, understanding essential investing principles is a must. With this book as your guide, you will gain the knowledge needed to learn and apply these essentials.

Taylor Larimore, Dean of the Vanguard Diehards as Money Magazine has named him, and one of the three authors of “The Bogleheads’ Guide to Investing”, has summed up the secret of successful investing in one concise sentence: The best way to beat the average investor, professional or otherwise, is to save regularly, avoid mistakes, keep your costs low (including taxes), diversify, and stay the course. The sentence is a true investing “gem.”

Best wishes as you begin your journey along the pathway to investing success!

Thanks to the Bogleheads for helping me make some sense of it all. Special thanks to Taylor Larimore and Mel Lindauer for their tireless assistance to others. And thanks to Rick Ferri, Bill Schultheis, Larry Swedroe, and all authors and contributors who are giving us the investing education we never had, and never knew about.

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Chapter 1 – Investing Essentials


Investing Essentials

There are many directions an investor can take when risking assets for higher returns, but for most of us who are simply trying to get from point A to point B (retirement), the really efficient, and least hazardous directions are actually few and simple.

Defining our goal
Investing: Money committed or property acquired for future income. A trade off between risk and reward while aiming for incremental gain and preservation of the invested amount (principal). Investing means investing in businesses, both in the U.S. and internationally. It is, by definition, a long term commitment to share in the successes of companies in businesses for profit.
Speculation: Aims at high gain or heavy loss.
Betting (wagering) that must result either in a gain or a loss. Gambling is neither risk taking in the sense of speculation (assumption of substantial short term risk) nor investing (acquiring property or assets for the securing long-term capital gains.

This primer focuses on sensible investing. Using a driving analogy: investing is not about speed, it’s about mileage. And over longer periods of time, the strategy proposed in the primer will provide you with higher than average returns without large commitments of time or study. The fundamentals are relevant whether you use actively managed funds or index funds.

Legendary investor Benjamin Graham felt that investors fell into two groups, aggressive or “enterprising’ investors and “defensive” investors. The two groups are distinguished by the amount of intelligent effort they are able to devote to working on their investments. Professionals–doctors for example–are in the defensive group, and so are the vast majority of individual investors. An example of an enterprising investor is Warren Buffett. Buffett, a disciple of Graham’s, began his career by reading the 10,000 pages of Moody’s stock manuals–twice. The lesson: know want kind of investor you are. Buffett, in turn, recommends the average investor simply invest in index funds.

Making Sense of Investing – Wall Street Marketing is NOT the Answer
It is understandable that beginners find the subject of investing daunting and confusing. But in addition to newer investors, there are also millions of people who have been investing for years and they still have an uneasy sense that they may be on the wrong road. Where do you start? Are there guidelines? There is an overwhelming amount of information out there, but knowing which advice will take us to our destination, and which puts us on a road that leads over a cliff, is the question this book will answer.

What’s traditionally been drummed into our heads is that investing is very complicated and should only be attempted by professionals or with the aid of very expensive and risky strategies and software programs. Don’t buy it. Investing doesn’t need to be complicated, and in fact should not be complicated. The portfolio selection method, as we will call it, provides investing with structure. It enables average investors to implement the method step-by-step. The so-called ‘know-how’ of a Wall Street analyst isn’t needed. In fact, their record of picking winning stocks and mutual funds in advance is dismal. Wall Street and the media’s self serving advice, ofter called “investment pornography,” should usually be avoided. According to research firm First Call/Thompson financial, at the peak of the bull market in March 2000, less than 1% all recommendations on stocks issued by Wall Street brokerages and investment banks were to sell.

If investing really is so easy, then why haven’t you heard of the portfolio selection method before? Because it is to Wall Street’s advantage to make people think that investing is complicated. Wherever money is involved, there are people who want a share of your money. Every dollar Wall Street takes from your investments is one less dollar for your family. It’s as simple as that. Unfortunately, it is extremely difficult to find someone from a large, mainstream investment firm that will level with you on your best investment options. Employees in large brokerage firms need to sell you expensive products that will make the firm a profit because that is how they keep their jobs. And they are rewarded by how much money they take in. So, what you really need to learn is what Wall Street doesn’t want you to know–which also happens to be the title of a very good book by Larry Swedroe.

Here are the six investing essentials necessary to put you on the road to investing success.
1. Understand risk and correctly develop an asset allocation that manages that risk. Asset Allocation is simply the percentages of your money you plan to place (allocate) into stocks, bonds and cash. It determines most of your investing risk.
2. Diversify your holdings. Diversifying means placing some money in different kinds of investments in order to spread the risk.
3. Keep costs as low as possible. Whatever you spend on buying and maintaining your investments comes directly out of the returns you receive. Costs are the second major reason for unnecessary losses.
4. Rebalance your portfolio when necessary. Rebalancing is simply readjusting your allocation percentages back to where you originally set them so you can maintain your chosen exposure to risk.
Formalize your investment plan. Developing a plan and then writing it down is a way of
demonstrating your commitment and clarifying your objective. It also serves as a compass to insure you stay on course.
6. Understand and avoid common behavioral mistakes, which can account for most of your unnecessary losses. Successful investing is about discipline and behaving correctly.

The following chapters will explain what the essentials are and how they work with each other to create a portfolio with maximum benefit. For those who like the technical stuff, here are two links offering an excellent introduction to the portfolio selection method.

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Chapter 2 – Understanding Risk and Asset Allocation

Chapter 2.

Understanding Risk and Asset Allocation

Asset allocation (AA) is a financial term that simply refers to what percentage of money you decide to put into stocks, bonds and cash—the primary asset classes. The purpose is to set the amount of risk you should be taking. It’s sounds simple, but the results say it’s not. It is the most significant decision regarding risk and potential returns you can make, but far too many investors choose to be overly aggressive (although they don’t realize it) and they end up bailing out near the bottom of a severe loss, meaning they got it wrong.

Defining Risk
The financial world defines risk as randomness with knowable probabilities that can be defined and calculated. But, there is another form of risk that we as investors need to understand, and that isn’t even called risk. It is called uncertainty. Uncertainty is risk with unknowable probabilities. It can’t be measured or calculated. As financial advisor Carl Richards says: It is the risk that is left when we have covered everything we do know about. Or, more to the point: It’s the other risk, stupid.

Unknowable probabilities occur very infrequently but have devastating consequences. Hurricane Katrina is an example. Several years after Katrina, the mayor of New Orleans said he should have evacuated the entire city. Why didn’t he? Because the power and destruction Katrina unleashed was off the chart and there was nothing in memory for comparison. In other words, it was unimaginable. In the financial world, we must live with a certain element of the unimaginable.

An example of risk aversion misplaced
In 2011 we are concerned about bond fund losses due to inflation. We know that interest rates have nowhere to go but up, and we know what will happen with bonds funds when rates rise–they will lose money. We also know how much–they will lose the amount of their duration for each 1% rise in rates. This risk is easy to see and calculate: it has knowable probabilities, and yet investors are moving out of bonds for fear of loss, and some are even moving into equities as an alternative. Furthermore, bond fund losses recover relatively quickly because of the increase in yield. So, much of the fear is over done, and certainly it is not rational to move into the higher unknowable probabilities of stocks as a less risky alternative because stocks might have 5 times or more loss potential than intermediate bonds. What’s going on is bond risk has come out of the shadows and can be easily seen, so investors do something to avoid a loss they know will happen. What they don’t seem to understand is stock loss, a far uglier creature, never comes out of the shadows, so it is not treated with the same fear. In fact stock market risk is a deceptive chameleon that may be most ignored at the most dangerous time.

I can present information that will help you with the knowable risks, but keep in mind that uncertainty and potential large losses always lurks in the shadows. There are a few different ways in which risk is defined, but here is as good a practical definition as there is: The risk of putting your money into stock investments is that it may be gone when you need it.

Asset Allocation and Risk
Extreme market disruptions occur much more frequently than the mathematics would predict. Severe bear markets should not occur as frequently as they do, and while the last three major Ones caused a drop of about 50% there is nothing to say we cannot see a much larger loss. Still in the memory of a few is the 90% drop in the great crash of 1929. What I’m trying to impress on you is it naive to assume the market will always provide wealth in the long run. Getting wiped out half way down the road isn’t going to get you there.

Many different approaches have been tried to connect risk with the very real pain of loss, but severe downturns continue to surprise investors and cause them to bail out and abandon their plan at the worst time. AND THEN they reduce their risk exposure. You don’t know how it feels to burn yourself with a match until you do it. Then you get a little more respect for lighting a match. I cannot convey the pain of getting burned nor can I convey the pain of losing a substantial amount of money—all I can do is warn you that for all but the extreme risk takers, it hurts more than you might realize. In some cases, it isn’t the loss that is disturbing, it is the feeling of loss of control.

The higher percentage of stocks you own, the higher your potential for big returns. But risk is a double-edged sword. Risk means in no uncertain terms that you might not achieve those big returns. The very fact that stock investing offers higher returns than safer investments can only mean there is higher risk of loss. Investing offers no guarantee, and there is no way to avoid the risk, and unlike the bond example, you aren’t going to get a clear sign for when the risk will show up.

Knowing this, smart investors always seek a good balance between risk and potential reward. In fact, balance and compromise is necessary in all investing decisions. Investing risk has two dimensions, one is loss frequency and the other is loss magnitude. If the experience of a worst case scenario is not stored in memory, there is a tendency to assume the frequency of a disastrous outcome is almost zero. However, the past 10 years has provided two real experiences with frequency. When looking at magnitude, maximum drawdown (loss) of an all equity portfolio is usually suggested to be 50% because this has been the maximum drawdown in any bear market since 1973-74. It’s occurred three times. Why do we assume that 50% is maximum? There is nothing at all to prevent deeper losses. In 1929 we experienced a 90% loss. And it took 22 years to fully recover! It happened, but it’s inconceivable by today’s standard because it isn’t in the memory bank. It hasn’t happened for so long, it won’t happen. Is it likely to happen again? No. Is it possible? Yes. The worst case scenario is often more consequential than any forecast can predict.

Of the two elements of frequency and magnitude, it is magnitude that causes the problems. Investors are naturally risk averse, but they don’t realize it until they are in the middle of a stressful situation. The pleasure of a $100 gain does not match the displeasure of losing $100. The pleasure of a $250,000 gain does not equal the pain of losing $250,000.

Before you make the decision about your asset allocation, you need to know what it is exactly you are trying to accomplish. To get maximum returns is not the right answer. You begin by defining your goals and the target amounts needed as best you can. Younger investors may have several goals they’re working toward such as retirement, college for the children, and a new home. Each of these goals has a different time frame and a different target amount of assets needed. And each requires a different asset allocation. The more you understand about risk, the more able you will be to make good decisions about your asset allocation and the more likely you will be to stick with your plan. Your decision should match your personal financial ability and emotional ability, and that’s why a good recommendation for one person may not work for another. Don’t compare your allocation to those of others, it isn’t relevant.
This link leads to a good article on risk by Peter Bernstein.

Here is a good perspective on how risk should be approached by Zvi Bodie, professor of finance, and Paula Hogan, CFP, CFA.

Emotional Temperament and Risk
New investors enter the arena with built-in biases. Recent studies have shown that how a person views risk is based on family background and lessons learned from their own experience unrelated to investing. These perceptions frequently result in newer investors overestimating their tolerance for risk. That has been clearly confirmed by the number of investors who abandon their asset allocation and bail out of stocks at the bottom of a bear market. Here is what Vanguard has to say: Our experience suggests that even long-term investors pay attention to short-term downside risks during the holding period. Furthermore, their real-time reaction to downside risk is much more significant than indicated prior to the realization of the downside risk.

So, how much of a loss is really going to keep you pacing the floor at night? How much of a loss is going to make you flinch?

What makes investors flinch?
1. Inexperienced investors move into defensive mode under stress and fall back on gut instinct, which quickly overrides the AA decision they made in good times.
2. Perception of risk is not constant. Risk may be perceived to be practically non-existent in good times and extremely high in times of market stress or personal emotional stress. If you have not been through a full market cycle, including a bear market, it will be very difficult for you to properly asses your reaction in times of real stress.
3. Choosing an asset allocation seems so simple to do that it’s often done without much planning. Most newer investors only focus on the allure of recent past returns which are right there to see. They downplay risk because it isn’t in sight. And that’s a point worth remembering— those times when you don’t perceive any real risk are actually more risky. Risk is all about surprises that can spoil the party.

So, what should you do? First, realize that your assumed tolerance level is likely to be lower under severe market conditions when it’s most important. Second, focus on your goals and your plan and set up asset allocations that match them. If you get that right, then you will find it easier to stick with your plan.

Risk Analysis Questionnaires
Some investors who talk with an advisor are given a risk analysis test. Others might be referred to web sites that have questionnaires designed to help choose an allocation. Don’t trust these questionnaires because what they really tend to do is confirm preconceived notions about your tolerance. They either ask you how much risk tolerance you have, for which you have no reference to determine, or they attempt to quantify your need for returns and then offer a portfolio without consideration for your emotional risk tolerance. Here is what William Droms, CFA, and Steven Strauss, CPA/PFS, had to say about questionnaires in an article in The Journal for Financial Planning titled “Assessing Risk Tolerance for Asset Allocation: “Virtually all experienced financial planners and investment managers would agree that a questionnaire by itself cannot possibly lead directly to a definitive asset allocation plan.”

The level of risk you choose should be based on factors including age, job type and security, marital status, contingency plans, and back-up resources. Then these factors have to be balanced against your emotional tolerance for risk. If your needs and abilities exceed your emotional tolerance, you are likely to dump your strategy at the worst possible time even though they were well analyzed. Notice I said the level of risk you choose. And that is exactly what you need to do. Do not select a portfolio based on the returns you choose. You can’t control returns–only risk. You may or may not get the returns you hoped for, but you always get the risk.

Basic Market Behavior and Risk
To help understand normal market risk, let’s look at typical market behavior. Here is what William Coaker, CFP, CIMA, says you will encounter in your investment journey: Investment professionals often tell clients, “I think the S&P 500 will be up 10 percent next year,” and clients like to hear that. But it almost never happens. From 1926 to 2004, the S&P 500 rose between 8 percent and 14 percent in only six years, an 8 percent occurrence. In fact, just 25 times in 79 years the S&P 500 returned between 0 percent and 20 percent, which is only 32 percent of the time. That means the index has been more than twice as likely to lose money or gain more than 20 percent than to experience returns between 0 percent and 20 percent.

The first thing to note is markets are volatile and you cannot expect things to go smoothly, nor can you rely on past behavior as a predictor of future behavior. We have seen fluctuations from the euphoria of “this time it’s different” to the despair of “the death of equities.” Normal markets are random and unpredictable in the shorter term. And contrary to popular belief, they are not less risky in the long term. You will lose money at times, no way around it.

Jack Duval, Registered Investment Advisor, has this to say in his article, The Myth of Time Diversification: the idea that the longer an investment is held, the less likely it is to produce a loss. It is an idea that enjoys wide circulation on Wall Street. It is wrong.

A Look at Historical Market Losses – Downside Risk You can get a fair perspective on risk by looking at actual stock market losses compared to how much money was allocated to stocks. The table below is based on actual market losses (price) encountered in the brutal 1973-74 bear market. A bear market is normally defined as a market decline of 20% or more. Drops of 10% to 15% are called corrections. Note in the table that a 100% stock portfolio lost nearly 50% of its value in two years (46% actual). If you had 50% stocks and 50% bonds, your loss would have been limited to 20%.

Equity Exposure……. Max loss
80%……………………………… 35%
90%……………………………… 40%
100%……………………… …… 50%
Data provided by Author Larry Swedroe on Morningstar’s ‘Bogleheads Unite’ Forum

On average, a bear market has occurred about every 5-6 years. Note that the two major bear markets since 1973-74 (2000-2002, 2008) have had drops very close to those of 73-74, but there is no guarantee that we can’t see one with greater losses. Also, be aware that some charts will show you worst one year losses, but most all of the worst bear markets incurred losses in two or more successive years, meaning the real total loss is worse than shown. When you have many years to go until you need the money and you have a reliable income, larger losses may be tolerated. When your time-line is shorter, 10-12 years from retirement for instance, you will want to reduce your allocation to stocks and go into defensive or asset preservation mode.

Here are two links to historical bear market data:

Making Up A Loss
Another way to help you decide on an asset allocation and risk level is to look at how much you have to earn to make up for a loss. Here is a table that shows the required gain for a given loss. Notice the make-up rate is not linear. The higher the loss, the higher the required gain to get even.

Loss (%)… Reqired Gain
5%………….. … 5.2%
10%…………….. 11%
15%…………….. 18%
20%…………….. 25%
25%…………….. 33%
30%…………….. 43%
35%…………….. 54%
40%…………….. 67%
45%…………….. 82%
50%…………… 100%

As you can see, a 50% loss from an all stock portfolio requires a 100% gain (it needs to double), but a 20% loss, which would equate to a portfolio of 50% stocks and 50% bonds, only requires a 25% gain. As Terry Savage notes in her book, “The Savage Truth on Money,” “Getting even with the bear is tougher than getting ahead.” What Ms. Savage is saying is it is much easier to moderate a major loss than try to make up for one. To take this one step further, let’s look at what happens to two portfolios, one 100% stock (investor A) and one 50% stock (Investor B). Let’s assume each is 5 years from retirement and each has accumulated $600,000 in assets. If a severe bear market occurred, investor A’s portfolio would drop to $300,000 and Investor B’s would drop to $480,000. Investor A must now double his assets—a 100% return—to get back to where he was before the bear. At the historical rate of return of 9.9%, this will take him 7 years. Investor B only needs a 25% return to get even again. With an 8.2% return—the historical return of a 50/50 portfolio—he can do this in 3 years. Recovering losses may not take as long as these example because in many cases substantially higher returns were generated in market recoveries. But quicker recoveries can’t be relied on if your future goals depend on the money being there.

One thing to note in these examples is that when the AA is reduced from 100% stocks to 50% stocks, the returns don’t get reduced by half, i.e. 9.9% vs 8.2%. When assessing your risk, consider your ability, willingness and need to take the risk. A younger investor will have more ability and may have more willingness if he has a secure job and a regular income and is continuously adding to his investments. He also has more need. Young investors need to grow their portfolios with a larger allocation to stocks. Ultimately, your asset allocation should be based on your entire financial situation. For instance, an older investor who has a pension or other steady income plus his investments has some stability and therefore may have some ability to take additional risk. A retiree depending only on withdrawals from his portfolio may not. Most retired investors need to think in terms of asset preservation with larger allocations to bonds.

Author Larry Swedroe, in his book, “The Only Guide to a Winning Investment Strategy You’ll Ever Need” suggests you not develop an asset allocation in isolation. You need to thoroughly review your financial and personal circumstances. Consider things like your need for cash reserves, job stability, job correlation to the economy and the stock market, investment horizon, insurance, estate planning, and back-up resources.

John Bogle, former CEO of The Vanguard Group and author of “Common Sense on Mutual Funds” says it clearly: “Choose a balance of stocks and bonds according to your unique circumstances—your investment objectives, your time horizon, your level of comfort with risk, and your financial resources.”

Suggested Allocation Ranges
The stock exposure an investor can choose ranges from 0% to 100% of course, but there are some guidelines. Young, inexperienced investors believe that with time on their side they can go 100% in stocks. And some retired investors believe they don’t need and don’t want any stock at all. Neither of these extremes seem to be a very good choice. Legendary value investor Benjamin Graham recommended holding no more than 75% stock and no less than 25%. William Bernstein points out in his book The Four Pillars of Investing that a portfolio with 80-85% stocks and 15-20% in bonds and cash reduces downside risk to a significant degree while hardly reducing returns at all. Here are the numbers. Please note that the returns used are historical. Future returns may be different, but potential losses are related to asset allocation and not returns, so they would remain about the same. If you think about this for a second, you will realize that the lower the expected returns, the less incentive there should be to take the risk of very high stock allocations. There is less on the up side without a reduction on the down side.

Average Annual Return – world stock portfolio
(Equity = 50% U.S/50% International – Bond = Total bond.) 1970-2009

100% Stock Portfolio = 12.4%
80% Stock, 20% Bonds = 11.5%
60% Stock, 40% Bonds = 10.5%

Maximum one year loss Note: Largest one year loss since 1970 occurred in 2008
100% stock = 43.1%
80% Stock, 20% Bonds = -33.4%
60% Stock, 40% Bonds = -24.5%
Data from Paul Merriman, Fine tuning Your Asset allocation – 2010 Update.

Note that going from 100% stock to 80% stock results in a return reduction of 7% and a worst one year loss reduction of 22%. A good compromise? Of course. On the other end of the spectrum, having no stocks at all exposes older investors to no growth, which may mean faster drawdown of their portfolios. Also, having 15-20% stock and the rest in bonds and cash actually provides little or no additional risk and better returns. Here are the numbers for the reverse portfolios of 100% bonds and 80% bonds and 20% stock:

Average Annual Return 1960-2004
100% Bond Portfolio = 7.2%
80% Bonds, 20% Stock = 8.1%

Loss in 1969 (Worst Year Loss)
100% Bond Portfolio = -8.1%
80% Bonds, 20% Stock = -8.2%
Data from Vanguard

One last note on choosing an allocation: Kahneman and Tversky discovered in their behavioral research study that a loss of $1 is approximately twice as painful to investors as a gain of $1 is pleasant. Why? The gain is expected, anticipated, and exciting. But the loss is not only somewhat of a surprise, it is a setback and may be seen as failure of the plan. People do not like losing their hard-earned money.

E. F. Moody, CPA clarifies this in his online article “Risk and Other Stuff About Investing: Though rarely commented upon, recent studies show that investors are not necessarily risk adverse as much as they are loss adverse.”

Frank Armstrong, CFP, author of “The Informed Investor,” likes to say “The impact of asset allocation on investment policy swamps the other (investment) decisions.”


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Chapter 3 – How Diversification Works

Chapter 3

How Diversification Works

Diversification – A simple explanation: Spreading your money into many broad areas is called diversification. It works something like this: Let’s say you are packing for a trip to a place you’ve never been and you don’t know what the weather will be like. What do you do? You pack a variety—some light clothes, some heavier ones you can layer, and finally a coat. You want to be prepared for any kind of weather. You are reducing the risk that you won’t be prepared, no matter what. You do the same thing with your investments because you are investing in the future – a place you’ve never been and where you can never be sure what awaits you.

Diversifying in the market
Before you can substitute market diversifiers for clothes you need to understand some basics about how the stock and bond markets are organized.

Part I. Market Basics

The Stock Market
The stock market is exactly that – a market for shares of about 7200 publicly owned companies of all types and sizes. To organize the market, the companies are divided by size, represented by their worth, into large, medium, and small sized companies. Company size is also referred to as market capitalization (market cap). Market cap is all the shares of a company times the price of the shares. All of the buyable shares are owned by all investors, so the market actually works much like an auction with the sellers trying to get the highest price and buyers trying to get the best deal. From the view point of investor money, market organization can be thought of in terms of where that money is invested. For instance, if you invested $1.00 in a total stock market index fund (you can’t invest directly in an index), that dollar would be spread out to all companies in the fund, with a percentage to each company stock equal to it’s percentage of the index fund. If the largest stock is 2.5% of the fund (which would mean 2.5% of the stock market), then that stock would get 2.5 cents. A company one tenth that size would get 0.25 cents. The percentages (the market cap organization) is a natural representation of where investors actually put their money. A cap-weighted index simply tracks this.

There are other ways to make indexes, for instance there are equal weighted index funds where each company gets the exact same amount of the dollar. However, these funds are not mirroring where investors actually invest, so they are in disagreement with the consensus of all investors. That may not be bad, but it is different and represents a higher bet on smaller companies because they get more of the dollar. The top 10 companies currently represent about 15% of the entire market capitalization. In  other words, 15% of all investor’s money is in those top 10 stocks. The top 25 stocks represent almost a quarter of the whole market. There are thousands of small stocks that make up the bottom 20% of the market.

The stock market is generally divided up into three size categories; large capitalization (large cap), mid cap, and small cap. Different methods are used to categorize the size ranges. Morningstar currently defines large cap as companies with market caps above 8 billion. Companies with market caps between 8 billion and 1 billion are classified as mid size. Small size companies have market caps below about 1 billion. The size distributions are not constant because market cap changes with stock prices.

Indexes have been created to track the whole market as well as various segments of it. The Wilshire 5000 is one index that tracks the whole market, but the Standard and Poors 500 (S&P 500) is the best known index and it is used as a benchmark for overall market performance. The S&P500 is composed of 500 large companies selected by committee to reflect the overall performance of the market, but because of the market cap weighting, those 500 companies represent almost 80% of the whole market.

The S&P500 follows the total market’s movements very closely. The 500 stocks in the index contain all the market’s large cap stocks, those with market caps above 8 billion, and about half of the mid cap stocks. The remaining 6700 stocks in the total market are the rest of the mid caps and all the small caps. As you can see, there are many more small stocks than large, but in investor’s dollars or market movement, they don’t have much impact. They make up only 20% of the market’s overall capitalization. This weighting makes the market look like an inverted pyramid with large boulders on top, some pebbles in the middle, and grains of sand at the bottom.

In addition to the three size separations, the market is also divided into value stocks, growth stocks and those somewhere in between, which are called blend. There are various measures used to indicate whether a company is a value type company or a growth type company. So now we have nine “boxes” that segment the market: Large value stocks, large blend stocks, and large growth stocks. Then the same three separations for mid and small stocks. Incidentally, the S&P500 and the Total Stock Market indexes fall into the large blend category because they are dominated by a broad spectrum of large cap stocks. Here are the holdiings of the S&P500 as defined by Morningstar (7/10).

Composition of the S&P 500
Large Value – 29%
Large Blend – 30%
Large Growth – 29%
Mid Value – 5%
Mid Blend – 4%
Mid Growth – 4%
Small Value – 0%
Small Blend
– 0%
Small Growth –

Compare this to a profile of the total U.S. stock market (7200 stocks).

Composition of the total Market
Large Value – 24%
Large Blend – 24%
large Growth – 24%
Mid Value – 6%
Mid Blend – 6%
Mid Growth – 7%
Small Value – 3%
Small Blend
– 3%
Small Growth –

Some market segments act differently enough from one another or the overall market that they are called different stock asset classes. For instance, small value stocks as a group do not follow the movements of the large blend group. Large value (LV), Large growth (LG), Small value (SV) and Small growth (SG) are like different kinds of clothes and are called asset classes for purposes of diversifying stock. Blends of asset classes do conform to size, but distinctive value and growth characteristics are subdued.  These sub asset classes are just for stocks and should not be confused with the primary asset classes of stocks, bonds and cash discussed in the asset allocation section.

In addition to the four classes of stock mentioned, international stocks and REITs (Real Estate Investment Trusts, pronounced Reets) are also well recognized asset classes because they too act quite differently than the total U.S. stock market. There are other groups as well that some investors consider classes, but you can do very well with just those I’ve mentioned. Asset classes are the real key to diversification.  Owning two mutual funds in the same asset class does not  increase diversification.

Major Stock Asset Classes
Large value
Large blend/growth
small value
small blend/growth
International small
Emerging Markets

To give you an idea of how these asset classes fluctuate in performance take a look at the Callan Period Table of Investments.

The Bond Market
Like diversifying with stock funds, it is also wise to diversify with bond funds. Bonds are loans called debt instruments (DI). There are a large variety of them and they are categorized by type and quality. There are government treasury bills, notes and bonds, state bonds, municipal bonds and corporate bonds of short, intermediate and long maturity. There are treasury inflation-protected bonds (TIPS), tax-deferred bonds (I-bonds) and low-quality bonds know as hi-yield or “junk” bonds. When you purchase a bond you are essentially loaning money. There are two main concerns with bonds or bond funds: one is quality, and the other is duration. As with stocks, quality and risk are intertwined.

Treasury bonds are backed by the U.S. government and carry no loss of payment risk. Corporate bonds are issued by companies seeking needed money. These can be of very good quality or very risky. Lower quality equals higher yields and higher risk. Companies in poor financial shape have to offer higher interest rates or no one will loan them money, but the higher interest comes with the risk of the company failing to return the loan. Each bond has a quality rating and each bond fund has an average rating. Hi-Yield funds carry mostly all higher-risk, low-quality bonds that are often called “junk bonds.” Limit your riskier bond fund exposure to 10%-15%.

The other consideration with bonds is the duration. The price of a bond, once issued, goes up or down depending on interest rate changes. Duration provides a sensitivity measurement for how much the price might change with rate changes. The longer the duration of a bond, the more the price will fluctuate with interest rate changes. Link to Vanguard Interest Rates and Bonds.

Link to Vanguard paper on bonds and interest rate movement:

Link to Securities Industries and Financial Markets Association

The price of a bond already on the market fluctuates to keep the older bond competitive with new bonds that have different rates. For instance, the price of a 10 year bond that pays 4.0% will go down if a new 10 year bond comes out paying 4.5%. This is because no one will buy a bond paying 4.0% unless they can buy it at a discount. Bonds with higher rates are issued when the borrower can’t find enough investors to loan money at lower rates. Longer term bonds have higher yields, but they also have higher durations, which makes them more volatile than short and intermediate term bonds.

A bond fund has a mixture of many bonds maturing at different times so funds use an average maturity of short, intermediate or long term. And each fund will also have a duration. Durations range from about 2 for short term bonds to 8 or 9 for long term bonds. A fund with a duration of 4 means the fund’s net asset value (NAV) will go down 4% for each 1% interest rate increase and it will go up 4% for each 1% interest rate decrease. Inflation-protected bonds have a built in component that moves with interest rate changes so it protects the bonds from being worth less because of inflation.

Link to Morningstar bond tutorial –

Link to Treasury Inflation Protected Securities (TIPs) tutorial –

General Investment Risks In finance, risk has a number of different meanings. We have already examined the most basic definition in the asset allocation section – the chance the money won’t be there when you need it. A second type of risk is called specific stock risk. If an investor holds a high percentage of his money in one stock he holds a high risk of losing a lot of money if something goes wrong with the company. This type of risk is about a small chance of a major catastrophe. Something like your house burning down.

The chances of a fine company going bad is small, but if it happens. And if it does, the consequences will be big if most of one’s money is in that stock. This type of risk can be eliminated by holding many stocks, and that is one of the reasons for holding mutual funds. It’s kind of like fire insurance. In a fund of 100 stocks, one company crashing doesn’t create much of an impact. Be careful about putting too much into the stock of the company you work for. Most recommendations say to limit investments in one stock to no more than 5%. You might be able to stretch this some, but don’t ignore the long-shot possibility of unseen risk. Working for a company and holding it’s stock could result in a double wammy of job loss and asset loss.

Part II. Diversifying Your Investment Portfolio With Asset Classes – the core of the portfolio selection method.
Once you have set your overall asset allocation—the percentages in your portfolio assigned to stocks, bonds and cash—you can turn to diversifying your equity holdings with the sub asset classes of large value, large growth, small value, small growth, international, small international, emerging markets, and REITs. Diversifying with these different asset classes can provide some reduction of a another kind of risk called volatility.

Volatility is a risk which measures how much a fund’s returns might fluctuate. It is technically defined as standard deviation (SD). And standard deviation is a mathematical risk factor used for tracking the swings in returns for stocks, bonds, and funds. The bigger the SD number, the larger a fund’s returns may fluctuate.

Volatile Assets in a Portfolio
Portfolio volatility reduction occurs because the returns of the different asset classes do not move together. They do not correlate with each other. Combining asset classes with different volatilities has the effect of lowering the volatility of the overall portfolio. And diversification does something else that is quite remarkable: it can increase your returns given the same amount of volatility risk. As Larry Swedroe remarks in his book, “What Wall Street Doesn’t Want You to Know “Diversification of risk through the ownership of low-correlated assets is the only free lunch in investing.”

In the following example, 30% of small international is added to the S&P 500 and the overall volatility (SD) of the portfolio is lower than either of the two asset classes alone. And the returns are improved by 2% over the S&P500 alone. Example of asset class diversification, 1970-2002:

Asset class Return – (SD)

S&P500 10.8% – SD = 17.5
Small International 15.0% – SD = 30.1
Mix 70 S&P/30 Int. 12.8% – SD = 17.2

The S&P500 is a large blend/growth asset class and small international stock is a class of stock that doesn’t act like the S&P – It doesn’t correlate with the movements of the S&P500. In fact, one may be going up while the other is going down—that makes it a good diversifier. Small international is very volatile on it’s own. In statistical terms, the SD of 30.1 means that in any year the annualized returns of 15% might be anywhere between +45% and -15%, 67% of the time. The other 33% of the time the swings can be much more, even twice as much. In practical application, standard deviation (SD) can be viewed as a measure of unpredictability. in short time frames, the returns can vary widely. For instance, small international could have two or three years with returns of +35%, but in the year after you invest the return could be minus 10%. This is one reason why you should never invest in a fund based on past returns. And the higher the SD of a fund, the more unpredictability and the less you should hold. When investors diversify properly, one of two of their asset classes might be down at any given time while others are doing well. But which asset class might be favorable in the market changes from time to time and those changes cannot be predicted. This is like changes of weather on your trip. But if you are diversified, you will have a much better chance of having something in your portfolio that is outperforming.

Eric Tyson says in his book, Mutual Funds for Dummies “To decrease the odds of all of your investments getting clobbered at the same time, you must put your money in different types or classes of investments.”

Let’s try one other example, this one with REITs. Data from 1972-2003

Portfolio 1
Stocks 50%, Bonds 40%, T-Bills 10%, REITs 0%
Return = 10.9%, SD = 10.8%

Portfolio 2
Stocks 45%, Bonds 35%, T-Bills, 10%, REITs 10%
Return = 11.2%, SD = 10.4%

Portfolio 3
Stocks 40%, Bonds 30%, T-Bills 10%,
REITs 20%
Return = 11.5%, SD = 10.1%

Notice again that the returns go up and the standard deviation goes down. Data provided by T. Rowe Price Investor Magazine June, 2005

There you have it, the magic of asset class diversification in action. It is the different correlations interacting together that make it work. Correlations between asset classes are always changing to some degree due to different market forces, but that’s not something to be too concerned about. In the example above, the percentages of REITs won’t always give the listed returns and SD, but you can be sure diversification will be working at some level as long as you don’t add too much of the more volatile asset class.

Link to a good article demonstrating the positive effects of diversification

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Chapter 4 – Diversifying with Asset Classes

Chapter 4

Diversifying a Portfolio with asset classes

A good approach to diversifying with stock asset classes begins with viewing the U.S. equity portion of a portfolio. The total U.S. market profile is about 72% large cap, 19% mid cap, and 9% small cap. Using this profile gives you something to use as a comparison for your own individual portfolio holdings. Getting too far out of line with the market profile by adding a very large portion of one asset class may cancel the benefits of diversification and actually add additional volatility (SD). It will also introduce something called tracking error.

Tracking Error
Tracking error is a portfolio’s deviation from the market returns. It occurs with portfolios that are much different from the market profile. Such portfolios will not follow the movements or returns of the total stock market. A non-conforming portfolio will at times have higher returns than the market, but it will also have lower returns at times. Inexperienced investors are quite pleased if their portfolio is beating the market, but many simply cannot stand to see the reverse. Having a portfolio that is down when the market is up causes many investors to abandon their strategy and change things, which hurts returns.

Portfolio Examples
The following portfolios are typical examples of those used by many investors, but they are not recommendations. What I’m trying to show is the process of developing a risk-controlled portfolio structured with recognized asset classes. It will be up to each individual investor to define their own risk profile and portfolio.

One of the simplest ways to build a portfolio is to use a mutual fund that tracks the entire market. A total market fund provides a lot of diversification because it has large cap value and growth stocks plus mid and small stocks in the exact proportion as the market. To further diversify, an investor should next add a total international fund. Usual recommendations for international exposure run from 20% to 50% of the equity allocation.

In the following examples all fund holdings add up to 100%. That is one recognized way of listing a portfolio. Viewing all accounts as part of the whole portfolio helps you get an overall view of everything you own. It also enables you to put assets in the most advantageous places.

Sometimes allocations are separated into percentages of stocks and percentages of bonds. Be sure you are clear on which way a portfolio’s holdings are being presented or recommended. In the following example, total international is 20% of the equity allocation, but it’s also 12% of the total portfolio as shown.

Fund                           Percent
Total U.S. Market Fund – 48%
Total International – 12%
Bond Fund – 40%
Total – 100%

This simple equity allocation contains all the major stock asset classes except REITs. William Bernstein writes in his book, The Intelligent Asset Allocator, “If over the past 10 or 20 years you had simply held a portfolio consisting of one quarter each of indexes of large US stocks, small US stocks, foreign stocks and high quality US bonds, you would have beaten over 90% of all professional money managers, and with considerable less risk.”

If you wanted to add REITs, recommendations for allocations usually run from 5% to 15% of equity. Although REITs are U.S. equities and mostly small and mid cap stocks, they are not considered in the market profile because they represent only about 2% and they don’t act like any other asset class.

In many cases an investor may not have access to total market funds, especially in tax deferred accounts through work or at various brokerage houses. When that occurs, a S&P 500 fund or a large blend actively managed fund would be a good choice. If an investor uses one of these choices, she might add a small cap fund. Then the portfolio might look like this:

Fund                 Percent
Large Cap Fund – 35%
Small Cap Fund – 5%
Total Int. Fund – 12%
REIT – 6%
Bond Fund – 40%
Total – 100%

Here is example that includes all the asset classes:

Fund                                Percent
Large Blend or Growth Fund – 15%
Value Fund – 15%
Small Cap Fund – 5%
Smal Cap Value Fund – 5%
International Fund – 10%
International Small – 4%
REIT Fund – 6%
Bond Fund – 40%
Total – 100%

You could add a mid cap fund in the mix too, but mid caps aren’t considered the best diversifiers because they act a lot like a combination of large and small. However, they can provide better-than-average returns at times.

Bond allocations
The fixed income portion of your financial assets is the safe part of your portfolio. It has been described as a portfolio’s belt and suspenders. Bond funds are great diversifers and the main controller of overall portfolio risk management. Like stock investments, bond investments do not have to be complicated. One typical bond portfolio in a tax-deferred account might look like this:

Fund                           Percent
Total Bond Market Fund – 60%
Inflation-Protected Securities (TIPs) – 30%
Hi-Yield Bond Fund – 10%

Total – 100%

It the example above, there is a total bond market component which covers many kinds of bonds and provides lots of diversification. The TIPs component will add an inflationary hedge. And finally, there is a higher-risk/higher return component in hi-yield bonds. You don’t want to add too much of a riskier component like hi-yield because the primary purpose of holding bonds is to moderate risk. There are times when hi-yield bonds can act much like stocks, and those times are when you need bond stability the most. For this reason, there are a few experts you do not recommend hi-yield bonds. Bonds in a taxable account might look like this:

Fund                                          Percent
Limited Term Tax-Exempt Bond  – 40%
State Tax Exempt – 30%
I-Bonds – 30%
Total – 100%

When using taxable accounts, it’s best to go with tax-exempt or tax-deferred bond funds or taxes will eat up much of the return.

The cash portion of a portfolio might consist of money market funds, CDs, stable-value funds, and savings accounts. Putting all three primary asset classes together results in a full portfolio that looks like this: Example of a diversified Total Portfolio: Stocks = 65%, Bonds=25%, Cash=10%. Note all funds add to 100%

Large cap value fund – 16%
Large cap blend or growth fund – 16%
Small cap value fund – 6.5%
International fund – 20%
REIT fund – 6.5%

Bonds = 25%

Total bond fund – 15%
TIPS – 7.5%
Hi yield fund – 2.5%

Cash = 10%

Money Market – 5%
CDs – 5%

Other examples—You add the allocation appropriate for your situation.

Taylor Larimore’s Thrifty Three
Total Stock Market
Total International
Total Bond

Rick Ferri’s Core Four
Total Stock Market
FTSE All-World ex. U.S.
Total bond

More Examples –

Here are a few final thoughts on asset classes. Historically, over long time periods, value stock and small stock asset classes have produced higher returns than the overall market. Many investors deliberately overweight these classes to some degree. If you consider something like this, remember that you will have higher tracking error and you may not have immediate positive results.

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Chapter 5 – Costs ARE A Big Deal

Chapter 5


Jack Bogle is a giant in the mutual fund industry. He is the founder of the Vanguard Group and the creator of the first universally available S&P 500 index fund. And yet, Mr. Bogle is not too popular with his peers. Why? Because he has spent his life rallying against high fees associated with mutual funds. Mr. Bogle’s message is very simple: Costs Matter. How much?

It’s highly unlikely you stand even a chance of beating the average return with high cost funds over extended periods of time. Unfortunately, this statement is so simple that investors can read right over it with just a nod of their head. But Jeff Acheson, director of retirement planning at Pittsburgh-based Schneider Downs & Co. puts it in perspective, “Hidden fees are a little bit like high blood pressure. You don’t really feel it, and you don’t necessarily see it, but it’ll eventually kill you.”

If you Google mutual fund costs, you will get dozens of articles all saying the same thing— high costs hurt returns. It seems simple enough if you are paying attention, but many investors do not believe it because they can point to a fund with high expenses that is outperforming. What they miss is the fact that no fund can outperform all the time. The extra hurdle of overcoming the costs eventually will take it’s toll.

Jim Peterson, vice president for Schwab’s Center for Investment Research says “You have to care about expenses. It is the most predictable characteristic of explaining future returns of funds. It’s more reliable than past performance. It can’t be said enough: with funds, costs matter.
The Beach Lesson provides a clear example of how costs work against you:

This is from the Securities and Exchange Commission (SEC) website: As you might expect, fees and expenses vary from fund to fund. A fund with high costs must perform better than a  low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858. Cost control is the very heart of long-term better-than average returns. It is a fact that causes Mr. Bogle’s peers to squirm. And yet, they cannot dispute it.

Costs, and hence returns, are subject to “the relentless rules of humble arithmetic.” The quote is a favorite of Jack Bogle. It is originally from Louis D. Brandeis in “Other People’s Money,” first published in 1914. People are used to the common idea that you get what you pay for, but in investing it is just the opposite. In the keynote speech at the opening of the 2006 Money Show in Las Vegas, Jack Bogle summed it up this way: “The great irony of investing, then, is not only that you don’t get what you pay for. The reality is quite the opposite: You get precisely what you don’t pay for. So if you pay for nothing, you get everything.” Our goal then is to pay as close to nothing as possible.

In his book, “Common Sense on Mutual Funds,” Mr. Bogle says “Asset allocation is critically important; but cost is critically important, too—All other factors pale into insignificance.” Costs, including tax consequences, take a direct bite out of the returns that go into your pocket. Every penny that goes to costs requires that much more return to break even.

Money Magazine columnist Walter Updegrave in his article, The Single Best Retirement Strategy, has this to say: If I told you there was a risk-free way to boost your retirement savings by 20 percent or more, would you be interested? In fact, what I’m suggesting is the soul of simplicity: Rein in your investment costs. By favoring low-cost funds over high-cost alternatives, you can dramatically increase your chances of having a secure retirement.

A 401(k) of low-fee funds will grow faster than a 401(k) with higher fees. Nest Egg at 65 –

Expenses                      Nest Egg
– 1.5%                      $663,600
Moderate- 1.o%              $732,400
Low – 0.5%                      $809.700
Ultra-low -0.25%             $851,800
Note: Assumes a 30-year-old earns $40,000 a year and gets a 3% annual raise.
Sources: T. Rowe Price and MONEY research.”
Walter Updegrave, Money Magazine, 12/17/04

Cost damage is even more dramatic in retirement. Consider a person in retirement who uses a large full-service brokerage. He has accumulated a $1,000,000 nest egg and withdraws $40,000 a year for living expenses. He pays the typical 1.0% in advisory fees plus another 0.5% in additional brokerage/service fees, which is common. But that’s 1.5% of all he owns, which equals $15,000 per year. So every year, on top of the $40,000 he takes out to spend, another $15,000— or 37.5% more—is lost to unnecessarily high expenses. The costs come out every year, even if nothing is withdrawn at all, and even if the investments lose money. Over 30 years four hundred and fifty thousand dollars would be lost to expenses.

The portfolio has to have returns equaling the withdrawals plus the costs just to break even. That’s an awful lot to ask with a portfolio that isn’t being pumped up with new money. Performance can come and go, but costs are forever. Imagine someone saying invest with me and I’ll take half your retirement nest egg for my fee. An exaggeration? I think you can clearly see that it is not. In the following chart, Mr. Updegrave points out how lower expenses increase the odds of retirement funds lasting your lifetime.

Expenses                  Odds
high – 1.5%                   31%
moderate – 1.0%         23%
low – 0.5%                    16%
ultra-low – 0.25%         13%
Note: Assumes 7% expected annual return before expenses, initial withdrawal of 4%, which is increased 3% annually for inflation.
Sources: T. Rowe Price and MONEY research.
Walter Updegrave, Money Magazine, 12/17/04

Tax costs seem to get even less respect than fund costs. Many investors use the phrase,
don’t let the tail wag the dog” To which, Duncan Richardson, chief equity investment officer at Eaton Vance Management in Boston, adds this caveat: “It’s not like the tax tail is this cute, little puppy dog tail,” he said. “It’s like an alligator’s tail. Ignore it at your peril.

Investors tend to dismiss taxes because they don’t directly see the impact of tax costs in their fund returns. The taxes are paid out of another pocket–the checking account–and somehow the connection isn’t associated with the cost of owning tax-inefficient funds in taxable accounts. The fact is that taxes can reduce returns by as much as twice the fund’s expenses.

Managing tax costs with careful planning can increase returns significantly. According to a study by Joel Dickson and John Shoven, “Taxes and Mutual Funds: An Investor Perspective” in James M. Poterba’s (ed.) “Tax Policy and the Economy” as much as a quarter of a mutual fund investors’ annual returns are consumed by the taxes payable on dividend and capital gains distributions.

And from the Mutual Fund Center, “Mutual Fund Costs,” at “Over time, the compounding effects of an average equity return of 10% being reduced by one-quarter are truly dramatic. Over the course of thirty years, with 10% annual returns, $10,000 will compound to nearly $175,000. At 7.5% returns, it will compound to $87,500—almost exactly half the amount.”

If you want to argue that the tax rates are lower than 25% that’s fine, but it isn’t likely they will remain there. And author Larry Swedroe cites a study by Charles Schwab: Schwab measured the performance of sixty-two equity funds for the period 1963-92. It found that while each dollar invested would have grown to $21.89 in a tax-deferred account, a taxable account would have produced $9.87 for a high-bracket investor. Taxes cut returns by 57.5%.”

The above information demonstrates the need to be aware of how tax-efficient a fund is. Funds create taxes by distributing dividends, interest, and passing along to you capital gains from trading stocks in the fund. Short-term capital gains and interest are taxed at regular income rates. Long-term capital gains and most dividends are currently taxed at 15%. Funds vary in how much taxable income they generate. Funds that return interest or significant dividends and funds that have high turnover are usually considered tax-inefficient. Funds that are not tax-efficient should be held in tax-deferred accounts. There are funds that are naturally very tax-efficient like the total market index and there are funds that are purposely managed to be tax-efficient. These types of funds are best used in taxable accounts.

Here is a list of securities in approximate order of their tax-efficiency (Least tax-efficient at the top.) from the Bogleheads Wiki:
Very Inefficient

High-yield bonds
Real estate/REIT
Any high-turnover active stock fund
Small-cap active fund

Moderately Inefficient
Small-cap or value index (without ETF class)
Large-cap active fund
Bonds (consider municipal bonds or I bonds in taxable)
Value ETF, or index fund with ETF class

Small-cap or mid/cap growth/blend ETF, or index fund with ETF class
Small-cap international ETF, or index fund with ETF class
Emerging markets index
Very Efficient

Tax-managed small-cap
Large-cap growth/blend index or total index
Large-cap international index
Tax-managed large-cap
Tax-managed international

Suffice to say that costs are a corrosive element in investing and the effect is compounded over time. Remember the compounding effect of returns? Well, you get the same compounding with costs, only negative. The larger your assets become and the longer the time, the more costs will take their toll. The more you can trim costs, including the taxes you’ll have to pay, the better your returns will be. In a nut shell, it’s really about investing as efficiently as you can. Don’t waste returns with high costs and taxes.

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Chapter 6 – Building Your Portfolio

Chapter 6

Building Your Portfolio—A Look at Fund Options

While individual stocks may be an option for some investors who have the skill, time, and interest, they are not the best choice for most investors. Here’s why: When you invest by purchasing individual stocks, you are competing head to head with professional stock selectors. Individual stock picking demands a lot more knowledge and attention than most average investors possess.  In other words, beating the average is very difficult. Eric Tyson, author of Mutual Funds for Dummies clearly explains: the notion that most average people and non-investment professionals can, with minimum effort, beat the best, full-time, experienced money managers is, how should I say, ludicrous and absurd.

An investor needs at least 50 stocks spread into different asset classes to be diversified, and no one stock should be more than 4-5% of equity holdings or the investor will add “specific stock risk” to his portfolio. So, for most investors, and especially those who don’t want to spend a lot of time on their portfolio, using mutual funds is the rational answer.

Mutual Fund Basics

A mutual fund is a pool of stocks or bonds purchased by the fund’s manager. An investor can buy the mutual fund and thus own all the stocks or all the bonds in that fund. There are also funds that contain both stocks and bonds. I’ve mentioned that there are around 7000 stocks available for purchase, and there are even more mutual funds! You can find a fund that covers any area of the stock, bond or international markets you wish to invest in.

There are two basic kinds of mutual funds—closed-end funds and open end funds. Open ended funds are far more popular and are the ones you hear about and see advertised. All references in this guide are for open-ended funds.

Mutual funds can buy and sell stocks at the manager’s discretion; therefore, the stock selection can change. If you wish to purchase a fund you would call the fund company or brokerage that has the fund you are interested in and place an order during a market trading day, but actual purchase will not occur until the close of the market that day. The price of a fund is called the net asset value (NAV) and it always reflects the average price per share of all the stocks held in the fund.

Mutual funds can further be classified into load funds, no-load funds, actively managed funds, index funds and exchange traded funds (ETFs). Index funds and index ETFs are also known as passive funds because they are designed to track a particular asset class or segment of the market without any managerial attempt to increase returns or moderate risk.

Mutual Fund Expenses – How they earn money
All mutual funds and ETFs have management fees. These fees are expressed as a percentage of assets removed from the fund before the total return is reported. Other fees, usually advertising expenses or commissions, can be attached as well under what is known as a 12b-1 fee. 12b-1 fees and management fees are combined and expressed as a fund’s expense ratio. Expense ratios can range from a very low 0.1% for some index funds to over 2.0%. On a $10,000 investment, that’s $10 per year compared to $200 per year.

Load Funds
Load is another word for commission. Funds that carry loads are sold by commissioned agents, advisors and brokers. Loads are applied most frequently in three ways: front end (A shares), back end (B shares), ongoing (C shares). There are several other letter designations for other asset classes as well.

A shares of a fund usually have a commission of around 5.75% of the money you invest, and it is taken even before the fund is purchased. If you hand the agent or advisor $10,000, $575.00 will go into the advisor’s pocket and only $9425 will actually be invested. The  commission is sometimes not obvious because the real value of the fund—the net asset value (NAV)—is not reported to you when it appears in your account statement. Instead, you might see a buy price, market price or something similar so it will appear that all the money was invested. Commissioned advisors do not like to show you what you paid, which ought to put you on the alert about their methods. A shares do offer discounts on the commission based on the purchase amount, and the fund company is supposed to tell you when you qualify, but you might have to ask.

Mutual fund B shares designate a back-end load. This is a commission taken when you sell the fund. Back end loads usually get reduced each year you own the fund. An example would be a 5% charge the first year, 4% the second, 3% the third and so on. But it may take 6 years or more to get out from under a redemption commission. And all the while you will pay a higher expense ratio for B shares than A shares because there is normally a 12b-1 fee (commission) attached. Most B share funds convert to A shares once the redemption fee is phased out.

C shares have the commissions built into the expense ratio and they show up in a 12b-1 fee, which is part of the overall expense ratio. These are called level loads, and they are applied as long as you own the fund. This commission can raise the total expense ratio to over 2%. Additional information on share classes can be found here.

In recent years more classes using different letter designations have been developed which further complicate the costs of funds. These loads have nothing to do with operating the fundthe money goes strictly to sales profit. The idea behind these commissions is that they are supposed to get you investment advice. But, advisors who make money this way often recommend investment choices that make them the most money. There is a lot of conflict of interest here that can bias an advisor’s recommendations.

No-Load Funds
No load funds are just that—they have no commissions at all. You buy them direct from the mutual fund company, a discount brokerage or through a fee-only advisor.

Index Funds
An index is a group of stocks chosen to represent the whole market or certain parts of the market. The performance of an index represents the average returns of the market segment being followed. The Morgan Stanley Capital International (MSCI) broad market index is one of several indexes that track the total U.S. stock market. You cannot buy the actual indexes, but you can buy mutual funds that track them.

There are index funds for all nine of the asset classes shown previously plus some others as well. The most famous index fund is the Standard and Poors 500 (S&P 500). The S&P 500 is used as the standard for the total market because it tracks the whole market very closely and it was created before there was a total market index fund.

The hallmarks of true index funds are they are capitalization-weighted and track their asset class closely. Most, but not all, are very low cost because they don’t have an active manager, they don’t need to spend money on stock research, and they have very low turnover. Many are also very tax efficient.

Exchange Traded FundsIndex
ETFs are put together and sold as a single unit like a stock, which means you can buy or sell them at any time during a trading day. But like a stock, you have to purchase through a broker and you may pay a commission for the trade and there will be a bid/ask spread meaning you may pay slightly more or less than the actual NAV to buy the shares. Buy/sell commissions can run from zero dollars at a discount broker to over $100 at a full-service broker.

When ETFs first arrived on the scene, they were all copies of true index funds. But now there are many more that index something other than a pure cap-weighted asset class and there are also actively manager ETFs. Like index funds, most ETFs have very low expenses. Avoid those that don’t. ETFs can be a good choice if you refrain from frequent buying and selling.

Actively Managed Funds
As the name implies, these types of funds hire a manger to put together and maintain a fund. The objectives of active funds as a group are far more varied than index funds which just have the job of tracking an index. In general terms, fund managers are trying to beat their benchmark index, although some actually try to limit downside risk as well. The ways in which mangers try to achieve their goals is where the creative variations come in. More on actively managed funds –

Choosing Passive or Active Funds
The debate over which is better is a never-ending one. The benefits of indexing are not obvious nor intuitive, and that is one reason they are only chosen by about 1 in 6 individual investors. But they are chosen by three out of four institutional fund managers.

Individual investors choose active funds for a variety of reasons. For many investors it’s simply because that’s what they learn about. You can’t turn on the TV or read a magazine without hearing about top performing funds. So active fund investors believe by selecting the right funds they can beat the index returns. Furthermore, they falsely learn it is easy to do. Index funds do not crowd the top of the hot fund lists, but they definitely do produce higher than average returns over longer periods of time. This is a well documented fact not even disputed by knowledgeable investors who choose active funds. There are two simple reasons for index outperformance: 1) Index funds have lower costs, and over time this advantage becomes very significant. 2) Index funds are not subject to several problems that active funds can encounter which reduce returns.

Costs and average returns
Index fund long term performance happens in a slow, methodical way. There are no stellar annual returns to make headlines. They simply produce consistent average returns minus low costs, and they never run into bad streaks, whereas active funds subject to the same performance average must first outperform well enough to overcome their higher costs. Then they must continue to outperform to show superior results. But the long term record clearly show they that they cannot do it consistently.

The following data shows the percent of funds beaten by their index for all nine market segments over a ten year period ending June, 2010. Over longer periods the numbers are even higher. After 20 years, outperformance is in the 80-90% range.

As you look at these numbers, you will observe that large value (LV) and small value (SV) have not outperformed their benchmark over the past 10 years. Do not therefore jump to the assumption that these two asset classes are better choices for active management. Five years from now, this list will not look the same.

Numbers for other time periods can be found by looking at Standard and Poors SPIVA Report online. SPIVA = Standard and Poors Index vs Active.

This following link provides a list of index fund advantages and a series of quotes from professionals compiled by author and investor advocate, Taylor Larimore.

Studies on active fund performance
There are dozens of studies showing index funds outperform actively managed funds over long periods of time. Most of them conclude that active fund managers show no persistent skill, and any noticeable outperformance is due to luck. But that may not be correct. It may be more accurate to say all top fund managers have excellent skills and are therefore indistinguishable from each other. They are all top of their class and the best available. They make a lot of money because they are talented. The skill level is high, but the competition is extremely tough and it tends to cancel out any outstanding manager. The end result is the same: individual fund managers don’t appear to demonstrate outstanding skill beyond their peers before costs.

The only place you do find persistence is in the two bottom quintiles where the less talented managers, or those saddled with restrictive company requirements, remain. All others in the upper quintiles fight for high rankings. Changes in position can be due to something as simple as changing market conditions or problems the fund managers must deal with that they themselves did not create. So, yes, noticeable winning streaks from the ranks of equally talented managers must involve a little luck that is independent of their skill. The distinction between luck and skill might not be all that apparent in fund managers, but the influence of luck can be easily seen in many other competitive examples.

The problem for individual investors trying to choose the best managers is a winning manager is not noticed until the streak is already started, and no one can tell how long it will last. All to often, it ends soon after the outperformance is discovered by investors. Secondly, there is no way to tell which manager will begin a winning streak in advance. So, performance records are not very useful in selecting the best manager or fund.

A Study Supporting Active Management
One recent study on active funds titled ‘How Active Is Your Fund Manager’ does conclude that a specific style of investing shows some persistence. The study also concludes that concentrated funds, market timing funds, and closet index funds do not beat indexing. The study’s conclusion also suggests that it is not the manager’s talent that shines, but rather it’s the method used. In fairness, it’s probably likely that most managers would not even attempt the superior strategy because it’s very demanding.

Beating the Market
One critical mistake uneducated investors make is to believe they can easily select managers that beat the market. Successful investors, however, understand that trying to beat the market long-term has unfavorable odds—it’s a a real uphill battle.

The purpose of investing is to achieve financial goals with an efficient, systematic plan. It is always a balancing of risk against reward—not a contest to see who can get the highest returns. This is not surprising news to the small percentage of investors who do use active funds successfully. Those who are successful have four things in common;
1) they are very knowledge,
2) they are very disciplined and avoid behavioral mistakes, especially overconfidence,
3) they keep the overall costs of investing as low as they can.
4) they don’t chase performance

The Reality of Investor Returns
Investors do not actually capture the returns funds produce because of:
1) behavioral mistakes,
2) costs, including taxes
3) fund performance variation that forces investors to make decisions on whether to sell or hold.

The losses are significant, ranging from 10% to over 50%. So, the smart play becomes eliminating things that can reduce returns. To put it simplified terms, don’t shoot yourself in the foot. Maximum long-term gains are the result of capturing the highest percentage of market returns. Increase the odds of long term success by minimizing behavioral mistakes such as overconfidence. Eliminate unnecessary costs, and minimize the possibility of potential problems beyond your control.

Active Funds Additional Risk
As mentioned, managed funds start off with the handicap of higher costs and an array of potential problems that can suddenly sink a fund. Investors need to understand that this handicap equates to higher risk of success because it’s not possible to identify those funds which will encounter problems or begin win streaks next year.

If an investor holds 10 active mutual funds, the odds are high that two per year will experience sub-performance. Investors can’t tell if the sub-performance is transitional or permanent so they must wait and watch. Managing a portfolio of all actively managed funds requires more time evaluating performance and searching for replacement funds. Because some will fail, they are not good choices for taxable accounts where tax consequences will add to the problem.

Potential Problems
Asset bloat – Nothing kills success like success. Popular funds draw a lot of new money. And ironically, too much success is one of the biggest causes of eventual failure. As the fund’s assets grow it becomes harder and harder for the manager to find good stocks to buy. A fund company with true fiduciary responsibility to its investors will close the fund, but most will just keep taking in the money until performance sinks to the bottom of the list.
Manager changes – Managers who have put up good numbers and received lots of media attention tend to move on to other, more lucrative positions. It’s worth noting, though, that some very good active funds have multi-managers, which suggests that the company’s underlying philosophy is more important than the manager.
Fund Purchase– it’s not uncommon for successful smaller fund companies to be bought-up by big firms with mediocre records and high fees. The funds with the good records are heavily advertised, but once the higher fees and new company management interference is in place the outstanding funds from the smaller company lose their luster.
Style drift – A managed fund that you purchased to cover the small value asset class can change to small blend, mid value or something else. When this happens, your target allocation gets shifted.
Objective changes – Managed funds can decide to change what they are investing in or how they invest, which dismisses the carefully chosen reasons you bought the fund in the first place.
Internal Pressures – There is great pressure put on fund managers to not underperform their benchmark. The result in some cases is to see a manager just try to mirror their index benchmark rather than chance underperformance. The result is a higher cost index fund, which has no chance of even matching the index after costs.

Choosing Good Funds.
I’ve explained why using active funds offers more challenges, and for some with the knowledge and time it might be a decent option. In other cases holding at least some actively managed funds is mandatory. Tax-deferred plans like 401ks, 403bs and 457s may not offer index funds or even top rated managed funds. Participants in these plans must work with what is available.

Fund Selection Process
1. The most important thing to look for when choosing an actively managed fund—and the hardest to recognize—is a fund’s commitment to shareholder fiduciary responsibility. Investors need to evaluate the company’s philosophy and how they interact with shareholders.
2. Select funds with lower expense ratios and never buy load funds. Many company plans that  carry load funds waive the loads. High expense ratios and 12b-1 fees are a drain on higher returns. The best funds also seem to hold advertising costs to a minimum.
3. Look for funds that have low turnover. Hidden transaction costs and capital gains taxes add to fund costs. Also, the best funds seem to be those that buy carefully and then hold their chosen stocks.
4. Look at five and 10 years past performance records. There is no way you can make a judgment based solely on past performance, but the farther back you can trace performance the better. Be very leery of funds with spectacular gains. Look for consistency and discipline.
5. Pay special attention to how much money the fund is managing (asset size). When a good fund is recognized by the crowd, it can receive a lot of new money that can cause problems. The best funds will close rather than continue to accept money that will harm the investors. This is a sign of fiduciary responsibility.
6. Pay particular attention to balanced funds. They seem to be the most consistently reliable over time, perhaps because they aren’t competing against, and not trying to beat, some stock fund benchmark. Unfortunately, these types of funds are not very good choices for taxable accounts.

Additional considerations –, html

Moderating Downside Risk
One other reason an investor might consider actively managed funds is to reduce downside risk. Some actively managed large value funds and equity income funds have lower downside risk as defined by standard deviation and beta. Note that while past performance of returns is not an indicator of future performance, historical risk characteristics are somewhat useful in getting some sense of what to expect from a mutual fund as long as the objective has not changed.

It may be a good idea to offset your large blend fund or large growth fund with a large value fund or an equity index fund having a lower risk profile if you wish to moderate risk. This is common practice for investors in or near retirement. These types of funds usually throw off dividends too. And since the total market and the S&P 500 are naturally weighted toward growth, a large value fund is a good compliment.

Three measures of risk to look at are a fund’s volatility (standard deviation), its bear market ranking, and it’s beta number. Beta is a number that indicates a fund’s swings in returns relative to movements of an index. For stock funds, the index used is usually the S&P 500, which as a beta of 1.00. A fund with a beta of 0.85 means the fund might go up or down only 85% as much as the index. In up markets it will underperform by about 15%, but in down markets it will lose roughly 15% less than the index. Part of the reason for some of the lower risk is probably due to these funds holding some cash. Index funds do not hold cash. And be aware that there is no guarantee that the calculated performance will match the actual performance. While this type of diversification and risk management works under most market conditions, be aware that in a panic sell off, all funds may go down together.

Building Your Portfolio – An Example
“The greatest enemy of a good plan is the dream of a perfect plan.”
A favorite quote of John Bogle originally attributed to Prussian general Karl von Clausewitz. There is no perfect investment plan. No one fund, no one allocation, or one strategy will be correct for every investor in all market conditions. This goes for professional fund managers who select stocks and bonds and it goes for the average investor who selects funds. And as you will discover, the investment options available to you will not always be exactly what you want.

When first starting out, things are usually quite simple. Your first investment venture might be an IRA or Roth IRA. Using these types of accounts allows you invest in almost any fund you want, but you will not have enough accumulated money to add to every asset class. One of the best ways to begin then is to use an asset allocation fund. These can be simple balanced funds or they can be fund-of-funds such as life cycle funds, or target retirement funds. These types of funds create an instant diversified portfolio for you. Be careful where you buy these funds though. Some companies (not Vanguard) tack on a management fee on top of the expense ratios of the underlying funds, which makes them too expensive.

Balanced funds and asset allocation funds hold both stocks and bonds and you can find them in different allocations to match your needs. These are the simplest worry-free funds you can get. You can buy them and forget them because even the rebalancing is done automatically within the fund. You can get fund-of-funds and balanced funds in both managed and index varieties.

At work you hopefully will have access to 401k, 403b, Thrift Savings Plan (TSP) or other retirement accounts. These can be great investment vehicles because of their tax deferral, but it’s the rare plan that doesn’t come with some compromises or problems, including high costs and limited choices.

If you have a 401k or other tax-deferred account, the best approach to building a good portfolio is to begin by choosing the best funds available in the company plan, then use other accounts to complete the portfolio.

To keep track, break things down like this example:
Overall Asset Allocation = 60% stock, 40% bonds and cash (define your own chosen allocation here)

Equities (equaling 60%)
large value fund – 18%
international fund – 15%
Roth IRA
large blend – 9%
sm cap fund – 6%
REIT – 6%
Total stock market – 6% (tax efficient)

Bonds (equaling 40%)
intermediate bond – 28%
Roth IRA
TIPs- 12%
Total = 100%

It’s not unusual to only find one low cost index fund such as the S&P 500 and one low cost bond fund in your company plan, and if that is the case, then that is what you should use. Tax deferred investing is a big advantage, so use what you can. Invest in the company plan up to the match. Then be sure to max your IRAs or Roths, and then add any extra saving to the company plan. If the company plan is a good one, max out contributions if possible.

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