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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Chapter 7 – Rebalancing

Chapter 7


Rebalancing is the rather simple but important process of maintaining risk at the level you have chosen. You do this by resetting your asset levels back to their original percentages (allocations) whenever they drift to far from your target. You will need to do this once or twice a year as some assets will gain faster than others or some may lose ground.

John Brennan says in Straight Talk on Investing “People tend to think about investing only in terms of making money. Making money is why we invest, but the reality is that if you don’t remember to manage risk along the way, you won’t do well at making money.”

That is a very important statement. Keep risk at the level you originally decided it should be. As assets grow, your stock allocation will become higher than you originally intended. There may be a temptation to let it ride, but this increases your risk, which you have carefully evaluated in your asset allocation model. In down markets your stock allocation will shrink. You may find it tough and counter to reason to add money to losing assets, but this is a way of buying when stocks are cheaper. Rebalancing in down years forces you to be a bit of a contrarian investor—one who doesn’t follow the crowd. This strategy can provide a bit of a return bonus and keep volatility in check over time.

There are several methods used for rebalancing, but it’s not critical that you follow an exact formula. Check your allocations once a year to see if the primary allocations have changed by more then 5% and watch smaller allocations to volatile asset classes to see that they haven’t gotten too far off the target. If you are adding new money on a regular basis, you can allocate it where needed to adjust to your targets.

Here are some general rules for rebalancing from author Larry Swedroe;
1) the main thing about rebalancing is the discipline of buying low and selling high, and restoring the risk profile.
2) you must consider costs of rebalancing (taxes and transactions costs) in taxable accounts as they will impact the frequency and timing of rebalancing.
3) rebalancing should always be done whenever you have new dollars to invest (no tax implications).
4) rebalancing can be done more frequently and more tax efficiently of course in tax deferred accounts.
5) given the evidence of short term momentum, it may not be best to rebalance too frequently (let the winners ride for short time, but not too long) . But again risk control is biggest issue to me—not returns.
6) once per year if you don’t have cash is fine—but even then I wouldn’t do it unless you had significant style drift

Mr. Swedroe advocates what he calls the 5/25 rule. When a major asset moves more than 5% off target, it’s time to rebalance. Example: Your asset allocation is 70% stock/30% bond. If equities grow to be 75%, then it’s time to rebalance. If an equity asset is 25% or less than total equity, then you use the 25% trigger. For instance, if you have 10% REIT, then the rebalance points would be plus or minus 25% of 10, which = 12.5% and 7.5%. Rebalancing at this level would not be critical for bond holdings. Rebalancing isn’t difficult, but it is important and part of your investing discipline.

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Chapter 8 – Formalize Your Investment Plan

Chapter 8

Formalize Your Investment Plan with an Investment Policy Statement

You have already done most of the work in making a plan by developing your asset allocation and  asset class percentages. Now you have to formalize it by writing it down. If that seems a bit excessive, it isn’t. Writing down your objectives, goals, and strategies:
1. declares you are serious
2. Protects against behavioral mistakes
3. helps you remember the details
4. helps you stay focused
5. makes you aware of something you may have missed.

Preparing for the future—managing money, saving, and investing—is a serious responsibility. It is no different and no less important than earning a living, maintaining a house, or protecting the things you’ve worked hard to get. The formal plan follows the same logic you might use for your next vacation, remodeling your home, or planning for your children’s education. Not planning results in nothing being done or making mistakes that waste time and money. To put it in more graphic terms, not planning and not following the plan can have a serious negative effect on your retirement life. None of the other investment rules will work in the long term without a plan and the discipline to stay with it.

A plan doesn’t need to be complicated, but it is so important that the experts agree that an investment policy statement be written and signed. A vision without a plan is an illusion. Here is what Lewis Schiff, author of “The Armchair Millionaire” has to say: “Define your financial goals and time horizon. What goals do you need to achieve in order to be financially secure or independent? For most of us, these goals would include having a certain amount to secure retirement. Your plan might target long-term growth, current income, protection of your capital, or some combination of all three. Other major goals might include college education or purchase of a home. These goals, with different time frames and different priorities will require their own investment strategy.
Define your risk tolerance.
Define your target asset allocation.
Define your individual investments.

The bottom line: All of your investing decisions should be grounded in your own investment policy statement (IPS). By taking a ‘top-down’ look at your finances and writing out a road map, your policy will add an important element of discipline to your approach.”

Sticking to a plan can be difficult at times. Any investment plan will be occasionally challenged by the market and second-guessed by the investor. The market will challenge your asset allocation decision at times by making it look like you’re doing it all wrong. Various sectors and segments of the market can get hot and everyone around you is jumping in. Even your best friend is clobbering your returns. On the other hand, the whole market may take a nose-dive and all you hear is gloom and doom. Temptation to join the crowd or rein in stock allocations can be very strong. These pressures can lead to common behavioral mistakes, which can be the major cause of losses for individual investors. You must be efficient in capturing all of the potential returns you can.

Ninety percent of what you read and see is useless noise and must be ignored. That’s easy to say, but actually very tough to do. Listening to noise is one of the major mistakes investors make and why you absolutely need to commit to a strategy and put it in writing. I don’t mean to say you should not alter your asset allocation when life style or goals change, but don’t flinch for any other reason. Take into account what might make you flinch, then set your allocation accordingly from the start.

This is the sort of blitz you are up against as Paul Farrell notes in an April 2005 Marketwatch article: “Last year, I estimated that the average investor was being overwhelmed by 43,000 fund and stock recommendations, via newspapers, magazines, cable television, radio and the Internet. The intensity of this noise confuses and brainwashes investors, resulting in costly mistakes.”

Chandan Sengupta, in “The Only Proven Road to Investment Success,” also warns of the danger: Noise is a constant problem and you have to recognize it and then dismiss it as not only worthless, but harmful. If you are not going to stick to your chosen investment method through thick and thin, there is almost no chance of your succeeding as an investor.”

John Brennan, in “Straight Talk on Investing” sums up the planning process nicely: “Making a plan need not be complex. It is all about looking ahead and assessing where and when your needs for money will occur. Then you decide on how you’re going to meet those needs. It’s essentially a three-step process:
1. Determine how much money you’ll need to have.
2. Figure out which kinds of investments should provide you with the money.
3. Calculate how much you need to set aside in order to make those investments.”

Your plan needs to consider building assets and managing existing assets in all accounts, including tax-deferred accounts at work like a 401(k) or 403(b), IRA, Roth IRA, as well as taxable accounts and emergency funds. Once that is done, you can subdivide your plan into individual goals. Goals with different time horizons will require different allocations, but it is best to keep the overall top-down view for a full perspective. Generally, money allocated to goals within a five-year time period should not be in stocks. The one exception, of course, is retirement. You will need to keep some stock in retirement because you will still be investing throughout your retirement years.

You can come up with an investment policy statement yourself or get some assistance from a financial advisor. Just remember, you need to have some idea of where you’re going and how you want to get there. If you don’t, an advisor may not be able to provide effective help. Here is an example of how a long-term plan for retirement might look:

IPS (Investment Policy Statement)
1) Investment Horizon – 30 years
2) Risk Tolerance – High due to investment horizon and evaluation of both financial and emotional ability to handle dramatic losses.
3) Financial Objective—2 million dollars. This objective can be achieved by starting with a sum of $30,000 and adding $12,000 per year for 30 years while getting a return of 8.5%. This financial goal will allow me to withdraw $80,000 per year (4%) beginning at age 62 for at least 30 years with a high probability of preserving the principal.
4) Rebalancing: I will review my allocations once per year (Feb.) and I will make adjustments by adding new money to adjust percentages back to targets.
5) Primary Asset Allocation: 75% equities, 25% fixed income
Equities – 70% domestic, 30% international
Fixed income – 100% domestic
Equities: Domestic allocation – Total market 25%, Large Value 25%, Small Value 10%, REIT 10%, Total International 30%
Fixed income: Total 25% of Portfolio – 25% Treasury Inflation-Protected Securities, 65% total bond market, 10% hi-yield
6) The plan allows for reduction in equity allocation as retirement gets closer and risk tolerance decreases. Allocation changes may also be evaluated if life-style changes or significant new goals occur. I will not let investor sentiment and Wall Street noise influence my allocation.


When should you get serious about an investment plan? Right now!
Here is a link to additional Information on Investment Policy Statements. Note that the first part is a quite detailed overview of what you need to think about. The second part is a detailed example. The third part is a real-world example. Notice that it is not complicated or lengthy.

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Chapter 9 – Behavioral Mistakes

Chapter 9.

Behavioral Mistakes

You have now completed the chapters on the mechanics of investing basics, and behavioral mistakes have been mentioned several times. If you wanted to apply the term ‘elephant in the room’ to the reason investors lose out on potential returns, behavioral errors would be it.

Behavioral finance as it’s called is a relatively new field. It attempts to better understand and explain how emotions and cognitive errors influence investors and the decision-making process. And while the researchers are beginning to understand what investors do to hurt returns, the investors themselves are quite oblivious to the mistakes they make.

As Warren Buffet has said, investing is simple, but not easy. Why? Because the cognitive skills needed to invest properly are in direct conflict to how we have learned to respond to familiar situations. We approach investing with those ideas learned in the family environment and in our own experiences unrelated to investing. Then, when faced with a new challenge, we apply those biases already ingrained in our memory. For instance, we are taught to be the best, don’t settle for average, you can do it if you really try. New investors are overwhelmed with information and endless recommendations, forecasts, insider tips (secret stuff) and excitement! These are bad stimuli for the investment brain, but to sort things out we fall back on things we know, although they may be very inappropriate when applied to investing. Furthermore, we can rationalize almost anything when we subconsciously want to choose one decision over another.

While the investment method discussed in this primer tends to keep behavioral mistakes minimized, you must be aware of the natural temptation to do the wrong thing. Don’t get emotionally involved. Good investing should be about as exciting as watching grass grow. And to go a bit further with this analogy, think of investing as a plow horse cultivating a field, and not a race horse.

Here are the most common behavioral errors and how they create bad decisions
1. Overconfidence. Overconfidence is perhaps the most common behavioral mistake, and while it’s pretty easy to spot by someone who is overconfident, it’s almost impossible for the afflicted investor to recognize it in himself. Ask any group of active investors trying to outperform average market returns and they will tell you they are indeed better than average. Why else would they attempt to beat the market in the first place? To make matters worse, overconfident investors are subject to something called the Dunning-Kruger effect. The Dunning–Kruger effect is a bias in which an unskilled person makes poor decisions and reaches erroneous conclusions, but their incompetence denies them the ability to realize their own mistakes. Overconfidence leads investors to frequent portfolio changes and higher risk taking due to overestimating knowledge and ability while underestimating risk. Ultimately, the results are higher costs and lower returns. Professional stock analysts and fund managers are not immune to this problem either.

Overconfidence is the most common problem, but it is also the most difficult to overcome. Many investors believe that they are adequately competent when they learn to speak the language of Wall Street as well as the pundits on TV, or they know the fundamentals of choosing stocks or mutual funds. What they fail to realize is there are millions of investors with the same knowledge and simply knowing facts is not knowledge, and knowledge is not wisdom. Overconfidence cannot be eliminated unless the investor takes a disciplined, neutral approach to the investing process. The investor must also realize that beating the market is not an easy task that can be accomplished with a little extra work. There are many factors involved beyond the investor’s control.

For an average investor, and that is most of us not formally schooled in finance and economics and without the Wall Street electronic equipment and constant research, it is best to not get caught up in the idea that we are better than average. Average on Wall Street is a very high water line and you are most likely underwater. If you believe you have the ability to choose winning stocks or fund managers, reading up on stock market history might provide a more sobering picture.

2. Loss Aversion and Risk Aversion. Loss aversion refers to the tendency for people to strongly prefer avoiding losses over acquiring gains. Loss aversion has several implications, but the fact is investors experience more pain over losses than they feel pleasure over the same amount of gain. In one classic experiment, players were asked how much they would need to win in a coin toss game before they would play when the other player won $100 if the coin turned up heads. The logical answer, of course would be $100, but the actual answer players gave was close to $200. They weren’t willing to lose $100 until the a win paid almost double.

Investors who experience loss aversion will focus obsessively on one investment that’s losing money, even if the rest of their portfolio is in the black. They are also more likely to sell winning funds in an effort to “take some profits,” while at the same time not wanting to sell losers. Loss aversion naturally leads to risk aversion. Risk aversion is the reluctance of a person to accept an investment with an uncertain payoff (stock risk) rather than an investment with a more certain, but possibly lower, expected payoff (bonds or bank account.).

3. Recency Bias and Information Overload . Recency bias is the tendency to weight recent market action as the basis for intended long term decisions. But of course, investors who use recent performance never make any decisions that last very long. Recency bias leads to buying high, selling low, and excessive, irrational portfolio changes. Information overload is somewhat similar to recency bias. The danger of too much information is we believe we can absorb it all, but the memory is selective to information we perceive as supporting our position.

In another simulation experiment done by pioneers Richard Thaler, Amos Tversky, Danial Kahneman and Alan Schwartz, two groups of subjects were given identical portfolios consisting of one stock fund and one bond fund to manage. One group was given updated information on the portfolio and the stock market monthly and the other was given information only annually. The groups could only make portfolio changes at the time the information was provided. The results showed that the group who received information monthly made more portfolio adjustments; however, at the end of the simulation time, this group underperformed the less active group by a remarkable 50%. When it comes to Wall street information, less is better.

Recency bias and performance chasing are made by investors who are either unaware of this common behavioral mistake, or they lack discipline and a good long-term investing plan.

4. Fear of Regret. Regret comes from the emotional reaction people get when they conclude they’ve made an error in judgment. Sometimes the decision is wrong, but it may have also have been correct, but the outcome was negative. Because investors don’t separate correct process decisions from outcomes, the feedback leads to further errors. Mistakes are treated as major failures, and they reduce confidence and freeze rational thought. Fear comes into the picture the next time a decision has to be made. Investors do lnot like to regret what they’ve done; therefore, they may be hesitant to make the next required decision and they may also drift from the correct decision making process and make a worse decision. Investors can become paralyzed if they focus on an anticipated outcome rather than following their established process.

Again, awareness is much of the battle. Investors need to establish a plan that is logical and uncomplicated and stick to it. Yes, occasionally a result may not turn out as hoped, but an undesirable outcome should be blamed on a good decision making process, and there should be no regret. In the long run, the plan will be rewarded.

5. Anchoring. When new or unfamiliar situations are presented, people attempt to relate oranchor” the new information to a familiar reference point even though it may have no relationship to the new situation. This tendency may cause investors to base decisions on irrelevant past experience or an illogical reference point. As an example, an investor may make a decision to buy more of a stock which has dropped in price based on previous high values without knowing any new information that may have triggered the drop. The investor anchored on the previous high value.

Overcoming the anchoring problem is not too difficult. The caution flag should go up when a conclusion is made without much examination or thought about new data simply because it seems to fit a previous conclusion. The proper approach is to explore the facts from a different perspective, or to seek input from other investors who don’t always agree with you.

6. Confirmation or Comfort Bias. This is a tendency for investors to form a consenting opinion of first impressions that align with preconceived ideas because information is selectively favored. Confirmation bias also leads investors to look for and file additional information that supports their beliefs. Overcoming confirmation bias requires the investor to actively seek and discuss and weigh opposing viewpoints.

7. Procrastination
Procrastination is very common and it leads to investors neglecting to manage their portfolios properly. It may cause them to not rebalance when necessary or to simply not pay attention to the performance of actively managed funds in their portfolio. Procrastinators may end up with a very different portfolio than they created and they may be caught off-guard in sudden market changes.

The six listed behavioral mistakes are major ones, but certainly not the only ones. Have a look at this list and review it once in awhile as a reminder:

Behavioral Issues and the Bottom Line
Studies have shown that behavioral mistakes reduce the return on investments that investors actually receive by 10% to as much as 75%. So what do investors need to do to pocket more of the returns? One word: discipline. Don’t focus on becoming too smart; instead focus on avoiding foolish behavior and you’ll be successful.

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Chapter 10 – On Your Own or Hire an Advisor

Chapter 10

On Your Own Or Hire An Advisor?

Jack Brennan in his book, Straight Talk on Investing says, “Remember, it’s in the interest of many financial services companies to make you think that investing is difficult.” While Mr. Brennan’s statement is true, so is Warren Buffet’s, “Investing is simple, but not easy.” What Mr. Buffett is referring to is the natural tendency to make behavioral mistakes, which can really hurt returns. So, if you are not disciplined, then you might need someone to keep you on track. But there may be another reason to use an advisor that is just as important—do you want to spend time managing your assets? Delegating management to an advisor can provide you with freedom to do things you enjoy more and insulate you from nerve-racking market gyrations that cause worry.

If you are just starting out and you haven’t accumulated a large asset base, you probably do not need advice, and you don’t need to spend a lot of time on your investments. However, if you have accumulated a hodgepodge of investments in various places, you may need some help in sorting things out. Before you decide one way or the other, evaluate your own situation and personality. Jonathan Clements in a Wall Street Journal article comments “If you want to see the greatest threat to your financial future, go home and take a look in the mirror.” Jane Bryant Quinn in The Washington Post gives a similar warning “The green—in our eyes and in other peoples wallets—brings out the worst in us. I don’t mean morally, I mean our worst instincts as investors. We think we make rational decisions. More often, we veer from hope to fear and back again, with out putting our brains into gear at all.”

Know Your Tendencies
You now know that building a good portfolio is not difficult, and if you can do that an advisor cannot put you into better investments. But there may be unseen behavioral hazards awaiting the unsuspecting investor, and this is where a good advisor may pay off.  Ask yourself the following questions:
*Am I impulsive?
* Do I have the temperament to act without panic?
* Can I view my situation objectively?
* Can I stay with the plan through thick and thin?
* Am I too competitive?
* Do I tend to procrastinate?

Answering yes to any of these questions may increase the tendency to make behavioral mistakes which cost money. Mistakes are generally made by investors who do not know the fundamentals, including the behavioral pitfalls. Belsky and Gilovich in “Why Smart People Make Big Money Mistakes” suggest that when we consider important financial decisions, instead of asking knowledgeable friends or professionals what they think about the changes we are considering, ask them what they think about the process used to make the decision. It is far more revealing.

In addition, there is the issue of desirability. Do I enjoy managing my own investments? Am I willing to take the time to learn what I need to know. If the answer is “not really,” then this is a valid reason to hire an advisor.

A good advisor may save an investor from making major errors, which would more than justify the added expense. So, there are very valid reason to use an advisor. But then, the investor needs to avoid another major mistake—choosing the wrong advisor. If you decide you need professional guidance, there are two ways to get it. One is to put your assets under management (AUM). The other is to manage your own investments but consult with an advisor occasionally on an hourly basis to ensure you are on the right track.

Here are the general ways advisors are compensated.
Commission only: No direct charge for financial planning or investment advice. Recommendations consist of investments and financial products that have commissions or fees that will come out of your investment. And investment choices will be limited to those investment options that pay commissions. Most of the investment options that carry no commissions will be excluded.
Fee-based or fee and commission: A fee is charged for financial planning or investment advice. Recommendations consist of investments and financial products that have commissions or fees that will come out of your investment.
Salaried: No direct charge, but incentives and awards are often provided in addition to the salary when certain financial products are purchased based on the advisor’s recommendations. Recommendations may also include investments and financial products that charge commissions or fees.
Fee only: The advisor receives no commissions; his or her only compensation is the fee you pay directly. The advisor may charge in one of two ways. Either a percent of assets under management or other direct fees that might include hourly consultation or a retainer for a specific project. The advisor receives no commissions; his or her only compensation is the fee you pay directly. There should be no investments or financial products offered that asses commissions.

Choosing An Advisor
The great paradox of using an advisor is that you must know some basics in order to evaluate the advice, and once you do, you also know enough to consider doing your own management. If you have gotten this far through the primer, you are already a more knowledgeable investor.

You now have some sense of what proper investing fundamentals are, which means you have some defense against really bad advice. The professional advice you receive may or may not be in your best interest, but from what I’ve seen, you are far more likely to get biased or even harmful advice if you don’t choose carefully. Unfortunately, because of extremely loose industry standards, it isn’t easy to find an advisor who is qualified and one you can trust.

What comes to mind when you hear the terms financial planner, financial advisor, investment counselor or wealth manager? You might be surprised to learn that these titles mean absolutely nothing. The Financial Institution Regulatory Authority (FINRA), formerly NASD, does not recognize them. Here is some enlightenment from Rick Ferri, who holds the Chartered Financial Analyst (CFA) certification: “The financial industry plays the game like no other. Every advisor calls himself something that makes him seem like an expert, but few people are. At brokerage firms, everyone is a Vice President. If they are not a VP, they are either very new or on their way out the door. In addition, everyone calls himself or herself a Financial Consultant, Financial Advisor, Financial Coach, Retirement Specialist, or some other nonsense title that means nothing. These are all self-appointed titles, and they can change with the wind.”

The type of advisors who hold no useful credential almost always promote high cost commissioned products. These are the high profile guys. They’re the ones who advertise heavily and aggressively look for your business. They promote through “free” seminars, dinners, mailing campaigns and cold calls. Friends and business acquaintances frequently recommend them simply because they’ve met them through business associations, and they don’t know any better. You don’t have to look for these advisors; they will find you!

Bruce Miller, CFP® clarifies; Real Certified Financial Planners (CFP) are bound by something called the ‘brochure rule’, that requires us to immediately disclose lots of information to a prospective client…including from whom and how much we are paid, even if by commissions. This is done by contract before any data collection or advising is done.“The CFP® Board now requires that all CFP® Certificants provide the fiduciary standard to their clients who retain their financial planning services.

And this is what AARP had to say in their July 2006 online magazine: “Fiduciary” means that the person working for you owes you the highest possible duty of care and loyalty, so that a relationship of trust and confidence exists between you and the planner. While you may think that this sort of trust and confidence will naturally exist, a fiduciary relationship usually depends on the facts and circumstances of a particular situation.

This link provides the definition of fiduciary responsibility as defined by The National Association of Personal Financial Advisors (NAPFA):

In the strictest sense, there is a distinction between a financial planner and an investment advisor. The role of ‘Financial Planner’ is unregulated and anyone may refer to themselves as such,  regardless of their training or lack thereof. An ‘Investment Advisor’ is regulated by the SEC, and requires that anyone who holds themselves out as an investment advisor and is compensated for it, must register with the SEC or their state’s equivalent and meet full disclosure requirements and must apply a fiduciary standard to their client’s investments. One other option is the large mutual fund companies themselves. The fees seem to be competitive, and if you are opening a large account, the fees may be reduced or waived. T. Rowe Price, Fidelity and Vanguard are three large, respected companies who are now offering advisor services. Recommendations will be from the company you go with of course, but these three companies offer a wide variety of funds so choices should not be a problem.

Factors to Evaluate When Looking for an Advisor

Look for CFP and CFA designations. Check for any non-compliance issues.
Education and background
Verify that education and background are consistent with credentials.
Do not hire anyone you cannot fire without personal repercussions—friends, family, members of church or social network.
Look for advisors with at least five years experience
It is very important that you get along with your advisor and you have trust in him/her.

Bruce Miller, CFP®: Once you find several credentialed advisors in your area, call and ask them what they specialize in. Tell them what your approximate goals are and if they think they’d be able to assist you. I recommend you then set up personal interviews with at least 2…. 3 is better.

When you do meet, like a visit to your doctor, they should ask questions, listen and take occasional notes. You should do most of the talking. At the end of 30 minutes, they should be able to clearly summarize your position and recommend a general course of action. They should have no hesitation in encouraging you to think over their general recommended approach and their estimated cost range. Any talk of financial products or recommended specific solutions, or even the slightest pressure to sign an agreement at the end of this first meeting is a bad sign and suggests you should go elsewhere.”

Questions to ask potential advisors;
1. Are You a Registered Investment Advisor under the Investment Advisors Act of 1940?
What are your qualifications? Licenses, certifications, regulatory agencies. What organizations, affiliations. How much experience?
2. Do you accept fiduciary responsibility?
3. Please provide a copy of your most recent and accurate disclosure form. ADV-II (Registered Advisor), U-4 (Broker / Dealer)
4. What services do you offer?
How many clients, what type of clients, minimum asset requirements?
5. Are you independent of financial-product sponsors–brokerage firms, insurance companies, banks? Do others you work with or recommend provide you with benefits for your recommendations?
6. What approach to planning and investing do you favor? Stocks, mutual funds, what kind of funds, annuities? Note: The advisor’s approach and risk management style should be in line with yours.
7. Will you be the only person working with me? In the office, outside professionals?
8. How much do you typically charge and how are your fees applied?
9. Will you provide a written statement of all fees, including direct fees and fees paid to other firms or organizations?
10. How will I pay you for various services?

Get an agreement, including costs, in writing for services that will be provided. It may be a good idea to copy these questions and send them before you meet with potential advisors. That will save you and the advisors some time. And it will send them a message that you know what you’re doing.

Be leery of any advisor who suggests annuities, with the exception of low-cost single payment immediate annuities (SPIAs) . Avoid wrap accounts, separate accounts, limited partnerships, private real estate trusts, leveraged funds, equity-indexed annuities, insurance products, cash value life insurance, or any products the advisor tells you can’t lose money. Never hire an advisor that says you don’t pay him—the fund company pays him.

If you hire an advisor, remember he or she works for you.

Bruce Miller (quote): Sometimes the best you can do is to find a planner who doesn’t have a compensation plan that would seem to be at odds with your best interests. And if you have a planner who has decided that ‘his/her own best interests are served by consistently providing a quality plan to his/her clients’, that is probably as good as it gets.

Two links for finding an advisor:

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Chapter 11 – Final Thoughts, References

Chapter 11

Final Thoughts, References, Glossary

While this investment primer touches on proper investment fundamentals, it isn’t intended to cover all you need to know. Following up with one of the suggested books will help solidify new concepts. And reading the primer first will help you digest the book material more easily.

I hope I have given you an idea of the mountain of research, data and facts that exists on the subject – information that you won’t find by asking an industry that prefers you remain in the dark. I also hope you have developed a warning radar for detecting information, suggestions and advice that are in conflict with your best interest

Investing in stocks is a way to generate future income, but it isn’t the only way and it requires that you take risk with your money–but it is a risk that has provided results worth the risk. Settle on a risk/reward measure that will help you achieve your goals while protecting what you’ve accumulated, not one designed to beat the market average. There are no hurdles you need to jump–balance risk against a reasonable return. Investing is not a competitive sport—don’t get fancy, and don’t listen to TV or magazine hype—what Jane Bryant Quinn calls “investment porn.” Ignore temptations to go after hot funds or choose funds based on recent past performance.

If stock returns came from history books, then the wealthiest people would be librarians.”
Warren Buffett

Managing your money is about the unglamorous task of being a defensive lineman, not the star quarterback.” Ben Stein, Phil DeMuth – authors of several investing books.

Don’t begin by looking at funds. Do a risk analysis and choose an allocation first, then figure  out how you want to diversify your investments – large caps, small caps, international, REITs, value, blend and growth. Only then should you consider funds.

If you’re just starting out, you may not have enough to invest to meet the fund’s minimum investment in every category. If not, then look for target retirement funds, or other funds that give you exposure to several funds in one. Also look at balanced funds that contain both stocks and bonds. If you have already accumulated a larger portfolio, the process is the same, but you might wish to choose individual funds to fill your diversification slots.

The most important investment a person can make is in education.

Good First Books
“The Bogleheads’ Guide to Investing” by Taylor Larimore, Mel Lindaur and Michael LeBoeuf
“The Coffeehouse Investor” by Bill Schultheis
“The Informed Investor” by Frank Armstrong

The Big Investment Lie” by Michael Edesess
“The Investor’s Manifesto” by William Bernstein

Books with More Depth
“John Bogle on Mutual Funds” by John Bogle
“Common Sense on Mutual Funds” by John Bogle
“Four Pillars of Investing” by William Bernstein
“Random Walk Down Wall Street” by Burton Malkiel
Any book by Rick Ferri or Larry Swedroe

Behavioral Finance
Why Smart People Make Big Money Mistakes” by Belsky and Gilovich
What Investors Really Want” by Meir Statman.
“Predictably Irrational”, by Dan Ariely
“Behavioral Finance and Wealth Management” by Michael Pompian
“The Little Book of Behavioral Investing” by James Montier

Free Online Books
Investing for the 21st Century” by Frank Armstrong

Serious Money, Straight Talk About Investing for Retirement” by RickFerri,

For General Information on Investment Basics (general information, recommendations, discussions based on MPT) (articles)

Advanced Information and articles on Investing (many good articles)

For General Information on Mutual Funds (Reference Library) (fund information and leaning center)

For Advanced Information on the portfolio selection method (modern portfolio theory) (theory and practice) (academic articles)

For Information on Exchange Traded Funds (ETFs)

For Information on 401k and IRA (401k help) (IRA help)

For Information on Financial Planners

For Information on Retirement Withdrawals

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