Free Money Finance

Portfolio Recommendation Beats S&P 500 by 9.4%

The following is a guest post from Marotta Wealth Management. For those of you interested, I have a similar, though not exact, investing strategy to the one he details below.

Exactly a year ago I encouraged you to avoid another lost decade in the markets. I recommended a specific balanced portfolio that today is beating the S&P 500 by 9.4%.

At the end of September, the S&P 500 was down 6.9% after one of the most volatile 12 months in the market's history. Even over the past 10 years it lost money with an annualized return of -0.15%. So although buy-and-hold investors are relieved the markets have recovered much of their losses from lows in early March, all is not dividends and capital gains.

To add to their distress, many buy-and-hold investors did not even receive the market return. They purchased closet index funds with overly inflated expense ratios. Excessive fees sapped value from their investments while the underlying strategy proved fruitless.

Many active investors fared far worse. In their scramble to avoid bloodshed, they sold near the lows. They didn't get back into the markets until the recovery passed the point at which they had exited. Timing the markets this past year was nearly impossible. The drop was precipitous, but the recovery was equally steep. Those who rebalanced at the low took money out of safe investments and bought into equities just when the outlook was the bleakest. These fortunate contrarians boosted their returns significantly.

So did those people who simply diversified into the blended portfolio I recommended a year ago. That portfolio experienced a 2.48% gain over the past year in contrast to the S&P 500's 6.91% loss. It beat the S&P 500 by an impressive 9.39%.

We generally do not recommend S&P 500 index funds. The S&P 500 is a capitalization-weighted index. It tends to buy more of a stock when it goes up and hold less of a stock when it becomes more reasonably priced.

If the S&P were a financial advisor it would say, "Let's buy mostly large-cap growth stocks in the industry that did well last year with a high price per earnings ratio." The result would be a very aggressive and volatile portfolio that does better at the end of a bull market than at the beginning. And it does miserably at preserving capital during a bear market--exactly what happened over the last decade.

So if you are invested primarily in funds that mimic the S&P 500, a lost decade should be no surprise. If we use market history to run hundreds of Monte Carlo simulations on a portfolio invested in an S&P 500 index fund, projections indicate returns at or below zero about 6% to 7% of the time. This scenario is an astonishingly accurate snapshot of trends in the past 100 years in which six 10-year periods showed no gains. These periods were the 10 years ending in 1914, 1921, 1932, 1938, 1974 and 1977.

If you were invested in the Vanguard 500 Index, your 10-year average return through the end of last month was -0.23%. The official rate of inflation during the past decade averaged 3.0%, but in reality it was probably at least 5%. If you were invested in an S&P 500 fund, your decade-long progress toward your retirement goals has stalled significantly.

But if you were a savvy investor, you did not lose this past decade. If you committed to a balanced portfolio, you experienced both higher returns and lower volatility.

Even a balanced portfolio of just six different common funds could have boosted your 10-year average return to 6.21%. And it would have lowered your volatility from a standard deviation of 16.25% to only 14.83%, a 6.36% better annual return with 1.42% less volatility.

The portfolio I recommended didn't cherry-pick investments that have done the best recently. Rather it chose widely used funds from each major asset class.

My comparison portfolio allocates 20% to fixed income in the Vanguard Total Bond Index (VBMFX). Of the remainder, it designates 31% to U.S. stocks with 21% in the Vanguard 500 Index (VFINX) and 10% in the Vanguard Small Cap Index (NAESX). Another 31% goes to foreign stocks with 21% in Vanguard Total International Stock (VGTSX) and 10% in the Vanguard Emerging Market Index (VEIEX). The final 18% is invested in hard asset stocks in the T. Rowe Price New Era Fund (PRNEX).

The funds just described have been popular for over 10 years. They have not made their gains from active trading. And they have low expense ratios. These are not necessarily the ideal funds to select today. Nor is this the flawless asset allocation. These are simply reasonable funds in each asset class.

Both in theory and practice, a balanced portfolio has proven to be a far superior way to meet your financial goals. In Monte Carlo simulations, balanced portfolios earn money over a decade, even the bottom 5% of random returns. The exact portfolio construction is less critical than including asset categories with a low correlation to the S&P 500. A well-balanced portfolio should result in good returns with lower volatility. Returns will still vary widely because the markets are inherently capricious, but the worst cases should be considerably better.

Of the six holdings listed here, the best return over the past 12 months was the Vanguard Emerging Market Index (VEIEX), up 17.38%. This holding dropped the most a year ago but recovered even faster.

Downward pressure on the U.S. dollar has continued in recent months. So we are still strongly advocating portfolios that hold a significant percentage of assets denominated in other currencies. These assets include foreign and emerging stocks, foreign bonds and hard asset stocks.

Holding on to an undiversified portfolio will, on average, keep on providing inferior returns with higher volatility. Don't continue to wait in vain for a poorly balanced portfolio to satisfy your investment requirements. You can't afford to miss another year or another decade.

Did You Miss the Ride Up?

Remember all the conversations we've had over the past couple years about staying invested in the market no matter what it does (assuming you have a long-term horizon) and especially when it's falling? Why is that? Because most people can't predict when it will go back up again. And of the ones that pull out halfway somewhere along the drop down, most will end up missing the big ride up.

And now we have proof of this yet again. With the Dow breaking 10,000 Wednesday, it's appropriate that we stop and take note. Who would have ever thought things would rebound this quickly? Who was smart enough to pull out of their stock investments at the last peak (or even somewhere near it) and hold cash until the bottom to reinvest? The answer to both of these questions is "almost no one."

On the other hand, who sold their stock investments this past March and put them somewhere "safe" so they wouldn't go down any more, only to miss the huge ride up that stocks have taken over the past few months? Answer: millions of people.

Yes, those that hung on had a quick ride down. But they stuck it out and most of their investments are back. And if they kept buying all the way down (and back up again), those purchases have done really, really well for them.

Of course I don't know what the stock market will do in the coming days and months. For all I know, it could drop to 7,000 over the next few weeks. But over the long term I am fairly confident that the US economy and the stocks that make it up will do well. That's why I keep invested in the market and continue buying -- because I think the stocks I purchase today will be worth a good amount more 20 years from now, I can't predict when the big jumps will happen, and I don't want to miss any part of the ride up.

Bond Primer: Yield vs. Total Return

The following is a guest post from Sound Mind Investing. Here's a review of SMI if you're interested. It's a basic piece (hence "a primer") but I'm sure some of you will find it very educational. And the rest of you can discuss what you think the interest rate risk is on today's bonds. Seems high to me given that interest rates are so low these days -- they can't go lower, can they?

A bond is simply an IOU. An investor lends money to a corporation or a government (federal, state, local) and in return gets the promise of regular interest payments, as well as the full return of the loan at the end of a specified period.

Bond investing carries two major risks. The first is that the business or government might run into serious financial troubles not be able to pay up. This is called "credit risk." The second risk is that you might get locked into a below-market rate of return (explained below). This is called "interest-rate risk."

When offering a bond in the marketplace, the issuer promises a certain "yield." For example, you might find a $1000 bond offered with an annual yield of 6%. In other words, that bond would pay $60 a year in interest (6% of $1,000).

But "yield" is only one aspect of what your bond investment will be worth going forward. Suppose interest rates were to fall after you make your $1,000 investment. For bondholders, that's a good thing, because when rates fall, bond prices rise (after all, you own a bond paying 6%; newer bonds might be paying only 5%). Someone may want to buy your bond so they can get a higher interest rate than currently available among new bonds.

Because your bond is in demand, let's say you can sell it after three years for $1,100. You now have a $100 capital gain. When you combine the yield and the gain you have what is called total return. This total is usually expressed in annual compounded terms.

In our example, you invested $1,000 and received back $1,280 over three years ($180 in interest payments — i.e., $60 a year — plus a $100 gain when you sold). To learn what your total return is in annual percentage terms, you ask, "What rate of growth would be required to turn $1,000 into $1,280 in three years?"

Using an online calculator that can perform time-value-of-money computations, you learn that it takes about an 8.6% per year rate of growth to do that. (In other words, if you had invested your $1,000 at 8.6% for three years, you would have had approximately $1,280 at the end of that time.)

What this means is that the 6% yield you received as you went along, plus the $100 gain at the end, made it possible to achieve a very nice 8.6% annualized total return.

But suppose interest rates rose after you bought your $1,000 bond? As a result, the bond's value dropped by $100 (this is the interest-rate risk referred to above). Now, newer bonds have a higher rate than your bond, so if you want to sell your bond, you’ll have to lower the asking price.

You don't have to sell your bond, of course, but suppose you need some cash, so after three years you sell your $1,000 bond for $900, taking a $100 loss. You would still have $180 in dividends ($60 for three years), but when you subtract the $100 loss on the price, you'd have only $80 to show for your efforts. While you thought you were earning 6% a year, it turns out you were actually netting, on average, just 2.6% per year (once the capital loss is subtracted from the yield).

As you can see, a bond's yield tells only part of the story. What you're really interested in is your eventual total return.

Being aware of the difference between yield and total return is especially important right now with interest rates being so low and the potential for inflation on the horizon (due to so much money being pumped into the system by the Fed). Inflation, or even a growing concern about future inflation, causes bond buyers to demand a higher return on their money to protect their future purchasing power. That means today's bond buyers could face significant interest-rate risk ahead.

So if you’re investing in bonds in today's climate, it's probably best to keep maturities short (1-to-3 years). Short-term bonds have much less interest-rate risk than long-term bonds.

The 5 Stages of Investing Enlightenment

The following is a guest post from Retirement Savior. I found this piece especially insightful since these are the exact stages I went through (many, many years ago.)

Have you experienced the stages to becoming an ideal investor? It is not difficult to learn the tricks of the trade if you put forth diligent effort. For many people, it follows a common pattern of 5 stages:

1. Seeing Successful Investors, and Trying to get Rich Quick

No doubt you have had friends of family tell you how much they made on a certain stock pick. It's so easy! Maybe they have a new advisor, or they heard it on Cramer or Fast Money. You just KNEW you should have paid more attention when you watched those shows. The next time you see Cramer back up the truck on another stock, you will have to check it out.

After you heard that last tip from your friend or from Cramer, you just had to buy that stock. And what do you know, you bought at the top. The stock price fell 10%, and you thought "It will surely come back, this is just a pullback and other people are taking profits. Once they are done, this stock will jump right back up." Only it didn't, and sunk further.

So you tried another stock, and then another. Every once in a while you could console yourself with a winning stock, but overall, this investing wasn't what you imagined. How could it be so different for other people who got rich, and not for you? You must be the unlucky one. This brings you to the next stage...

2. Realizing You Will Not Get Rich Quick

Did you know that your friends aren't telling you about both their winning picks AND their losers? They generally only tell you the profitable ones. They aren't telling you about the 30% loss in that small tech company that they are sitting on, waiting for the price to get back to breakeven.

If only you knew that you aren't the only unlucky one losing money on hot tips! Everyone who chases these returns, the pot of gold at the end of the stock market rainbow, fails to get rich easily. Only when you realize this can you reach enlightenment stage #3.

3. Educating Yourself about Investments

Why in the world of investing not as easy as you pictured? When you see dozens of stocks that have doubled or tripled in just a few short years, you believe that there must be some way to buy when the stock is low and to know when to sell.

Not at all. Warren Buffett and George Soros can't even buy at the bottom and sell at the top. There is no reason why you should be able to either.

Slowly, you learn that a diversified portfolio is the only free lunch that the market gives you. You learn about ETFs and index funds, and maybe a little about finding stocks of solid companies that are selling cheaply. You learn that the way to better returns is to control your costs, by holding for the long term and only picking funds and ETFs with low expenses.

4. Coming Up with a Plan

So you decide to set up a plan. You calculate how much you should need for retirement. Then you come up with a plan for how much you should save each pay period, month or year. You put that savings in a qualified, tax-sheltered retirement plan, and if your employer offers a match in the retirement plan, you put in the maximum matched amount up to your ability. If you can fund an IRA, you open one of those as well.

You decide your risk tolerance based on your time horizon until retirement, and adjust your asset allocation accordingly. You know that there will be bear markets and drawdowns in your portfolio, but you also know that your strategy will lead to solid returns that will hold up over the long term.

If you want to invest funds on your own outside of retirement plans, then you have a written plan of your risk tolerance, what types of asset classes or securities you will buy, and what your criteria are for taking profits and losses. You also acknowledge that you will not buy based on stock tips, nor from what talking heads spout on TV shows. You do not mind if other people bought a hot stock and you didn't. In fact, you are more concerned about protecting your capital from losses than having high returns.

5. Implementing a Disciplined Plan

Congratulations! You have reached the last stage. Here is where you execute your plan. You contribute your planned amounts to your retirement plans, while investing according to your asset allocation strategy. You will not deviate from your plan, because you know in the end it will get you where you need to go. You continue learning and applying your knowledge to your investing, and realize that you have beaten all of the pitfalls and traps that the investing world lays in your path.

Now if you aren't yet at stage 5, go and make it happen!

The Whip Cracks Both Ways

The following is a guest post from Marotta Wealth Management.

Inherently volatile, the average daily fluctuation of the stock market is about 0.76%. If this movement were always up, the market would appreciate to more than six times its value in a year. If all the movement were down, you would have less than 15 cents for every dollar you invested at the beginning of the year.

Most of this fluctuation is like the beating of a hummingbird's wings--lots of movement but no progress. Every year after matching all the up days and down days, you are left with about seven days that represent the entire year's investment gain or loss. Thus daily movements are 97% noise and 3% direction.

Volatility, therefore, is a matter of perspective. Are you watching the hummingbird or its wings?

I've charted the movement of the S&P 500 total return since 1950 from eight different perspectives in what I call a "whip chart." Each measure of risk and return is analogous to a different part of the whip.

Out at the very end of the whip is a bit of thread called the cracker, or popper. As all the momentum of the heavier whip flows into this light thread, it curls back on itself. The snapping sound comes from the cracker accelerating beyond the speed of sound, creating a tiny vacuum and sonic boom as the air rushes back in.

We can compare the cracker to the six-month activity in the market. On average the six-month movement is up 6.4%, equivalent to a 13.2% annualized return. For the sake of just measuring speed, we convert all the market movements into how far they would have moved at that speed over a year.

On an annualized basis, six-month returns deviate wildly, about 23.7%. The standard deviation (SD) measures volatility statistically, or how much room it takes for the cracker to snap. Approximately 68% of returns will curl around within 1 SD (±23.7%), 95% will fall within 2 SD (±47.4%) and 99.7% will fall within 3 SD (±71.1%). Stock market returns are by nature capricious and exceed the statistical norms for returns that fall outside of three deviations.

In fact, the past six-month period was more than 3 SD above average, earning 40.5% (97.5% annualized). And the six months preceding that were below 3 SD, losing 41.8% (66.2% annualized). Because six-month returns are compounded, when annualized the positive side multiplies and the negative side is diminished. Therefore the 3 SD isn't exactly ±71.1%. The 3 SD return is compounded as +89.2% to -55.6%.

Unlikely ups and downs like these are sometimes labeled "black swan" events. Or they may be described by the number of SDs they fall within. For example, because these two recent events are slightly more than 3 SD, they are called "four-sigma" events.

Four-sigma events should occur less than 0.3% if market returns conformed to a Gaussian bell curve, but they do not. The markets are inherently volatile. Market returns are better described by a branch of mathematics known as power laws. Instead of a neat statistical bell curve, these formulas are used to describe fractals where the same patterns can sometimes be wildly larger or smaller than the one you are looking at. Having just experienced two four-sigma events, these are not simply academic musings.

Every time the cracker pops, and the news is talking about how good or bad the markets are doing, should signal you to rebalance your portfolio. Having just finished a four-sigma positive market run, now is an excellent time to take some money off the table. The cracker snapped up, and if you rebalanced at the bottom your asset allocation now tilts more toward stocks. By rebalancing your portfolio you will reset your portfolio to an allocation ready for the next move of the whip.

Annualized returns are slightly better behaved, more like the "fall," a bit of unbraided leather at the end of the whip. Annual returns within one sigma range from +29.2 to -5.2%. The two-sigma range is +46.4% to -22.4%. And the three-sigma range is +63.6% to -39.5%.

The leather fall attaches to the braided thong with a fall hitch. And a knot called a keeper holds the braided thong to the handle. Just as each of these parts of a whip experience smaller movements, so the SD continues to diminish for returns over a year and a half (fall hitch), 3 years (thong), 5 years (keeper) and 10 years (handle).

The handle of a whip, our 10-year horizon, is much more manageable. The one-sigma range for an annualized 10-year return is +16.2% to +6.33%. The two-sigma range is +21.1% to +1.40%. Not until a three-sigma event can a decade-long return for the S&P 500 turn negative. The three-sigma range is +26.1% to -3.5%. The past 10-year return has been -0.8%

The 10-year return (the handle) swings more than a 20-year return (the arm), which moves more than a 40-year return (the shoulder). Volatility begins to lessen as you move further and further away from the end of the whip. From the perspective of a whipping cracker, volatility is extreme, snapping faster than the speed of sound. But if you are a fly sitting on the shoulder of the person wielding the whip, you haven't moved.

At every stage of the whip, the average trend is more than 11% positive. Picture the person holding the whip as riding an escalator that is slowly but constantly ascending. Despite the whip cracking up and down, the general trend is upward.

Rebalancing frequently recognizes and takes advantage of the volatility of this trend. Staying invested during market gyrations takes advantage of the escalator.

Why Life Insurance is a GREAT Investment

Ha! That title got you going, didn't it? :-)

No, I'm not losing my mind and abandoning index funds, I'm simply reiterating what seems to be the "new prevailing knowledge" espoused by the mainstream media -- that investing in insurance products is a great idea because it's "safe." For instance, consider this item from the "10 myths of investing's new era" piece on MSN:

Myth 6: Life insurance is not a good investment

This canard spread as 401k's and IRAs supplanted cash-value life insurance as Americans' most popular ways to build savings while deferring taxes. True, the investment side of an insurance policy has higher built-in expenses than mutual funds do. But two factors point to a revival of insurance as an investment. One is guaranteed-interest credits on cash values, which means that if you pay the premiums, you cannot lose money unless the insurance company fails. The other is the boom in life settlements. If you're older than 65, you can often sell the insurance contract to a third party for several times its cash value -- and pay taxes on the difference at low capital-gains rates.

Truth: A good investment is one in which you put money away now and have more later. Checked your 401k lately?

Think this is overreacting a bit? I do. Anyway, here's my take on the situation:

1. We had a once-in-a-generation (if not longer) economic meltdown and now "the rules have changed", right? Wrong. We did have a meltdown, but that doesn't mean we all need to run from growth in search of safety.

2. I think the key learnings from the economic tumble are that: 1) we all need a diversified portfolio (and the closer we are to needing the money, the safer investment vehicle you need it to be invested in) and 2) we shouldn't build our financial futures on expectations (like borrowing way too much for a house because we "know" it's going to go up in value.)

3. Re-read #2. Are these new learnings? Unfortunately, they are for much of America (and hence that's why our economy's in the tank -- too many avoided common financial principles in the past.) But for the rest of us with even a bit of financial sense, these really aren't new points at all.

4. Insurance as an investment can be a valid financial move under the right circumstances (just like almost anything can be.) Is it a great option for most people? Not in my opinion. But my opinion is worth what you paid for it (zero) and your situation may be one where investing through insurance products makes sense. As always, run the numbers for yourself.

5. Remember the relationship between risk and return. The more risk you take, the higher the potential returns. The lower the risk, the lower the potential returns. A few comments on these principles:

• Most people won't be able to retire on the very low (relatively speaking) returns offered by "safe" (or "safer", if you prefer) investments. You'll be saving for 100 years if all your money is barely keeping up with inflation.

• You'll need a blend of stocks, bonds, etc. to try and balance risk and return (you're trying to get a higher return without taking as much risk). This is what asset allocation is all about.

• As such, no one investment (insurance, stocks, bonds, gold, and so on) is the ONLY option for you today. Like in "days of old", you must be diversified (again, many people had to learn this the hard way).

Ok, I'm sure I missed something, so feel free to fill in the blanks. But I at least wanted to note that many of the "rules" of investing we've always had are still valid today, after the crash -- we just need to follow them.

Why Annuities Are a Bad Idea

The following is a guest post from Retirement Savior. I've recently covered annuities and wanted to do so again since any post on this topic seems to bring out a great debate on the subject. :-)

Summary: Are you sure that your investments will return greater than a lowly 3-4% over the long run?  If so, the guarantee of an annuity is probably more comforting mentally than financially.

A recent WSJ article had me thinking about annuities and risk avoidance. Because of the crisis, investors have had a huge interest in annuities both variable and fixed.   They are high-fee products that have been on the defensive in recent years, and justifiably so.

Fixed annuities are contracts that pay you a fixed amount based on a percentage of your principal investment for the rest of your life.  Variable annuities are basically a set of mutual funds sold by the insurance company where an investor accumulates investments over a period of time, in return for a percentage payout later on that can grow over time for the rest of the beneficiary's life.  They usually come with a minimum payment to compensate for any bad investments.  These products typically have high fees (1.33% average annual expenses according to 2009 Morningstar data, in addition to the investment fund expenses).

Investors feel more comfortable with these contracts because of the limited downside, but they do not have an understanding of the nuts and bolts of the issue. If the annuity company pays out 5% a year on the principal, then for an investor to believe that they are getting the better side of the deal, they must assume that they would not be able to invest the money on their own and take 5% withdrawals without the portfolio running out during their lifetime. If the average annuity fee is 2% per year after mutual fund expenses, this should be quite an easy target to beat. Take a minute and if you can beat a typical variable annuity:

• $100,000 accumulation investment, to begin payouts at age 60.
• 5% annual payout starting at age 60, with 3% payout increase per year from investment growth.
• Death at age 90.

The total payout over the 30 years in the above scenario is $250,013.39.

Imagine you invested $100,000 on your own. To get the same performance as the annuity above with the same payouts, you would need to have a 2.84% annual return net of fees.  Do you think you can get those returns after fees?  I thought so.  In fact, there should be no reason that a diversified, well planned portfolio shouldn't more than double those returns after fees.

You might say that I have made an unfair example, and that variable annuities can have much higher returns with investments in stocks.  I would disagree.  Consider that the fees (around 2% per year) are so much higher than you would have with ETFs, or that annuity withdrawals are taxed at ordinary income rates instead of long term capital gains rates.

Do not be fearful about your retirement savings, because with a well structured and disciplined investment plan, you can disregard annuities and make more money on your own.

Time to Rebalance Your Portfolio Again

The following is a guest post from Marotta Wealth Management. 

The S&P 500 over the past six months is up over 40%. You have had smooth sailing and are beginning to feel comfortable again. Don't. It's time to tack once more and rebalance your accounts.

Studies show that rebalancing your portfolio can boost your returns by as much as 1.6% annually. This rebalancing bonus is measurable but by no means guaranteed. It works best in choppy volatile markets with asset classes that don't move in sync with one another.

It is always a contrarian move, expecting the wind to change. But when it does, rebalancing can fill your sails again. However if the market continues moving in the same direction, there can be a rebalancing penalty. The past year has been a little of both.

During the 12 months ending August 31, 2009, the S&P lost 41.28% for the first 6 months and then gained 40.52% for the last 6 months to end down 18.25%. Remember that when the market loses 41%, it must earn more than that to return to its starting value. During that same time, the Barclays Aggregate Bond Index appreciated 7.70%. Averaging these two returns together gives a return of down 5.28%.

Imagine your portfolio as a catamaran with twin hulls. One pontoon is invested in the S&P 500 and the other in the bond index.

At the end of February at the bottom of the markets, your sailboat was down 19.00% and one pontoon was riding way out of the water. You have 64% invested in bonds and only 36% left in stocks. Without rebalancing, your portfolio has grown more conservative just when a more aggressive stance would be advantageous. By the end of the year your portfolio is only 5.28% underwater, and the imbalance is less pronounced at 57/43.

During the first six months, the markets were dropping precipitously and the stock pontoon was getting lighter by the day. Rebalancing means moving some funds from the relatively heavier bond side to the lighter stock side now riding high out of the water. As long as the stock side continues to lighten, moving more money in hurts returns. Rebalancing also seemed like madness, at least until the end of February when the markets bottomed.

Then after February, the markets began to rise and the bond side became comparatively lighter. Rebalancing in rising markets means you can begin to take some of those profits back off the table. Continually taking money out of equities while they get heavier again dampens returns slightly.

Yet because the markets changed course at least once at the end of February, rebalancing tended to improve returns. Doing so every month boosted them by a meager 0.15%. Had there been more reversals as a mix of positive and negative months, this rebalancing bonus would have been higher.

Monthly rebalancing isn't usually the best strategy. It is better to let the trend continue for a while and rebalance less frequently when the market is making new highs or lows.

If you were brilliant and rebalanced your portfolio after six months just once at the end of February, you only lost 1.08%. This move would have resulted in a 4.20% bonus over the negative 5.28% return of a buy-and-hold strategy.

The worst strategy would have been getting out of the markets near the bottom to cut your losses, the equivalent of dropping your sails and turning into the wind. Getting out of the markets at the end of February would have resulted in locking in a 15.98% loss. Even getting out at the end of November would have meant an 8.98% loss.

Rebalancing requires discipline. You set a target asset allocation for your investments and then periodically buy and sell different investments to stay focused on your objective. Without rebalancing, those categories that do well may continue to grow as a percentage of your portfolio until they significantly underperform the markets. The ones that do the best often bubble and finally burst. Rebalancing avoids this needless anguish.

Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). Decisions made at this level are the most critical in determining the course of your portfolio.

Even if you are creating a very aggressive portfolio, including some fixed-income investments actually increases returns. This strategy can keep your portfolio from capsizing. Stable investments provide some cash on the sidelines to buy stocks after a market correction, which both boosts as well as evens out your investment returns. Thanks to the effect of compounding, smoother returns produce better returns.

Periodic rebalancing is the simplest and most common method. Waiting for an asset category to exceed some threshold and then bringing the allocation back within some tolerances seems to produce slightly better returns and lower volatility. Although different ways of rebalancing can produce somewhat variable results, committing to a regular rebalancing plan is more important than the method you use.

Portfolios naturally grow out of balance as the wind and waves buffet your investments. Doing nothing risks keeling too much as one pontoon grows inordinately heavy and the other light. This hands-off stance risks capsizing an otherwise brilliant investment strategy. So given everything that has occurred in the markets, now is a good time to rebalance your portfolio.

How to Survive a Market Decline

Here are some thoughts from the great personal finance book Grow Your Money!: 101 Easy Tips to Plan, Save, and Invest. They give some thoughts on how to survive a market decline (timely topic, huh?) as follows:

• When in doubt, doing nothing is often best.

• Diversification is your best defense.

• Always remember that you are investing for the long term.

FYI, the book was written in 2008, so I don't know if he wrote this before the market meltdown or as it occurred.

Anyway, my thoughts on these are as follows:

• Many people, in their panic and haste, sell at absolutely the wrong time, thus compounding the market's problems by their own foolishness.

• If you have a plan and are invested for the long term, why should you do anything differently? In fact, if you believe in the market/economy in the long term and it's going down now, why wouldn't you buy more, if anything? That's what I did. And the index funds I purchased in the darkest days of the meltdown have done pretty well since then. That said, my net worth isn't where it was in the late summer of 2008, but I'm within 5% of my all-time net worth high, which in part has been aided by those funds I bought when the world was collapsing.

• I think we've all had a lesson the past year in why diversification is a needed part of every investment strategy.

For some additional thoughts on this topic, I suggest you check out 5 Strategies for Investing Properly, Cautiously, and Intelligently in This Bear Market. 

How to Buy Company Stock

Here are some thoughts from the great personal finance book Grow Your Money!: 101 Easy Tips to Plan, Save, and Invest. Their thoughts on buying company stock are as follows:

If you work for a company whose stock is publicly traded, it's way too risky to put more than a dollop of company stock in your 401k plan. The financial fortunes of some loyal employees have and will continue to be decimated by a plunging stock, a la WorldCom and Enron. Not only did many employees of failed companies lose most of their retirement savings, but they lost their job to boot.

If you want to own the stock, do so through the company's stock purchase plan. Many plans offer the stock at a discount that is too good to pass up even if you sell the stock shortly thereafter.

Unless you have a tremendous amount of money, try to limit your holdings of a single stock -- your employer's stock or and single stock, for that matter -- to 10 percent to 20 percent of your total investment holdings.

Here's my take on these thoughts:

1. I'm tracking with him 100% on buying company stock through a discounted purchase plan versus doing so in a 401k. I don't work for a publicly traded company, but when I did and had these options, this is what I did. We got the stock at something like a 10% discount, so I bought every time I had the chance. Then I sold the stock as soon as I was allowed to do so (I think there was a three-month holding period.)

2. I had always heard the rule-of-thumb was 5% to 10% of your total investments in your own company stock, with the preference being 5%.

3. What's this say about people like Bill Gates that have 99.9999% of their fortunes in one stock? Or does it even matter since they are tremendously wealthy?

Money Is a Drug

The following is an excerpt (actually, it's Chapter 1) from Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money, published FT Press.

In the summer of 2008, Rob Arnott’s research indicated there were problems ahead in the commodities boom. Arnott, founder of Research Associates, Inc., the giant Newport Beach-based money manager, is a quantitative investor as well as a contrarian who goes against the herd. His entire career has been built on finding ways to counter human emotions, including his own. His research but not his gut instincts told him that prices in commodities, including oil, had gone too far, and the future held more downside than upside.

This was not the conventional wisdom: Oil prices had surged by 300% between 2003 and 2007, and their climb upward seemed to only be accelerating. In 2008, prices crossed the once unthinkable $100 a barrel threshold, then $110, and finally brushed past $140 a barrel. Mainstream thinking held that the price increase was the result of changed fundamentals in the world economy. The newly awakened Chinese and Indian economies, with their nearly unquenchable thirst for raw materials, could only send the price of oil to higher and higher levels. Analysts who questioned if oil was in fact in the midst of an unsustainable price bubble were dismissed as bubble headed.

Arnott questioned his quantitative-based commodity. After all, the smart money, led by sophisticated institutional investors such as Harvard’s endowment, continued to pour money into oil. The continuing rise in price seemed to reinforce the wisdom of their decision. As Arnott admits, “I looked for ways to tweak the models, to fix them because the models were missing the huge bull market in commodities. That is what my intuition told me.” Arnott’s intuition, which was in conflict with the models, was wrong. The models had been right.

The price of oil soon crashed, but not before Arnott had sold his position. As an investor, he has trained himself to listen to his intuition—only to then do the opposite. “I use intuition, but in a warped fashion,” he says. If he feels comfortable about the direction his models are pointing him in, if they are in sync with his intuition, he immediately begins to worry.

He explains why so much of investing is nonintuitive: “The natural instinct is to follow others. As we were evolving on the plains of Africa, if everyone in the tribe starting running, you better start running. But in investing, if you act after everyone has starting running, you are catching the late end run of an asset and your timing will be atrocious.” For most investors, doing what comes naturally means chasing trends, doing what everyone else is doing. But although this makes sense in other areas of life, it is not a wise strategy for investing.

The easiest way for an investor to overcome this vulnerability is simply to build a natural skepticism to natural instincts. You don’t have to become a dogmatic contrarian—you just have to question your first impulse. Take, for example, a typical scene at a cocktail party. Someone brags about their fantastic investment. The natural reaction is to ask yourself if you are missing out on a great opportunity. The more skeptical and informed reaction should be to ask if the great past performance will continue into the future. Have you missed your window? Is it still attractive at current prices?

Arnott has trained himself to ask these counterintuitive questions when thinking about a new investment opportunity, and he feels everyone else can do the same. But he is merely one investor among many. And, the fact is, during the bubble years few investors showed this sort of skepticism—or any sort of skepticism. The entire world seemed intoxicated with money. It did seem like one big cocktail party, at least for people benefiting from the boom. With markets, as well as bankers’ bonuses soaring, why worry?

The cocktail party analogy holds a deeper truth about why investors may have suffered from impaired decision making and poor self control during these years before the crash. This was more than a simple case of minor intuitive errors in reasoning. Instead, according to MIT finance professor Andrew Lo, the real problem is traders literally were drunk on money. As Lo testified before Congress about the origins of the credit crisis:

“While this boom/bust pattern is familiar to macroeconomists, who have developed complex models for generating business cycles, there may be a simpler explanation based on human behavior. There is mounting evidence from cognitive neuroscientists that financial gain affects the same pleasure centers of the brain that are activated by certain narcotics. This suggests that prolonged periods of economic growth and prosperity can induce a collective sense of euphoria and complacency among investors that is not unlike the drug induced stupor of a cocaine addict....”

Lo, who is CEO of a hedge fund in addition to his work as an academic, has an interest in neuroscience. He has wired foreign exchange traders with biofeedback devices during the course of their work. When the market showed significant changes, so did the physiological response of all traders, but inexperienced traders were a lot more emotional when trading. For instance, they exhibited rising heart rates compared to the pros. For Lo, this indicates some emotion is necessary for decision making, but too much is problematic. (Neuroscience, though it has a different focus from evolutionary psychology, is consistent with and often supports the idea discussed throughout this book that humans have two decision systems—an intuitive one and an analytical one. Different responses exhibit different patterns of brain activation.)

I met with Lo at his office at MIT overlooking the Charles River. He was wearing sneakers, which made him look like either a trendy hedge fund manager or a down-to-earth academic. (Of course, he is both.) Lo explained to me how the way our brains are wired could lead to an economic crisis: “The situation had been building for 10 years. Everyone was making money all the time. Traders became confused because money was so cheap and risks were so hidden. Bond traders became caught up in a feedback loop.” It is Lo’s contention that the traders’ brains were affected by this loop. Financial success triggered the same neural circuits as by cocaine. Said Lo: “The same neural circuitry that responds to cocaine, food, and sex has been shown to be activated by monetary gain as well.”

As a result of their financial success, traders became inured to risk. In fact, they began to take on extreme financial risks—the financial equivalent of someone who is hallucinating stepping out of a 30-story building because they are certain they can fly. And to make matters worse, banks encouraged this risky behavior. Traders who refused to jump, were in effect pushed—or fired by their employers. Risk managers at large investment banks, in the months leading up to the crash, were sidelined or terminated if they warned the banks were taking on too much risk.

What this all suggests to Lo is the need for an external solution: a government intervention. If there is something hardwired in our cognitive processes that pushes us to excess, someone has got to stop us. Not everyone has the discipline to be a hyper-controlled investor and resist temptations that turn out to be damaging. Nor did financial institutions see any rationale to puncture the growing bubble. That leaves regulation as the mechanism society uses to prevent itself from indulging in self-destructive behavior.

Fire code regulation is a great example. Creating buildings with well-built emergency stairways, sprinkler systems, and clearly labeled exit signs is costly. This building infrastructure isn’t free. Why not leave it up to the market to choose which buildings are fireproof and which ones are not? Those worried about fires will pay more; those less worried will choose the second type of building.

Lo explained why, as a society, we haven’t left it up to the market to sort out this choice for us: “Left to our own devices, no would pay for the expensive infrastructure because when we walk into a building, our assessment of the likelihood of fire is zero,” said Lo. It is a cognitive bias. Intuitively, we underestimate the probabilities of this sort of catastrophe. But as a society, we have learned the hard way that people don’t worry about fires until after the fact. As a result, we put in regulation to ensure that buildings offer adequate fire safety.

The metaphor to financial markets and the crisis is clear. Here, we didn’t put in regulations to prevent banks from doing what they felt comfortable with in terms of risks. There was an inadequate “financial infrastructure” in terms of strong bank regulation and adequate bank reserves in place to protect the financial system in case of a catastrophe. Banks, left to their own devices, discounted this likelihood. They pursued aggressive trading strategies that seemed safe at the time, only to create conditions that led to a collapse in prices and an eventual fire sale of assets.

Errors in judgment, therefore, aren’t just ruinous to individuals: They can be damaging to society on the whole. A containable problem can quickly grow into something much worse—either a fire or a financial meltdown—if society chooses to ignore or discount people’s all too predictable biases.

Lo ended our interview on a poetic note, telling me that as a society, we need to look to Odysseus for guidance: “Just as Odysseus asked his shipmates to tie him to the mast and plug his ears with wax as they sailed past the Sirens of Circe’s island, we must use regulation as a tool to protect ourselves from our most self-destructive tendencies.”

-----------------------------------

My conversations with Rob Arnott and Andrew Lo were really about the same problem: investor irrationality. Arnott’s strategy is squarely focused on improving returns, asking what is best for the investor. Lo’s arguments are more macroeconomic, asking how these biased individual decisions add up collectively.

Later, I will turn to the macro issue of the role intuition played in creating the conditions that led to the financial crisis. I then explore how to build a stronger financial system, given the way humans really think and behave, including the need for better regulation. More immediately, I now turn to specific investments and how in a time of panic, rather than engaging in an irrational flight to quality, there may be more profitable ways to invest. These behaviorally based investing strategies are literally “counterintuitive.” They require overcoming your own initial instincts and taking advantage of others’ rush to snap judgment about investment decisions.

Investment Strategies Part 5: In Defense of Diversification

The following is a guest post from Marotta Wealth Management.

Diversifying your asset allocation among investments with a low correlation can and should reduce your portfolio's volatility and boost your returns. But critics are claiming this strategy is no longer valid. That's because they don't understand the nature of what happened in 2008.

Fickle followers of asset allocation point to the market drop in the fourth quarter of 2008 as evidence that diversification has been discredited. Every investment philosophy and asset class moved downward at the same time. They point out that asset classes are more highly correlated when stocks move down than when they move up. In other words, they complain that just when diversification was supposed to help, it failed.

So does modern portfolio theory need to go back to the drawing board? In many cases critics are not suggesting alternatives, but they are sure something else is needed. They see the trees but are missing the forest.

Correlation is measured mathematically and does not necessarily reflect a causal explanation. It is a fact that every investment class moved down at the same time. But you must understand why in order to evaluate ways to defend against it in the future.

Everything went down in sync because it is all denominated in dollars. The markets moved not because the markets changed but because the value of the dollar changed.

When all the financial institutions either had to deleverage or go bankrupt, they needed dollars for their very existence. The demand for dollars naturally went up. When the credit markets froze and financial institutions would not lend to each other because they suspected their collateral was toxic, the velocity of money went to zero. As a result the demand for dollars went up.

When the value of the dollar doubles, everything else denominated in dollars drops in half. Deflation sinks all ships equally. Everything consequently moves in sync, and correlations approach 1.0.

For example, take investments A and B. Imagine that A would have gone up 2% while B would have gone down 2%. These two investments would have had a correlation of −1.0. They would have been perfectly negatively correlated and provided diversification. But when the demand for dollars skyrockets and both investments are denominated in dollars, the result is very different.

In that case, investment A goes down 48% and investment B goes down 52%. The movement of the dollar swamps the relative movement of the underlying asset, and all correlations approach 1.0.

In my December 2008 article, "When Will the Markets Stop Dropping?" I wrote, "It is as though your next-door neighbor got into credit card debt and is now trying to pay it off. On his front lawn he is having a yard sale. His couch is going for $10, his good china for $20 and his plasma TV for $25. And you think to yourself, "That's the exact same couch I just paid $200 for, and my neighbor is selling it for $10!" In fact, you are amazed that the entire contents of your house have dropped in value.

"Diversification among household contents did not help because the financial institutions that are deleveraging also owned a nice diversified portfolio. Nothing is fundamentally wrong with couches, china and plasma TVs. The problem is that when a nation is deleveraging, everyone wants cash to pay off their debts."

No one wanted shares of stock because they needed cash to deleverage and survive. Financial companies wanted barrels of oil even less as oil dropped from $140 to $32 a barrel. The downward slide in oil and other commodities provides further evidence that the movement was a movement in the value of the dollar.

In other words, if you measure the market's return in dollars, it dropped roughly in half. But if you measure the market's return in barrels of oil, it doubled in value.

You can see additional evidence as the federal government began pouring trillions of dollars of bailout money first into the financial institutions and then salted liberally through government largess. The primary purpose was to devalue the dollar and therefore revalue stock prices. They wanted to stop deflation and reinflate stock market values.

So, assuming my analysis is correct, how could investor portfolios that are valued in dollars have been protected against a sudden and sharp demand for dollars? Well, the short answer is that with a few exceptions, they couldn't. It wasn't just a failure of diversification. Most other strategies failed worse. So-called balanced funds or target funds have seen a decade of losses. Because they have fewer equities, they didn't have enough growth in the decade before 2008 to remain positive. Only the diversification into small value, foreign, emerging markets and hard assets gave well-diversified portfolios a positive 10-year return. And ironically, the categories with the best 10-year returns are the same ones that dropped the most at the end of 2008.

We could liken searching for a viable strategy when the dollar suddenly doubles in value to looking for a safe location when the sun goes supernova. But in our case, what would have been trying to be safe in 2008 would only be extremely foolish in 2009. What is safe when the dollar suddenly doubles in value is extremely foolish when the government is relentlessly pouring out dollars to devalue it.

A recent Wall Street Journal article quoted Ibbotson Associates chief economist Michele Gambera about what he deemed safe in the event of such a nova. Gambera concluded that only a few asset classes other than cash proved helpful. They were gold, intermediate-term government bonds and Treasury Inflation-Protected Securities (TIPS). Well, there are few surprises in that list. Cash and cash equivalents are always a good investment when the demand for cash suddenly increases.

But sometimes cash and fixed-income investments are as equally risky as they were prudent this past fall. Now that the dollar is being devalued, cash is a risky investment. We recommend that at least half of your portfolio be protected against the risk of a falling dollar. You can do so with investments in foreign bonds, foreign stocks and hard asset stocks. One of the best ways to protect your portfolio, hard asset stocks as a class have also provided one of the best returns since 2002.

Gold is a strange category for Gambera to include in his recommendations. Investments in gold did not fare well in the last half of 2008. Gold prices topped $1,000 an ounce in the summer of 2008 and dropped to a low of about $700 at the bottom of the markets in November. It is true that during times of market turmoil many investors flee to gold and push the demand for gold higher. In the recent situation, however, crisis gold did not correct as much as the markets and has still not rebounded well. Although on average, gold doesn't appreciate more than inflation, it is still normally a safe store of value. Just not in the fall of 2008.

So how much of your investments should you allocate to cash, treasuries and other stable investments? Always keep five to seven years of spending in relatively stable investments. That will help you sleep well during a dollar crisis--at least for the next five to seven years! The remainder of your portfolio should be able to weather the duration of even this tsunami.

So is asset allocation dead? By no means. No better way exists to protect your investments. But all these events remind us that monetary policy, deficit spending and the actions of the Federal Reserve do impact currency stability.

The markets are inherently volatile, including the financial markets that trade loans. It was government intervention in the credit markets that helped put all our eggs in one basket. The Community Reinvestment Act (CRA) and government-run Fannie Mae and Freddie Mac contributed to the lending crisis. Their policies encouraged or even required financial institutions to make loans to those with little ability to repay. The unintended consequence was the shock of the imminent failure of our financial system and the sudden dive in the value of the dollar.

Recently, monetary policy is moving in the other direction. The markets are going up partly because massive government deficit spending is devaluating the dollar. Now is not the time to protect your assets against deflation. That tsunami has passed. The current danger is a backwash flowing in the opposite direction. Now is the time to protect your assets against inflation, and cash again may be the most dangerous asset category.

5 Strategies for Investing Properly, Cautiously, and Intelligently in This Bear Market

The following is a guest post from Stephen T. McClellan, author of Full of Bull (Updated Edition): Unscramble Wall Street Doubletalk to Protect and Build Your Portfolio.

This is a perilous period in the stock market; a deceptive bear market that disguises its downward drift. Beware of misleading Wall Street doubletalk, as it tempts investors into this dangerous bear market. The Street tends to discourage and even hinder proper investing. Its advice is unreliable and often contradictory. Professional insiders know better than to take the Street literally. To be an astute investor you must fathom the puzzling, strange, ambiguous ways of Wall Street that it would prefer to keep secret. Be a cautious, realistic, long-term investor. Preserving capital is paramount -- the most important investment strategy that I emphasize in Full of Bull. Entering this bear market is a risky strategy.

1. Keep Short Term Influences at Bay

The Street wants you to pay attention and generate commission trades on a regular basis, to create business. That is why it regularly alters stock opinion ratings and is always so optimistic. Brokers market stocks, analysts recommend stocks. They are not objective advisors. The investment world evolves around the exceedingly short-term trading mentality of Wall Street. So too the media. TV stock market programs need you to tune in everyday, every hour, to collect advertising dollars. The message had better be new and different every time you switch it on, to keep you interested. It is all about drama, ideas, news, and color to engage you. Companies and executives are similarly short-term focused. Their emphasis is on current quarter earnings results and managing Street and investor expectations low enough to "beat" the consensus. Keep these subjective short-term influences at bay. Put them in perspective. Pay some attention but do not let them be a consuming distraction.

2. Steer around confusing Wall Street gibberish. 

A Wall Street Journal headline recently declared, "AIG Corrects . . . " Given the Street's eternal optimism and favorable bias, it uses the term "correction" to indicate a stock-price decline. I always viewed this as absurd since the Street never labels a stock-price rise as a "mistake." Thus, I assumed the article pertained to the dive in the AIG stock. What a surprise. It was referring instead to a 24% rally in the shares and described "what analysts said was a partial correction from the stock's sharp decline in the first four days of the week." This is an ultimate example of the baffling Street terminology and guidance. You need to cut through this malarkey, correctly interpret Wall Street commentary and opinions, and avoid the pitfalls of inappropriate research guidance. Step back, think, ponder, observe, and take an intelligent approach to investing.

3. Understand that being wrong is part of the process.

A Wall Street pioneer and renowned investment consultant, Peter L. Bernstein, who passed away recently, lived through the boom and bust of the 1920s and had a 70-year career as a Street portfolio manager. When asked what was the most important lesson gleaned during his seven decade run, he was emphatic -- the idea that " You can figure this thing out. You have to understand that being wrong is part of the [investing] process." His approach was always to consider the consequences if the investment decision is wrong. His strategy was to take big risks only with small amounts of capital, and only take small risks with big amounts of money. Investors must avoid incurring whopping losses. Have the discipline to reassess if a holding declines by some 20%. The economic and stock market outlooks are ominous. Investors should take a guarded stance.

4. Know that bear markets regularly tempt investors to wade back in.

During bear markets, each time there is a precipitous drop, it is followed by a modest recovery, masking as the beginning of a new bull market. Do not be deceived into believing that such bear market rallies are the outset of a new bull phase. Alan Abelson pointed out in Barron's that the new buzz word on the Street was "exit strategy," as the market faded following the March-April bear market rally. His view is that investors could have avoided this necessity with better foresight, that is, with an appropriate "entry strategy."

5. Beware of dead-cat bounces. 

Even a dead cat will bounce if it falls far and fast enough. Any stock or market that drops similarly will experience a rebound at some point. After single-digit declines four quarters in a row, the stock market nosedive worsened to double-digits in the fourth quarter last year and again in the first quarter earlier this year. So a spring back in the second quarter was a reasonable occurrence. But it was hardly the beginning of a sustained recovery. The market could still easily plummet by at least 10% as the bear market endures. A reasoned, conservative investment approach precludes jumping into stocks given the hazardous conditions. However, this is not the counsel you will hear from Wall Street.

Use Wall Street's information and research content, not its conclusions or recommendations. Do not be fooled by the Street. Successful, long-term investors focus keenly on investment entrance strategy and conservative management of capital. It is not what you make, it is what you keep. The Street pays little heed to risk, the possibility of permanent loss of capital, in the pursuit of big gains. But an intelligent investor should seek consistency rather than outsize gains, and always pay attention to protection of capital, especially in these precarious times.

Your Home Never Was an Investment

A couple years ago I asked if your home was an investment or not. The main question was whether or not you should count on your home to deliver good, solid gains over its lifetime (like you'd expect from an investment) or if it was simply a place to live and possibly get moderate gains, but not expect much more. As you might imagine, opinions were divided on the subject.

The reason I'm bringing it up again is that I found this Wall Street Journal piece that says home ownership never was a road to riches. A summary of their thoughts:

Columbia Business School’s Christopher Mayer, who has studied housing markets, says our experience with home-price gains is pretty typical. Home appreciation nationally has run about 1% above inflation over time.

The big price run-ups from the late 1990s through 2006 or 2007 were an aberration. The biggest value you derive from home ownership isn’t appreciation. “It’s being able to live in it,” Prof. Mayer says, and avoiding the rent you would otherwise have to pay.

Once you add in imputed rent and subtract property taxes, Prof. Mayer estimates, my 2% annual home-ownership return looks more like 6%.

That’s why you should buy as much home as you need—but no more. A bigger home than you need isn’t an investment—it’s an extravagance, the equivalent of renting a bigger apartment than you need. You may choose to do so, but that doesn’t make it a smart move financially.

A few thoughts on this topic from me:

1. 6% isn't bad these days. Then again, compare it to what stocks can/should do over the long-term and it's way below "investment" grade.

2. I think home ownership is an investment of sorts as it's part of your overall asset allocation. As such, owning at least a basic home is part of a good investment strategy (when looked at from a broad perspective) IMO.

3. That said, you don't need to buy more than you really need. As I've shown, it can be really costly to do so.

4. My general feeling is that you should use my formula for buying a house -- a home that fits your needs and budget -- and use the surplus to invest (versus socking most of your savings in your home) if you're seeking to maximize your net worth.

Of course, if you simply want a bigger/more expensive home and can afford it, then go for it. Just don't count on it earning you what you'd get from alternative investments.

Your Job, Your Investments, and Total Diversification

The following is a guest post from Vik Tantry, the voice behind Kanjoh, a directory of free videos explaining the fundamentals of asset allocation, personal finance, and banking. The thoughts below are interesting concepts, similar to what I've shared in This Seems Like a Bad Idea to Me and Ouch! Here's a Reason You Need to Be Very Conservative in Retirement Planning.

Diversification is important for most individual investors. We hope to reduce risk by investing in a wide variety of asset classes. However, in designing our portfolios, we often ignore one of our most important assets: our job and career.

For most people, their job is their primary source of income. Income potential in a job is largely driven by profit and growth within the industry. But what if things start going badly and it becomes harder to make ends meet? In this case, it would be great to have some investment gains to offset the loss in income. This will help smooth out an investor's cash flow over the long run.

How can this be achieved? Let's illustrate with an example. Phil is a real estate broker with more than twenty years of experience. He understands the ins and outs of the real estate market, and knows that real estate tends to move in cycles. When times are good, he will be able to generate significantly more income than when things get bad. Therefore, to smooth out his returns, Phil devotes a small percentage of his portfolio to short-selling a local real estate investment trust, a fund that actively buys and manages local properties.

In the boom years, Phil's income goes up due to an increased number of sales, while his short position will result in a loss. However, if the real estate market goes south, the short position will start increasing in value. This capital gain will help hedge away some of Phil's loss in income. As a result, Phil can sleep soundly knowing that he has at least some level of protection against a market collapse.

This strategy of "betting against your career" seems counterintuitive. Many of the most successful investment managers recommend "investing in what you know." After all, you are likely to make more informed decisions if you understand the context of an investment opportunity.  While this may be true for professional, full-time investors, the next example illustrates that this strategy can in fact lead to a dangerous level of overexposure.

Like Phil, Josh is an experienced real estate broker who understands the fundamentals of the industry. Josh decides to use his knowledge to speculate on the local real estate market. He starts by purchasing one house, then two, and then five. Because the market is going up, Josh can easily borrow the money to finance his investment decisions.

But all of a sudden, the local market experiences a sharp decline. In the course of a year, Josh's properties fall nearly 30% in value. He would incur large losses if he sold right away, so instead he chooses to continue making the monthly mortgage payments. However, the rough market makes it difficult for him to sell houses. The decrease in income, high monthly payments, and decline in housing value all lead to a cash crunch.

Hedging against loss of income is not limited to the real estate market. Software engineers should protect themselves against a tech bust, and financial analysts should hedge against banking collapses. After all, the last thing you want is to lose your job and savings in one fell swoop. Instead, a carefully constructed strategy of considering your job as part of the investment decision can help avoid such calamities and reduce your overall risk.

Safeguard 8: Avoid an Advisor with a Lavish Lifestyle

The following is a guest post from Marotta Wealth Management. After reading this, you may want to check out my thoughts on how to pick a financial planner.

There will always be swindlers masquerading as investment advisors. You can learn to recognize such people by their over-the-top lifestyle. Avoid them at all costs.

The differences between the manager of a Ponzi scheme and a model citizen are almost imperceptible, which is not surprising. Those who would perpetrate a Ponzi scheme are usually not the demons everyone makes them out to be. And they are obsessed with appearing successful.

This fixation on appearances, however, is the red flag. If you are the millionaire next door, you know that frugality is one of the marks of an effective financial advisor.

But you may have to train your eye to recognize an immoderate lifestyle. If someone in business is worth $300 an hour, some apparent extravagances may in reality be productivity gains.

For example, if you hire a chauffeur to drive you to and from work each day so you can be productive, society gains. If you hire a gardener so you can continue contributing in your area of expertise, society gains. And if you hire a butler or a chef, so long as you employ someone else for less than $300 an hour, society gains.

Productivity gains are not synonymous with a lavish lifestyle, and with some careful observation you can learn to discern the difference. Productivity gains are all about function, and if you discover them you will find out accidentally. In contrast, the whole purpose of an extravagant lifestyle is to be noticed.

Consider Bernie Madoff. He and his wife lived in a $7M penthouse apartment in New York City and a house worth $3 million in the Hamptons. They also owned a $9.3 million Palm Beach mansion. Plus they maintained a $1M million chalet and two boats on the French Riviera.

They spent an average of $100,000 monthly on the corporate credit card on chartered jets, limousines, top hotels, fine wines, world travel and shopping. When they drove themselves, they rode in style in a BMW and or one of two Mercedes. Madoff bought a vintage Aston-Martin for his brother as a company car. The couple owned a Steinway concert grand piano worth $39,000. Madoff purchased tickets at the Mets Citi Field at $40,000 a season.

Madoff was also a prominent philanthropist, but his interests were anything but altruistic. He started the Madoff Family Foundation and gave to charities, which in turn invited him to serve on their boards. Madoff then invited them to invest their endowments.

He and his wife also gave more than $200,000 to the Democratic Party. He gained high-level connections to those in Congress who write the laws and are supposed to provide regulatory oversight. Madoff was one of the first to exploit kickbacks for brokerage order flows. He argued they should remain legal and not alter the price that customers received. His connections prevailed.

The Madoffs themselves owned $62 million in securities and $45 million in municipal bonds. They loaned their sons $22 million and $9 million, respectively. Oddly enough, having siphoned billions, the couple only has a net worth of about $823 million.

Wealth is what you save, not what you spend. That's why an ostentatious and excessive lifestyle is a red flag for an investment advisor. The middle class buys liabilities like boats and cars. The rich buy investments. If Bernie Madoff had bought businesses and investments, he would be able to make restitution of those initial investments. He might even be able to pay a fraction of the gains he claimed to have.

We all wonder what happened to the $65 billion. Much of it was phantom gains, and a lot of it was simply spent a million here and a million there. Excessive spending is a warning sign that your advisor doesn't understand wealth building personally.

In April this year, the Securities and Exchange Commission (SEC) charged Shawn Merriman of Aurora, Colorado, of collecting $20 million in a Ponzi scheme "to support his lavish lifestyle." He lied to investors, reporting "impressive and consistent annual returns" as high as 20%.

Merriman was known for showcasing his high-end art collection. U.S. marshals seized hundreds of works of art including some by Rembrandt and Picasso from his sprawling three-story home. Also seized were a silver Aston Martin, 1932 and 1936 Auburns and a 1932 Ford Highboy.

This spring the SEC also filed charges against Pennsylvania advisor Tony Young for allegedly stealing $23 million from investors to "support a lavish lifestyle for his family, including payments for expenses related to horse ownership and racing, construction, boats, limousines, chartered aircraft and other luxuries." That lifestyle included an opulent vacation home in Palm Beach, Florida, near the Madoffs' vacation home. Young also lied to accountants who prepared statements and claimed his losses in 2008 were only 5.8%.

Ponzi schemes are often discovered after market downturns when investors make the mistake of fleeing to safety. They want to take their stellar returns and put the money someplace safe while the storm blows over, only to find that no money is really there.

Additionally, the news cycle runs in themes. After the Madoff scandal, every Ponzi scheme became national news. The theme, played over and over, is that all financial services, from Fannie Mae to AIG, are rife with corruption and mismanagement and need more government regulation.

But more control won't protect you from dishonesty. More law can't protect you from an unethical person. Fannie Mae and Freddie Mac had direct congressional oversight. Madoff was good friends with the regulators. Regulation is more likely to be used politically than responsibly.

Your best defense is to engage an advisor whose daily practices reflect ways to safeguard the money under his or her fiduciary care. As part of identifying such an advisor, make sure there is a mutual understanding that an ostentatious lifestyle is not a valid financial goal.

Wealth Without Wall Street

The following is a guest post from The Insider's Guides.

“Wall Street's world turned upside down”

These were the headlines in 2009.

Wall Street financial management has proven itself worthless. Bill Gross was right. “Professional money management is a gigantic rip-off.” Only 2 advisors provided their clients with the correct advice about the total collapse of the market in 2008-9. In one year, most money management clients have seen their accounts plunge 40%, 50% even 70%. No advisor has fired him/herself. No advisor has returned their advisory fees and commissions. In fact, most advisors hid from their clients during the worst of the storm, as acknowledged by Fidelity executives in May 2009.

The naked truth—YOU must build wealth without Wall Street.

What to do?

Look at Wall Street “turned upside down.”

• First, when money managers buy and sell securities in their mutual and hedge funds, they are trying to predict the future of the market. There is no proof this can be done over time. Yesterday’s winners are usually tomorrow’s losers. The AVERAGE market return has been 12%, so a few managers will beat the average by luck—Just not the same ones every year.

• Second, you must pay the costs of the manager, her/his marketing group and operations, whether or not s/he makes you a dime. It is always better to pay as little as possible for the same performance over the long term. Costs can take up to 33% of your returns, over time. Investors averaged only 2.57% annually from 1984 through 2002 despite buying the ‘winners’ at the top.

• Third, managers are paid for increasing “ASSETS under management,” not for making you rich. Bringing in more assets is a full-time job. It is expensive to market the funds given that there are now thousands available. It is inevitable that popular funds will grow until they produce average returns with high expenses. Managers want to be rich, not right.  It takes luck to pick successful stocks. You do not benefit from economies of scale. As assets grow, fees do NOT shrink.

• Fourth, there is much less chance of you being treated poorly by fund management if the structure and governance are customer-oriented like Vanguard’s and TIAA-CREF’s are.

• Fifth, many professional managers and Wall Street “insiders” place their core assets in index funds. As bond guru, Bill Gross, said, “professional money management is a gigantic rip-off.”

• Sixth, since no manager can consistently beat the market, a mutual fund or hedge fund for that matter, must be evaluated as a commodity. Commodities are usually judged on price. As Benjamin Graham, legendary value investor, said, “Investors should purchase stocks like they purchase groceries—not like they purchase perfume.” Actually, all financial services should be purchased this way—insurance, mortgage, credit, banking.

• Seventh, due to changes in access and technology, some manufacturers of financial services and products have decided to enhance their direct to customer channel. Even though Vanguard funds have not been sold by personal selling, it has grown to rival most fund complexes. Discount brokers are now considered to have better customer service than brokerage firm services, according to Consumer Reports. Even though Progressive Insurance is sold by agents, their success in the direct channel has been impressive. 

• Eighth, Wall Street cannot reduce the risk of investing. Most individual investors have lost 30% to 50% of their life savings in the last Wall Street bubble. Many investors now realize that Wall Street is selling snake oil. Even the promise of diversification has left many realizing that “experts” can’t control risk.

• Ninth, Wall Street used to control price—raising the price of investing to grow revenue directly lowers investor returns. The advisor or fund with the highest price does NOT guarantee success: only expenses to investors. 

Investors can now control the price. We can use low-cost mutual funds and brokers. Since Wall Street cannot predict the markets and we don’t know if stocks will outperform all other assets over time, we must take the Pascal wager:

Pascal’s wager: The consequences of not being in the markets are worse than being in it for the long haul. Buying the market returns at the lowest price is the best solution for long-term wealth-building. You are better off without “professional” advice.

Example: Member Ron Delaney of New York will gain $400,000 because he asked about his 401k plan. Mutual fund fees are the largest source of overcharges—$400,000—over time. Ron did not believe pension costs were as high as we said. He asked his HR person about the costs of his 401K plan. He received a packet of materials. Finally, he calculated that his annual expenses were 2.1% and his annual fee was $50. His plan offered index funds for just 0.70%. He picked which funds he needed and saved $2,800 ($4200-$1400) every year. By the time Ron retires, he may have added an extra $400,000 to his 401k.

Your choice is clear—avoid Wall Street. Their “advice” is just marketing hype. Their research exists to sell their products. Take the advice of unbiased advisors like master investor Warren Buffett,

By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.  Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.

The Psychology of Why People (Used to) Hate Annuities, Part 2

The following is an excerpt from Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money by David E. Adler. This is a fascinating book about the psychology of money and how our instincts and emotions often harm us when we make investing decisions. The excerpt below is part two of a two-part series (part one was posted earlier today.)

Annuities

There are rational reasons to buy an annuity when you retire. The foremost is you don't have to worry about outliving your money. With a guaranteed check coming in each month, you need never live your final years in poverty. On top of this, annuities also have the potential for higher returns than from traditional investments because of their inbuilt insurance features—if you survive that is. For people who make it into their 90s, the income from an investment in traditional assets would only be 40% compared to the income from the same amount of money spent on an annuity. The fact that people aren't necessarily good at handling their money once they have retired makes the arguments in favor of annuities even more compelling. This is why the wildly enthusiastic consensus among most economists, to say nothing of the insurance industry, is that annuities are a great thing.

But the consensus among the public is that annuities aren't so hot: Only a tiny fraction of people buy them. Many people hate annuities, which puzzles academics. Hence, economist Franco Modigliani, in his Nobel Prize acceptance speech, said, "It is a well-known fact that (individual) annuity contracts...are extremely rare. Why this should be so is a subject of considerable current interest. It is still ill understood."

It is no longer so "ill understood." The answer has to do with human psychology. Annuities, until recently, were a bad match for what most people, as opposed to most economists, worried about. One rational reason not to buy annuities is they tend to be very expensive, with the pricing opaque and hard to figure out. Also, they make the most sense if you plan to live a long time, and therefore attract people who are unusually good at doing this. Insurance companies have noticed, and priced annuities accordingly, meaning they are costly. They aren't actuarially fair, and the pricing favors the long lived instead of the general population. And they have some risks: Because they are contracts with individual corporations, if the insurer goes bust, there goes your annuity. Finally, annuities are complex and hard to understand, and people don't like complexity. The complexity starts with the name, with many things called an "annuity" that aren't annuitized. For instance, insurance companies offer products with annuity in their name that really resemble mutual funds: You don't have to surrender your principal and they don't guarantee lifetime income. The annuities I am referring to are "life annuities"—irrevocable insurance products that in exchange for a payment offer a minimum level of guaranteed income that lasts a lifetime.

The central problem is framing: Consumers view annuities as risky gambles rather than insurance. If we die early, we lose; if we live a long time, we win. Economists, and insurance companies, view annuities as insurance: not against dying but against the risk of outliving your wealth. They call this longevity risk—the risk that you live longer than you expected and have budgeted for. Anyone else would consider living to a ripe old age a good thing. Not economists who fret about all the financial dangers involved, which can be mostly taken care of by annuities.

This brings us back to Jeffrey Brown's framing experiment. Says Brown, "If I think about how much money I have in a bank, then an annuity looks horrible. I am giving up a lump of wealth and whether I get it back or not depends on how long I live; so it seems risky. But if I think about how much I am going to be able to spend every day, then an annuity looks great."

Insurance companies are well aware of our psychological problems with annuities, and current behavioral economics research into this area. Their psychological insights are allowing them to engineer products that meet consumer's psychological as well as financial needs. This includes "reframing" our perception of annuities by highlighting their insurance features. Some annuities are now explicitly offered as longevity "insurance"—these are usually ones designed to kick in very late in life, at 85 plus. Or another idea is to link an annuity to long-term care insurance, a sort of two-for-one product, addressing two big concerns of the elderly: cash flow and healthcare. Variable annuities try to emphasize growth and income, appealing to our desire for both. The biggest changes are in "guaranteed death benefits." Insurance companies are trying to take the "gambling with your life" feature out of annuities, through guaranteed death benefits. The idea is you, or rather your estate and beneficiaries, get the money back if you die before the annuity has kicked in. In fact, the development of annuity products is so rapid and extensive, much of it based on applications of behavioral economics, that insurance companies, once seen as plodding and dull, are at the center of financial innovation. It looks like they will succeed in making annuities popular.

But I still see challenges ahead because there is one remaining big psychological—and real—problem with annuities, and that is control. If you buy an annuity, you give up control of your money. Maybe the insurer will let you buy the annuity back, but such a rider is extremely expensive. And a true annuity is irrevocable. "Irrevocable" is not an easy concept or word to swallow. Once you buy an annuity, the money is no longer yours. Before you had, say $1,000,000. After the purchase, it now is the insurance company's. You get a check every month, but you no longer have the $1,000,000 to play with.

Even though an annuity reduces the risk you won't outlive your money, there are other risks to worry about, like the risk you won't have enough money exactly when you need it, if you get really sick, for instance, or have a sick grandchild. It doesn't have to be so morbid: You might prefer the flexibility of playing with your money. For all I know, you might have the desire to buy a $15,000 bottle of champagne and spray it around a nightclub, or go on a mega shopping trip to Dubai and end up broke afterward. These might be your desires. But it would be hard to live your dream on your carefully doled out "oldster" allowance in the form of an annuity from your insurance company.

So the question comes down to this: Do you want all your consumption needs insured in the form of annuity, or just some or maybe none of them? I don't think this is about being rational versus irrational; it's just a matter of your tastes, how you want to invest your money, and how you want to spend it.

The Psychology of Why People (Used to) Hate Annuities, Part 1

The following is an excerpt from Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money by David E. Adler. This is a fascinating book about the psychology of money and how our instincts and emotions often harm us when we make investing decisions. The excerpt below is part one of a two-part series. The second part will run later today.

Take the following retirement quiz about two people who have made permanent decisions on how to spend a portion of their money in retirement. Which sounds like a better deal to you?

Quiz #1

Each person has some savings and can spend $1,000 each month from Social Security in addition to the portion of income mentioned in each question. They have already set aside money to leave for their children when they die. The choices are intended to be financially equivalent and based on personal preferences for spending in retirement.

Mr. Red: Mr. Red can spend $650 each month for as long as he lives in addition to Social Security. When he dies, there will be no more payments.

Mr. Gray: Mr. Gray can choose an amount to spend each month in addition to Social Security. How long his money lasts depends on how much he spends. If he spends only $400 per month, he has money for as long as he lives. When he dies, he may leave the remainder to charity. If he spends $650 per month, he has money only until age 85. He can spend down faster or slower than each of these options.

Results: How did you answer? It is likely that you felt Mr. Red had a better deal than Mr. Gray. His consumption was guaranteed for life whereas Mr. Gray risked running out of money after age 85.

This financial quiz (actually a psychological experiment) was developed by the economists Jeffrey Brown, Jeffrey Kling, Sendhil Mullainathan, and Marian V. Wrobel, who wanted to understand what factors went into people's retirement decisions. They found the majority of participants when presented with this exact choice preferred Mr. Red's situation to Mr. Gray's.

Then the economists varied the experiment slightly. They rewrote the setup paragraph using new language and new descriptions, which conveyed a slightly different message. They tested it on a new group of participants.

Here is their new quiz. Try taking it. You might not change your answer because you have already seen the original version. Nonetheless, try reading the introductory paragraphs slowly and carefully, letting it put you in a new frame of mind before making your decision.

Quiz #2

Two people have made permanent decisions on how to spend a portion of their money in retirement. Which sounds like a better deal to you?

Each person has some savings and receives $1,000 each month in social security, in addition to the portion of savings mentioned in each question. Each person has chosen a different way to invest this portion ($100,000) of their savings. They have already set aside money to leave for their children when they die. The choices are intended to be financially equivalent and based on personal preferences for investing in retirement.

Mr. Red: Mr. Red invests $100,000 in an account which earns $650 each month for as long as he lives. He can only withdraw the earnings he receives, not the invested money. When he dies, the earnings will stop and his investment will be worth nothing.

Mr. Gray: Mr. Gray invests $100,000 in an account which earns a 4% interest rate. He can withdraw some or all of the invested money at any time. When he dies, he may leave any remaining money to charity.

Results: The majority of people who took this quiz said Mr. Gray had a better deal.

Quiz #1 and Quiz #2 are, of course, exactly the same in financial terms. But in psychological terms they couldn't be more different, because of the differences in language and descriptions. In the first quiz, everything is presented in terms of consumption: Mr. Red and Mr. Gray spend the money. When taking the quiz, you are confronted with the consumption consequences of financial decision. The second quiz emphasizes investments. It uses words such as invest and earnings. It mentions the account balance. When taking this quiz, you think about the return on the investment.

Psychologically, these differences in perspectives are known as frames. The underlying information is the same, but we filter it and make our decisions depending on how the choices are couched. When the financial decision is framed as a consumption decision, Mr. Red's guaranteed spending money looks the good deal. When the financial decision is framed as an investment decision, Mr. Gray's opportunity to invest his money looks like a better deal. In another words, context can be as important as content when it comes to financial decisions, even very important financial decisions.

I spoke to Mr. Brown (this is beginning to sound like a Quentin Tarantino gangster movie where each character is named after a different color, but here I am referring to the eminent economist Jeffrey Brown of the University of Illinois who cocreated this experiment). He said this of his results: "Traditionally, economists have had the underlying view that people are hyper-rational and are trying to maximize their happiness (what economists call utility). If you believe that, then how you package the information shouldn't impact their decisions. But you have huge swings in how people behave depending on how the information is packaged."

The larger point of the experiment is not just that framing has an impact; it is specifically about how retirement planning is "framed" in the U.S. and how we are conditioned to think about it. Should our financial focus be on building wealth for retirement, or on what we can consume after we retire? Is the right measure of financial success how much wealth we have when we retire? Or how much we can spend each month after we retire? Like the quiz, these are different ways of looking at essentially the same problem.

It is Jeffrey Brown's contention that we have been conditioned to think about retirement as mostly an investment decision, similar to quiz #2. Whereas he feels thinking about retirement as largely a consumption decision, similar to quiz #1, is more appropriate. Says Brown, "The messages that individuals receive when encouraged to save are all about how much you have in your account and your rates of return. But really you should think about how much can you eat each month, how much can you consume." This subtle conditioning or "framing" has a real result when we retire. Most people see themselves as Mr. Gray and choose the investment solution. However, most economists feel we should be in a consumption frame of mind, and follow Mr. Red's choice.

If it is not already clear, Mr. Red has bought an annuity: $650 a month. The experiment is an attempt to explain why annuities are so unpopular, despite their many economic advantages.

--------------------------------------------

Part two of this piece will post at 7:15 pm today Eastern time. Update: Here's part 2.

Safeguard 7: Avoid Investment Advisors Who Sugarcoat Reality

The following is a guest post from Marotta Wealth Management. If you'd like to read any of the first six safeguards, you can find them here.

We've already discussed the many ways you can safeguard your money. But these methods cannot protect you from an unscrupulous advisor. My brother, who is a lawyer, has a saying we must all take to heart: "You can't do a good deal with a bad person."

Morality can be described as a continuum from pure altruism to unadulterated self-centeredness. All advisors have their shortcomings, of course. But excellent advisors work hard to cultivate certain traits, and among them honesty is paramount. This quality in an advisor includes communicating clearly and straightforwardly exactly how bad the markets have been and can be.

Advisors naturally want to look good, and you must overcome your own desire to have a good-looking advisor. You need the truth. You can handle the truth, and without it, you certainly can't make realistic financial plans.

The markets are profitable. The markets are volatile. You can't pick just one. Even in our recent financial meltdown, I believe the wisdom of rebalancing back into fallen markets will be vindicated. But you still need to know the facts.

There are certain red flags to watch for with advisors, ways they may try to circumvent the tough honesty you need. I include both what conscientious advisors should do for their clients, as well as how financial salespeople hide their mistakes.

Ask your advisor to provide a return for your entire portfolio, not just the underlying investments. Reporting how each investment did doesn't show how you did. Your advisor can buy an investment at the very end of the quarter and then report it did well during the entire quarter. Or your advisor can sell investments that are not doing well toward the end of the quarter. These changes do nothing for you, but they help an advisor who doesn't report a return on your entire portfolio look successful.

Also, advisors should give you an accounting of your return net of all fees and expenses. Any fund expenses, fees, commissions or trading costs diminish the bottom line of the return. Only by receiving information at the portfolio level can you measure the net effect of every expense you were charged.

Always insist on a time-weighted return (TWR). Returns can also be dollar weighted, sometimes called an internal rate of return (IRR). Often the IRR looks better. It is possible for the TWR to be negative and the IRR to be positive.

A TWR removes the effects of cash flows, which allows you to judge how your advisor's underlying investment strategy performed. If your advisor reports both, that's fine. But he or she should include the TWR as well, which is considered the industry standard and allows you to compare apples with apples between two different strategies.

Returns should be reported consistently over standard and preestablished time periods. In addition to the quarter that just ended, our firm reports year-to-date, the past 18 months, and the returns gained since we began to track the portfolio. We chose 18 months because it is the shortest time period that is still long enough to discern significant market trends.

One year isn't long enough to eliminate market noise. We've considered adding three- and five-year returns, but whenever an advisor changes the time periods reported, it is cause for concern.

The bottom of the last market occurred in October 2002, so three-year returns started looking good in the fall of 2005 and five-year returns in the fall of 2007. The recent market downturn provides an opportunity to report these longer time periods without arousing suspicion that these intervals are being changed simply for window dressing.

Getting an accurate accounting of your portfolio's return shouldn't be optional. If your advisor can't supply it, perhaps it means they don't know themselves or don't consider it important to their recommendations. Unfortunately, many so-called advisors in the financial services world would prefer to focus instead on how their own fees and schedule of commissions are doing.

Even if you safeguarded your money in the many ways we have suggested, you should also insist on only entrusting your money to an advisor who regularly reports what total TWR, net of all fees and expenses, your investments have made for the quarter and for longer periods of time.

The Psychology of Selecting Mutual Funds

The following is an excerpt from Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money by David E. Adler. This is a fascinating book about the psychology of money and how our instincts and emotions often harm us when we make investing decisions.

How do we pick a particular mutual fund to invest in? The answer is very simple: Its performance last year, last quarter, or even last month. Of course, advertising helps, too, but "returns-chasing behavior" as it is technically known, pretty much captures our actions when it comes to mutual fund choices. The #1 fund in the country last year in terms of performance will be near or at the top of mutual funds attracting the most new investment dollars.

And performance here means absolute raw performance, not adjusted for risks, fees, taxes, or compared to a benchmark such as the S&P 500. If it makes more money than we paid for it, we see it as a winner, even if the S&P did much better. Alternatively, if a mutual fund is below what we paid for it, but every other investment is doing significantly worse, we aren't impressed.

But after we make our performance-related investment choice, our one moment of action, we as investors appear to go to sleep. Our inbuilt inertia and apparent passivity when it comes to investing take over. We open an account and then sit on our hands. The fund may stumble, but we don't seem to react. We leave our investment where it is. Most investors don't reallocate from low-performing to high-performing funds, even within their portfolio. Returns-chasing behavior, therefore, only goes in one direction: We give new assets to high-performing funds, but leave old assets with the underper-forming managers. An unattractive analogy is to roach motels: We check in, but don't check out.

This returns-chasing behavior is seemingly hardwired in humans, from the most naive individual investors to the most sophisticated institutional investors. Everyone does it. It is why hedge funds, which may have had their highest returns in the 1980s and 1990s (although no one knows for sure), became such a popular investment a decade later, even though their best days were probably long behind them as a strategy. Financial planners, in surveys, say they don't chase returns, but an analysis of their investment choices by Daniel Bergstresser of Harvard Business School found plenty of evidence of it. And we know that returns chasing is what drives individual investors in their choice of mutual funds.

Returns chasing isn't automatically a bad strategy. In most circumstances, learning about the track record and history of what you are investing in should be valuable information. Even so, as every investment prospectus warns us, in a rare moment of clarity, "past returns are no guarantee of future returns." This is true, but do past returns tell us anything about future returns when it comes to mutual funds? They do, but not in ways we might assume.

Performance and Persistence

Alpha is the catchphrase bandied about by hedge fund managers and other finance types as shorthand for their market-beating performance (in another words, their skill). Sometimes called "Jensen's alpha," it is a technical measure of the "excess return" on an investment compared to what the market would give you, adjusted for risk. For hedge funds, alpha is their mantra, their obsession, maybe even their mojo. It's everywhere in their speeches and publications and the names of their conferences. They call each other "alpha" males. Mutual funds managers keep a bit quieter about alpha, but nonetheless mention it, too.

The word alpha, as used in a financial context, was coined in the 1960s by Michael Jensen, then a graduate student at the University of Chicago. He was interested in mutual fund performance—was it based on a manager's skill from picking stocks or just the market going up or down on its own? He had to figure out a way to measure this, which is when he invented the concept of "alpha." He defined this as "a risk-adjusted measure of portfolio performance that estimates how much a manager's forecasting ability contributes to the fund's returns." Alpha was indeed an analytical breakthrough—the word and concept stuck and is now part of financial culture.

But that is only part one of Jensen's story. There is a second part that is completely forgotten, at least by hedge fund guys. And that is what happened when Jensen went looking for evidence of alpha in his study. He couldn't find any, at least over an extended period of time. The mutual funds he studied were not able to beat the market for any long time period. Examining the performance of mutual funds for the period 1945 to 1964, Jensen concludes: "The evidence on mutual fund performance indicates that these 115 mutual funds were not on average able to predict security prices well enough to outperform a buy-the-market-and-hold policy. Also there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.... On average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses."

The ability to beat the market for a specified period is known, at least by academics, as persistence. Though Jensen didn't use the word persistence when writing about alpha, it is implicit in his measure and another of his discoveries. As he modestly wrote to me when I asked him about this research: "I do not recall the idea of persistence being in existence before my study, but the study was a long time ago."

Everyone still talks about alpha, but no one talks about persistence. An investment manager might get lucky once or twice, but whether he or she can persist in generating excess returns over the market for more than a few months is really the question—and the question you should ask when selecting a fund that claims to be able to beat the market. If you ever meet a fund manager who brags about his alpha, you can ask it of him directly: "What about your persistence. How long can you keep it up?" (There might be a less aggressive way of asking this, but the point remains).

If mutual funds can't persist in beating the market, then returns chasing makes no sense as a strategy. Doing better than the market in the past is no guide to the future. The question of persistence in mutual fund performance is an unsettled one. It has been studied extensively since Jensen's day. Most academics are intrinsically skeptical that a mutual fund would be able to beat the market for very long. They use seemingly noncommittal but in fact savage language, claiming that any real evidence of persistence of market outperformance by mutual fund managers is "elusive."

Wall Street has a different view, of course. There is always the example of Peter Lynch, who ran Fidelity's Magellan Fund and had returns almost double the S&P for many years. Part of the discussion of persistence has to do with the time period you are talking about. There are managers such as Bill Miller of Legg Mason who had great runs for a while. Miller had a 15-year winning streak, only to be followed by a 10-year losing streak. This culminated in his disastrous 2008 presentation at an investment conference in New York. The topic: "The Credit Cycle—What's Next?" Miller recommended financial stocks as a great buy. He singled out Bear Stearns, in which he was one of the biggest investors, having committed $200 million of his fund's money. An audience member raised his hand and asked Miller a question: Was he aware that Bear Stearns was in crisis, in fact was cratering that very morning? Miller seemed shaken. He quickly left the conference. His $200-million dollar investment was soon worth only $15 million dollars.

Miller's downfall is exceptional, but it is also clear that many mutual fund managers have exceptional skills at picking stocks, as Miller himself did for a while. Mutual funds have some great years, extraordinary years, that can't be explained by dumb luck. So, what's really going on here in terms of persistence and performance?

Buy High, Sell Low: The Basic Instinct Driven Error of Investing

The following is an excerpt from Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money by David E. Adler. This is a fascinating book about the psychology of money and how our instincts and emotions often harm us when we make investing decisions.

Benjamin Graham once said, "An investor's chief problem, even his worst enemy, is likely to be himself." This is nowhere more true than when it comes to deciding to buy or sell a stock. We have an uncanny ability to buy stocks that are poor investments and sell stocks that are good investments. In essence, we buy high and sell low. In general, investors tend to shoot themselves in the foot—because they follow their instincts.

Once upon a time most economists and some investors thought people behaved rationally when it came to their money. Economic theory assumed investors, on average, would make good, even optimal decisions in terms of maximizing their wealth: Real money was at stake, so people would do the thing that earned them the most. Psychologists who study how people make decisions were under no such illusions. They knew our decisions are driven by irrational impulses, gut instincts, and the way our brains process information, rather than the cold rationality embedded in economic models. Finally, researchers stopped arguing about theory and studied how investors actually make decisions. They found that investors behave the way psychologists predicted, not the way economists predicted. Behavioral economics was born.

The most clear and startling finding came from Terry Odean, an economist at Berkeley. Odean's research is now one of the classics of the behavioral finance literature, even though arguably the field is too young to have classics. Odean studied the stock selection-decisions of individual investors. He found we do everything wrong: We trade too often for no economic gain. We are undiversified, holding only a few stocks that get our attention. The details get even more interesting. We easily sell off stocks that have done well, but we have trouble letting go of stocks that have performed badly, holding onto them in the hope they will come back. This is ruinous on two levels. By selling winners and holding onto losers, we are setting ourselves up for a tax hit, because we face taxes on stocks that have appreciated. Because stocks prices show momentum (see Chapter 12, "Momentum," for more about these effects), the stocks we have sold tend to keep rising. And the stocks we hold tend to keep falling.

Our trading patterns make no economic sense given these results, but they make a lot of psychological sense. We feel we should at least get what we paid for a stock, even if the stock market has no interest in our feelings. The behavioral economists Meir Statman and Hersh Shefrin called this the "disposition effect" as shorthand for our "predisposition to get-even-itis." As a result, we have trouble letting go of stocks that are worth less than we paid for them. Amplifying this impulse is the different way we experience gains and losses identified by the psychologists who pioneered behavioral economics. Losses are more painful than gains. Moreover, we are willing to gamble on the downside, to make a certain loss less certain. By holding onto our losers, we are hoping they will go up. For our stocks that are winners, we aren't compelled to gamble and want to lock in our gains. And as a result we sell our winners and hold on to our losers. Psychologically, we are satisfied, only to be punished by the stock market for our actions.

Odean was familiar with these behavioral theories and predictions. His personal history in many ways anticipated his nonconventional research agenda. Odean was a college dropout, who had worked as a New York City cab driver among other jobs, before returning to get his undergraduate degree at Berkeley at age 37. As a "mature student" he met psychologist Daniel Kahneman, the future Nobel Laureate then in the process of refining his work on decision making. Kahneman suggested Odean continue on in graduate school in economics rather than psychology. Odean analyzed real stock-trading data for evidence of psychological factors at work, which no one had bothered to do before. He discovered how precisely trades followed the disposition effect, with investors trying to get even in terms of what they paid for a stock.

Odean remembers the reactions to his discovery at the time, way back in 1997, which is not exactly light years ago, but a very different economic environment from today. The tech bubble was just heating up. "The standard response from professors was 'Personally I think this is interesting but my colleagues won't be as open minded as I am,'" says Odean. The group dynamics at work interested him as a behaviorist. Everyone liked thinking of themselves as open minded. But at the same time, no one dared risk publicly acknowledging in a group setting the merits of the behaviorist approach.

The news media had no such hesitation. Odean's findings broke out into the press, which is rare for an economics research paper, and Odean did numerous TV appearances (though audiences were surprised to see an economist sporting an earring the size of a class ring). The profession changed its views. The disposition effect in stock trading, once a heretical idea, is now mainstream, and even arguably part of a new orthodoxy. Every financial planner warns against the human tendency to sell our winners and hold on to our losers.

This instinctive error in stock trading might still pose some dangers to investors, but has greatly diminished in impact. The effect is now widely known, and the age of the day trader is over in any case. Most trading is now done by institutional investors, where the disposition effect is less pronounced. It isn't their money, so they are less emotionally involved.

Being aware of the disposition effect is primarily a defensive strategy. (If you are trading stocks, next time you are holding on to a losing position, hoping it will come back, ask yourself how realistic this belief is. Also consider the tax consequence of selling.)

However, you can take advantage of the disposition effect exhibited by other investors. This profitable trading is one way to make money off of psychological insights about investor behavior. It is a variation on the momentum strategies discussed later in the book.

Again, central to the strategy is the fact that people don't like to sell things at a loss. This is an immensely strong behavioral bias. The way to make money is to apply this insight to earnings announcements. Suppose a company has surprisingly good earnings. The stock goes up. Investors have no trouble selling off their winners. The market becomes swamped with sellers so the price doesn't rise immediately. But let's say the opposite happens. The company has a negative earnings surprise. The stock goes down. Investors are very unlikely to realize their losses. They hold onto the stock, hoping it will come back. As a result, the price of the stock doesn't fall, at least not at first.

What this means is in both cases it takes a while for the stock price to reflect its new situation. If the stock has gone up, the dumping of shares slows down its price increase. If it goes down, the hoarding of shares slows down its price decrease. In both cases, the stock price eventually reflects its true value but takes a while to get there, giving you time to move, to buy stocks going up, and to short or sell stocks going down.

Though exploiting the disposition effect can be a profitable strategy, there is an additional factor influencing the speed of change, making returns more predictable—and that is knowing the reference point, the price at which someone purchased the stock. The disposition effect always involves a reference point. If you bought IBM at $1 and it goes up to $20 and then drops to $19, you still view it as a winner. But if it drops to 50 cents, then get-even-itis effect kicks in, quite intensely. You now are extremely reluctant to sell the stock. If there are many investors like you, the price decline will be severely slowed down. This gives hedge funds more of a profit window because the market isn't reacting instantaneously. Sophisticated hedge funds now try to identify and sort the purchase price of a stock in order to be able to identify the magnitude of the disposition effect in order to improve returns.

The trading strategy based on the disposition effect and stock price sorting was first identified by Andrea Frazzini, a finance professor at the University of Chicago Business School, who is also well known in the hedge fund world. Frazzini explains: "From my active investor point of view, I like to short stocks with bad news." But even if you aren't shorting these stocks, you should consider selling them, according to Frazzini. It won't generate enormous market-beating returns but instead may simply be the sensible thing to do. He says, "Stocks with bad earning announcements keep going down for a while. Individual investors should just sell them. Waiting can only lose you money."

For stocks with good news, waiting to sell makes sense. The disposition effect means everyone is selling, depressing the rise in price at first, but eventually it reaches fair value. Waiting eventually makes you money.

In other words, do the complete opposite of what your gut impulse tells you, as seen in the disposition effect. Sell your losers. And hold on to your winners.

Investment Strategies Part 4: Don't Rebalance at the Sector Level

The following is a guest post from Marotta Wealth Management.

Rebalancing between asset classes boosts returns and decreases volatility. But setting your asset classes based on sectors of the economy is not an effective strategy.

You can rebalance your investment allocation at three levels: stocks and bonds, between asset classes and among subclasses. At the highest level, rebalancing between stocks and bonds reduces risk. Selling some of your stocks after the market has appreciated limits your portfolio’s volatility and locks in some of your gains.

Correlation between investment categories helps define asset classes and sort out which are merely subclasses. The lower the correlation, the greater the bonus you can gain by rebalancing regularly. Rebalancing between U.S. stocks, foreign stocks and natural resource stocks offers a significant bonus because these asset classes have the lowest correlation.

Smaller bonuses are available within each asset class for categories with a higher correlation. But the law of diminishing returns comes into play as the number of categories continues to double and the correlation between divided subcategories approaches 1 (one).

Some investors try to allocate and rebalance between sectors of the economy. For example, Dow Jones divides the economy into these 10 sectors: Financials, Consumer Services, Telecom, Industrials, Basic Materials, Consumer Goods, Utilities, Oil and Gas, Technology and Health Care.

I don't recommend rebalancing at this level. You cannot know what percentage to allocate to each category. Putting 10% in each sector doesn't make sense because the division is arbitrary. Dow Jones puts Oil and Gas together in one sector. If they had divided it into two sectors, it would not have justified twice the investments. Dow Jones divides the index one way, and the S&P 500 indexes another.

Additionally, some of these sectors represent a greater percentage of the economy. If you set your target percentages now, the economy will change and your targets will be out of date. Technology has grown significantly as a percentage of our economy. Investors who continually moved out of technology missed much of the best returns during the 1990s.

Ten sectors taken two at a time produces 47 different pairings, each with its own correlation and rebalancing bonus or penalty. I computed those statistics using annual returns from 1992 through 2008. Some pairings have a bonus, and some have a penalty. I don't recommend rebalancing at the sector level, but an analysis of which sectors offer a bonus and which cost a penalty can suggest some investment strategies.

Some have a high correlation and have little or no bonus, such as Consumer Goods and Financials. Consumer Services, Telecom and Technology are also all highly correlated.

Basic Materials and Oil and Gas are subcategories of the natural resources asset class and therefore highly correlated. Oddly enough, they have one of the largest rebalancing bonuses partly because they represent different natural resources that are subclasses of the natural resources asset class. This is also true because Oil has had its bubbles.

Categories with a higher average bonus for rebalancing include Financials, Telecom, Technology and Oil and Gas. These are all sectors that have expanded and then corrected sharply.

Rebalancing out of bubbles is always warranted and valuable. But of course recognizing them is challenging. The bonus for rebalancing out of technology is the smallest of these because the growth in technology was mostly a shift in the economy and only a bubble at the very end of that trend. Shifting out of technology early would have killed returns. Timing the shift perfectly would have been difficult.

Rebalancing in this case is a poorer version of tilting toward value. A better bonus would be gained simply by emphasizing those stocks with a low price-to-earnings (P/E) ratio. When stocks in a sector bubble, they often experience high P/E ratios because they represent a greater percentage of the S&P 500.

The markets are smarter than the experts. It is by definition that they know what market cap a given industry deserves. It may bubble in its growth getting there, but you only know the bubble is over after it bubbles.

Four sectors offer a large rebalancing penalty with each other. They are Industrials, Basic Materials, Consumer Goods and Services.

Sectors of the economy wax and wane with the business cycle. As a result, when stocks in one sector of the economy are performing poorly, they may continue that way for some time. This form of rebalancing will result in lower returns than if you just let the market cycle adjust your portfolio.

Business cycles vary in length. As a result, annual rebalancing will incur a large penalty when you move out of a sector that did well last year into a sector that will do poorly next year. The penalty appears to be the worst for sectors that peak and valley at similar times during the business cycle, such as Industrials and Basic Materials or Consumer Goods and Services.

In this case, intelligent rebalancing, which takes the business cycle into account and rotates which sectors you are emphasizing, would at least try to capture the bonus and avoid the penalty. Knowing where you are on the business cycle, however, is just as demanding as predicting which industry will have the highest return.

Utilities are the least highly correlated to other sectors. They are a defensive sector and often do better than other sectors when the market is dropping. A sector rotation strategy suggests overemphasizing utilities and underemphasizing stocks when P/E ratios are high.

Sectors of the economy grow or dwindle based on global macroeconomic trends. Over time, companies responding to market conditions increase the capitalization of those goods and services that society demands and decrease those that are phasing out of the economy.

In the beginning we were an agrarian society. Then the industrial revolution began in America and Great Britain. Now we have more of a service-based economy. Perhaps genetics will bring about a health-care boom in the near future.

The lifetime of my grandparents spanned the Wright Brothers to landing on the moon. Your grandchildren may choose a college major that hasn't even been invented yet.

Setting percentages of your portfolio at a level of the sector of the economy doesn't make sense. If you set those percentages today, based on current levels in the S&P 500, our economy may never again match those percentages. There is no reversion to the mean for sectors of the economy.

Setting investment percentages also doesn't allow you to make strategic investments in sectors that you expect to grow and outperform over the next three to five years.

Rebalancing at the capitalization level (large cap and small cap) makes sense because large- and small-cap companies will always exist. Small companies have a higher expected rate of return because it is easier to double the size of a small company than a large company.

Similarly, it makes sense to rebalance using investment style (value and growth) criteria because these are universal descriptions of stock types and not specific to industry. A company can move between value and growth based on its price. Overweighting value companies outperforms growth stocks because of the risk of a growth company faltering in its expansion and causing a serious price correction. Limiting your investment in such stocks slightly smooths and boosts your returns.

Although the markets as a whole often revert to profitability and growth, this isn't true of individual stocks or industries. Most of the dot-com stocks that bubbled at the beginning of 2000 will never regain their former glory. Buggy whip manufacturers are no longer ubiquitous.

A better strategy is to look for three- to five-year trends in the economy and simply overweight those that have the best chance of continuing to grow in importance. Such trends last long enough for investors to take advantage, assuming they are looking forward to what may do well and not backward to what has been recently bubbling. Two such industries I would expect to do well going forward are health care and technology.

The most critical expertise that an investment manager can provide is a good investment philosophy. Investment analytics give you the best chance of matching your specific financial goals with the diversified investment mix that is optimum to meet those goals.

The Best Way to Maximize Your Investment Return

For daily tips and ideas on how to grow your net worth, subscribe to Free Money Finance using this link.

There are three basic variables that impact the total return your investments generate. They are:

• Amount saved -- The amount of money you save every year.
• Return rate -- The rate at which your money grows.
• Time -- The number of years that your money is allowed to grow.

All of these are important and we talk about them frequently, but which is MOST important? Well, I developed a quick spreadsheet, ran some scenarios, and wanted to offer my findings to you. (But before I do, anyone want to guess which one has the biggest impact on the outcome?)

To begin this process, I had to make assumptions about a person's saving/investing to get a baseline investment return. Here's what I assumed our mythical person did with his investments:

• Earned $50,000 a year and saved 10% of that (or $5,000) per year.
• Earned an 8% total return after fees, taxes, etc.
• Invested for 30 years.

Using these assumptions, I found that this person would have $566,416 at the end of 30 years (FYI, I used this calculator to check my numbers.) In other words, $5,000 saved per year at 8% for 30 years generates $566,416. Pretty simple, huh? (BTW, I assumed that the money invested did not earn anything in the year it was invested. It started earning in the next year.)

Next I started tweaking the variables one at a time, leaving the others the same, to see what the impact would be. I tried to pick increases that I felt were comparable. In other words, I assumed that it was just as easy (or difficult if you prefer to look at it that way) to save $1,000 extra per year as it was to earn an additional 1% per year as it was to save for five extra years. I'll comment on how valid those assumptions are in a minute, but for now here are the results:

• I increased the amount saved to $6,000 per year. $6,000 per year at 8% for 30 years equals $679,699 or a 20.0% increase versus the original result.

• I increased the return rate to 9% per year. $5,000 per year at 9% for 30 years equals $681,538 or a 20.3% increase.

• I increased the time to 35 years. $5,000 per year at 8% for 30 years plus an addition 5 years of growth (but no extra investment) equals $832,251 or a 46.9% increase.

So, when you increase the amount saved by 20% per year, your overall increase is 20%. This seems to make sense and be "fair." But if you increase your return rate by only 12.5%, you get a 20.3% increase in the total, a much better result. Yet when you save for an additional five years, a 16.7% increase in time, you get a much, much better return -- an increase of 46.9% total. Quite interesting, wouldn't you say?

Now it would be easy to declare time the winner, rate second, and amount third, but a few other things have to be taken into account:

1. In reality, saving an extra $1,000 isn't comparable to earning an additional 1%. Earning that extra percent is a lot harder. So while the rate increase delivers more, it's much more likely that you'll be able to save more, thus I'd place the amount saved over the return rate in importance.

2. Time saved really is the winner. In fact, if our mythical person saved for only two extra years instead of five, he would have earned about as much as the 1% increase in the rate and $1,000 extra. Therefore, IMO, it appears clear that time saved is the most important factor in investment returns.

3. The good news: the two most important factors in determining a good investment return are ones that we have the most control over. It's much easier to add extra time (by putting off necessary withdrawals and starting as early as possible) and the amount saved (increasing income/decreasing expenses to save more now for investing) than it is to try and earn an extra 1%.

4. That said, you can't buy extra time. You can keep extending it on the back end as much as possible, but if you're 50 years old, planning to invest and let your money sit for 35 years isn't a realistic option. So for older individuals, I think the amount saved is the most important factor in maximizing your investments.

5. Yes, there are some flaws in this simple analysis. For instance, most people don't earn $50,000 starting in year one. Thus it would probably be hard for them to save $5,000 in year one. Furthermore, people start earning as soon as they invest, so the actual numbers are a bit higher (though for comparison sake they are all accurate here.) And investments don't earn return rates in a straight line, they vary from year to year. Finally, I had to make several assumptions that will likely be different than the actual scenario for any specific individual. So sure, there are things that could be changed, but this analysis does give us a good view on the comparable impact of the three factors.

6. If you do all three -- increase the rate to 9%, increase savings to $6,000, AND increase time to 35 years -- you really get a huge impact. The amount at the end of the 35 years grows to $1,294,265, 129% more than the initial scenario. That's why people spend so much time trying to increase all three of these, because if they can, the payoff is really big.

Now, on a personal note, here's what I'm doing to make these three factors as high as possible:

• I'm saving/investing as much as I can each year in a variety of ways. For details on what I'm saving/investing, see I'm Still Buying.

• I'm doing all I can to maximize my return rate -- investing in index funds in the lowest cost alternatives I can find.

• I'm going to postpone withdrawing funds from my savings for as long as possible by working part-time once I "retire". For details on why I think I can do this, see What I Plan to Do During Retirement.

I realize that much of the information here is not new news to seasoned investors. But for those just starting out (especially new grads that have a chance to save for 35 years) or those unfamiliar with how investing works, I thought this information would be insightful.

For those of you who are more advanced investors, I'd appreciate your thoughts/comments on this analysis. It's likely that your perspective will make this piece better, so I'll look forward to your comments below.

Investment Strategies Part 3: Rebalance Regularly Between Asset Classes and Subcategories

The following is a guest post from Marotta Wealth Management.

The investment metric correlation helps you continually take your gains off the table for safe spending. And it helps you determine what constitutes an asset class and which subcategories to consider for further diversification. Once these categories are defined, correlation can also reveal how much of a bonus to expect from your returns when you rebalance between two categories.

In his 1996 article "The Rebalancing Bonus," William J. Bernstein presented a brilliant formula to approximate the extra return you can expect by rebalancing your portfolio regularly. We rarely focus on a formula in this column. But there is deep wisdom here, both for portfolio construction and for determining which categories are worth regular rebalancing. Here is the formula:

B1,2 = P1P2{σ1σ2(1 - c) + (σ1 - σ2)2 / 2}

Where B is the bonus, P is the percentage allocation, sigma (σ) is the standard deviation (SD) and c is the correlation between the two assets.

The implications of the formula are useful, even for average investors. We can learn six valuable lessons from Bernstein's model.

First, notice the approximate size of the rebalancing bonus. A 50-50 allocation between two investments with a 0.5 correlation where each investment has an SD of 20% might be typical for equity investments. Such a mix has a rebalancing bonus of 0.5%. We will use the formula to demonstrate ways to boost this bonus. Even a half percentage point is noteworthy.

Investment professionals divide an extra 1% into hundredths of a percent, called "basis points." Earning an extra 50 basis points is huge. Investment advisors bend over backward for an extra 10. So rebalancing pays.

Second, the rebalancing bonus is the sum of all possible rebalancing bonuses. Our example of a 50-50 allocation has a 0.5% bonus because there is only one potential allocation mix to rebalance. With three categories allocated 33-33-33, the bonus rises to 0.67%. Each of the three rebalancing opportunities contributes 0.22%. Four categories split 25-25-25-25 provide a 0.75% bonus by giving six smaller rebalancing opportunities. Five categories of 20% each give 10 separate pairs of rebalancing for a 0.80% bonus.

Investors are taught to minimize the number of investments and investment categories. Although there is a gradual law of diminishing returns, diversification provides investment gains any time the investment itself is worthwhile and the correlations are low. With computer support for the analysis and rebalancing, investors can handle a large number of categories and holdings.

Third, note that the rebalancing bonus is proportional to the product of the percentage allocated to each holding. With a 50-50 allocation, the product is at its maximum at 0.25. A 60-40 allocation is nearly as high at 0.24. With a 70-30 allocation, the product drops to 0.21. And 80-20 drops all the way to 0.16.

The bonus is at its maximum when roughly equal allocations are made to each asset category. The smallest allocation should be at least half the size of the larger allocations. Our example, with four equal holdings of 25-25-25-25, resulted in a 0.75% bonus. An allocation of 30-20-30-20 is still high with a 0.74% bonus. But a 40-10-40-10 allocation drops the bonus to 0.66%. And an allocation of 85-05-05-05 drops the bonus way down to 0.27%.

Thus when an option is investment worthy, it merits a significant allocation. A good rule of thumb is to only skew an investment choice as much as two thirds to one third. Always invest at least a third into the smaller allocation.

The remaining lessons come from the terms inside the curly brackets of the formula. The allocation product is multiplied by the sum of these two terms. Maximizing their sum augments the bonus gained from rebalancing. Either of these two terms might be zero under certain circumstances. Each term has lessons to teach the savvy investor.

The first term depends on the correlation between the two investments. That is, the lower the correlation, the higher the bonus. A correlation of 1 has no bonus. Our example had a correlation of 0.5 and a bonus of 0.5%. If the correlation drops to zero, the bonus doubles from 0.5% to a full percentage point. At negative 0.5, the bonus becomes a full percentage point and a half.

So lesson 4 teaches us that the lower the correlation between two investments, the greater the importance of rebalancing. Rebalancing at the asset class where correlation is the lowest is more consequential than rebalancing between suballocations with a higher correlation.

Fifth, we learn that the higher the volatility of the investments, the greater the bonus in actually rebalancing. In our original example, both investments had a SD of 20%. The higher each SD, the higher the rebalancing bonus. By raising the SD of both investments from 20% to 30%, the rebalancing bonus increases from 0.5% to 1.13%. At 40%, the bonus is 2%. At 50%, the bonus is 3.13%.

Emerging market investments are extremely volatile. When they appreciate, an excellent strategy is to trim the position and take some profits off the table. When it drops precipitously, it is equally critical to reallocate and invest some more. Volatility equals opportunity if you rebalance regularly.

The last term is the difference between the SDs. It was zero in our example because the SDs were both 20%. To consider the contribution to this term, take the case where one of our investments has a 20% SD. But the other investment is as secure as possible and has a SD of zero. The first term becomes zero, but the second term makes up the difference.

With half invested in stable investments, the rebalancing bonus when the other half has a SD of 20% again is 0.5%. As the equity investment becomes more volatile, the bonus increases. At 30% SD, the bonus is again 1.13%. At 40%, the bonus is 2%. And at 50%, it is 3.13%.

Thus the greater the difference between the SD of two investments, the greater the bonus from rebalancing. Moving money from bonds back into stocks after a market correction yields substantial gains. A recent study from Fidelity shows exactly that: "Millionaires who used past recessions as buying opportunities now boast an average of $1 million more in investable asset than millionaires who shifted into more conservative investments."

Finally, we must learn to recognize when rebalancing provides a good chance of boosting returns and when it is unimportant. Rebalancing between two categories of U.S. stocks with a 0.85 correlation only gains a 0.15% bonus. In contrast, rebalancing between fixed income and emerging markets gains nearly 1.5%.

I asked formula creator William Bernstein how he might caution investors. He answered, "Rebalancing works best with high-volatility, low-correlation assets with similar long-term returns. Although this usually boosts the return of the equity part of the portfolio, if the returns are different enough, as occurred with Japanese equity over the past two decades, it can actually reduce return. This is not a free lunch."

The markets are inherently volatile. Rebalancing works best for categories that qualify as asset classes or subclasses. Next week we explore which investment categories do not warrant rebalancing because you are more likely to reduce returns than boost them.

Rebalancing is always a contrarian move, selling what has done well and buying what has done poorly. Many investors don't have the discipline to take that step when it is appropriate. But regularly rebalancing your portfolio offers expected returns about a percentage point better than buy and hold. Rebalance your portfolio regularly, and take advantage of this bonus.

What is the Right Asset Allocation for You?

Sound Mind Investing says that the most important investing decision is determining asset allocation -- how much of a portfolio is allocated to stock-type investments and how much to fixed-income securities such as bonds. The article notes that academic studies have established that as much as 90% of your long-term results can be traced to this fundamental allocation decision.

90% huh? Ok, so I guess it's important. :-)

And before we jump in further, here are some additional comments from SMI that serve to better frame the conversation:

On the one hand, we have stocks, which are volatile but produce high returns. On the other we have bonds, which are relatively stable but produce lower returns. How should you go about combining them in a portfolio?

So, if asset allocation is so important, then we all would like to know what the "correct" allocation is, right? Unfortunately, it's not that easy. It's kind of a moving target based on several factors. Here's how Get Rich Slowly summarizes the issues involved in the allocation decision:

Determining the best asset allocation for your portfolio involves a combination of:

• Investment time horizon — When do you need the money?
• Risk profile — Can you handle the ups and downs of the stock market?
• Rebalancing — This is something you should do once a year or so.

Given these variables, here are three different, though similar, opinions on how we should all set our asset allocations. First, these thoughts from SMI:

The key ingredient in this recipe is time. Over shorter periods, stock returns are much more variable. Maybe you'll do great; maybe you'll do poorly. Given a long time frame, however, you can be quite confident that stocks will provide higher returns than bonds.

That's why it's generally recommended that younger investors take advantage of the many "tosses" in their future by investing heavily in stocks. They can afford to ignore the short-term ups and downs, while focusing on the highest long-term returns possible. Later, as you move closer to retirement and the number of future tosses declines, it's prudent to scale back the short-term risk of loss by gradually increasing the percentage of bonds held in the portfolio.

Ok, so the older we are, the more we need invested in bonds. That's a bit general, don't you think? Dough Roller gets more specific with the standard asset allocation rule-of-thumb:

As a starting point, many view a neutral allocation between stocks and bonds to be 60% stocks and 40% bonds. If you read a lot of the literature on asset allocation, you'll see the 60/40 split used frequently. According to one report published on FundAdvice.com, a 60/40 allocation produced a compound annual return of 10.4% from 1970 to 2006. Now that doesn't mean that a 60/40 split is right for everybody, which brings us to an oft-repeated formula for determining a reasonable allocation: 120 - your age = the percentage to invest in stocks, with the remainder allocated to bonds.

And for one final perspective, the Motley Fool lists the following four rules to setting an asset allocation:

• Rule 1: If you need the money in the next year, it should be in cash.

• Rule 2: If you need the money in the next one to five (or even seven) years, choose safe, income-producing investments such as Treasuries, certificates of deposit (CDs), or bonds.

• Rule 3: Any money you don't need for more than five to seven years is a candidate for the stock market.

• Rule 4: Always own stocks.

This last suggestion is the closest to how I personally set my own asset allocation, but my investments are also fairly close to the "120 - my age" rule as well. Coincidence? Maybe. Then again, maybe both of these are a good reflection of the same principles -- some cash, long-term in stocks, shorter terms in bonds/CDs/etc.

How about you? How do you set your asset allocation?

Investment Strategies Part 2: Use Correlation to Define Asset Classes

The following is a guest post from Marotta Wealth Management. Part one of this series was titled Investment Strategies Part 1: Rebalance into Stable Investments in an Appreciating Market.

To boost returns and protect your investments, you can use the investment metric called correlation. It will rebalance your portfolio at three levels of investment allocation: stocks and bonds, asset classes and sectors of the economy. The dominant categories of stability and appreciation are the most basic way to view your portfolio. By continually trimming your stocks while the market appreciates, you can replenish the money that we hope you are setting aside regularly for safe spending.

Over a long enough time, an allocation to lower performing investments such as bonds generally results in a lower expected return. Thus asset allocation at this level helps control risk. It also provides enough allocation to stable investments to cover a period of safe withdrawal rates of five to seven years, so the appreciating assets have time to recover after a market correction.

Below the broadest categories of lower risk bonds and higher returning stocks are candidates for asset classes (see this link for a chart). Asset classes are used to set the percentage of your investments that you will put in each category. Each investment advisors may define their asset classes differently. But studies have shown that diversifying among categories with the lowest correlation produces the most return for the least risk. Therefore these categories represent the optimum candidates. As the correlation rises, assets are more apt to be classified as merely sectors or subsectors of the investment world, rather than asset classes.
 
Six-month correlations fluctuate over time. Many of the correlations between investments were near their lows in mid-2007. Throughout this article I cite correlations at these lows usually against the S&P 500. Recently, six-month correlations have been relatively high. A demand for dollars has caused all categories to move down in sync with one another.

The Natural Resources Index at 0.38 has one of the lowest correlations to the S&P 500. This index does not represent commodities but rather the companies that produce or provide them. For example, the index tracks oil and mining companies, not the price of oil or minerals.

Examples of these natural resources include oil, natural gas, precious metals (particularly gold and silver), and base metals such as copper and nickel. It also covers other resources like diamonds, coal, lumber and even water. Real estate is also included because land serves as the underlying hard asset. Having such a low correlation clearly shows these companies deserve their own asset class.

Many advisors don't have an asset class for natural resource stocks. Instead they select one portion of the category, typically real estate, and make that the asset class. This can also be a good idea. Real estate indexes have correlations as low as 0.49 against the S&P 500. We use real estate as a subclass within the natural resources category because at times it has a low correlation with energy and other commodity movements.

Not only do natural resource stocks have a low correlation to other U.S. stocks. They have an even lower correlation to U.S. bonds. Natural resources (commodities) often exhibit a negative correlation to fixed-income investments due to their inverse relationship to inflation. So their optimum allocation depends on both the amount you designate to stocks and the amount you designate to bonds.

The second best candidate for an asset class is foreign stocks. The correlation of the EAFE Foreign Index is 0.57. It hasn't always been that low. The correlation between U.S. stocks and foreign stocks fluctuates over time between 0.4 and 0.9. When the correlation is high, many advisors argue that no benefit will accrue from investing in foreign stocks. When the correlation is low, it is often because foreign stocks are doing better.

At the end of April 2009, for example, the EAFE index hadn't lost anything over the past 10 years. Compare that with the S&P 500's negative 2.48% annual return resulting in a 22.2% loss for a decade's worth of investing. At times little diversification may be realized by investing in foreign equities. But the benefits happen consistently enough for our firm to consider foreign stocks its own asset class.

Some people try to diversify internationally by investing in U.S. companies that gain a significant portion of their revenue from sales abroad. But studies have found that these multinational companies still track fairly closely with other domestic companies. And they don't offer the same benefits as investing in foreign stocks.

We use country selection and emerging markets as our subclass allocation. At 0.50, the Emerging Markets Index correlation to the S&P 500 is even lower than the EAFE. It has also has had some of the best returns, recently averaging 8.24% and totaling 120.7% over the past 10 years.

And these stellar returns include having lost 42.90% over the last year! Sometimes you have to make a large profit to still have decent returns after a market correction.

Because correlations fluctuate, defining what constitutes an asset class and what constitutes a subclass is subjective. It is always open to review and reevaluation. Generally, a correlation that can drop below 0.6 with other asset classes is a good candidate to become its own asset class. The correlation of around 0.85 between emerging markets and other foreign stocks suggests it should simply be a subclass of foreign stocks.

Within the asset class of U.S. stocks are also several subclasses that provide opportunities for diversification. The Russell 2000 small-cap index, for example, has a correlation of 0.75 against the S&P 500.

Using correlation to define our top-level asset categories, therefore, we use three asset classes for stability (short money, U.S. bonds and foreign bonds) and three for appreciation (U.S. stocks, foreign stocks and natural resource stocks). Then within each asset class, we suballocate for additional diversification.

Most investors and even many advisors use investment categories entirely contained within U.S. stocks and bonds. A low correlation investment strategy, in contrast, would suggest broadening your horizons to obtain the lower volatility offered with a broader definition of asset classes.

I'm Still Buying

A couple weeks ago in my post titled The Poor Economy is Having Very Little Impact on Me, one reader made the following comment:

What got many people INTO this mess were bubble heads always insisting that it was always a great time to buy a house and it was always a great time to buy stocks. Remember when FMF would post "I'm buying stocks because they're at a great discount" back in 2007 when the dow dropped from 13k to 11k? Well the DOW is now at 8k and it should be a great time to buy stocks but I don't think I've read a single post this year where FMF says "it's a great time to buy stocks."

Well, what got people into the current economic mess wasn't buying homes or investing -- at least buying homes they could afford and investing in index funds (what I do) -- but I'll leave that alone. Today, I'd like to address the comment that implied I've stopped buying stocks (index funds in my case) because the market has been bad.

We'll start out with how I answered that implication in the comments of the original post. I pointed to two pieces where I mentioned that I was still buying. Here's what I said in 2008 Net Worth Review: Ouch! this past January:

"I'm still investing at a good rate (401k and part of my paycheck) automatically each month as well as saving in other avenues throughout the year. I know the market will come back eventually and since I have a 20-year time horizon, the money I invest now should do well over that time. That said, I'm expecting the next year or two to be really rough. But who knows what will really happen? I certainly don't."

And in May I said the following in More Reasons to Invest in Index Funds:

"I've continued to invest in index funds (mostly stocks, but some bonds) throughout the stock market's fall and I'm counting on the fact that they'll do quite well when the rebound occurs."

Now, let me state for the record, that I have been buying and kept on buying all the way through, into, and now (hopefully) out of the recent economic decline. Here's what I've done over the past year, for example:

• Contributed monthly to my 401k. I put in the maximum each year, split into 12 equal, monthly installments. This money goes into a stock index fund.

• Automatically have some of my paycheck diverted to Vanguard and invested in a stock index fund and a bond index fund every single month. It works like clockwork -- I set it up once and it happens automatically now.

• Made contributions to our kids' 529 accounts. I not only contributed the maximum amount that we can deduct on our taxes for 2009, but since I felt I wanted to save more and that stocks were at a low price, I doubled that amount a couple months ago. These funds are invested in age-appropriate mutual funds.

• Made contributions to our kids' education savings accounts -- the max for the year already. These are in cash now as they're being transferred from Etrade to Vanguard as I write this.

• Contributed the maximum allowed into my SEP IRA. All of this money was invested in a stock index fund.

So for any of you wondering, yes, I have kept investing all through the downturn and I plan on continuing to do so. I have a long-term (15 to 20 years) investment time frame and I believe the US economy will recover and grow well within that time, making my investments worth a significant amount more than they are now.

Why Even the Best Investors Can't Pick Winning Actively Managed Funds Consistently

What seems like a long time ago, I wrote a piece talking about the impact costs have in determining the success of your investments. The takeaway was that if you wanted to get the best return possible from your investments, you needed to make sure costs (trading costs, taxes, various fees, etc.) were as low as possible. My solution? Index funds.

But others argued (and have kept arguing) that either they or actively traded fund managers can pick out better investments and outperform the "average" (which is supposedly what index funds get you -- more on that later). I argued back that this was not so, but often to no avail. Oh well.

Then I found this piece recently from MSN Money. It details the fall of the mighty Fidelity Magellan, once the premier investment in the mutual fund industry. The article details how Magellan's results have dropped dramatically through the years despite having access to the best investing minds in the world. This story serves to illustrate several issues:

• Even the best minds can't regularly outperform the market.

• If a particular manager does manage to beat the market in the short term, many of them move on to other funds and investors are left without the key ingredient that made their fund a success.

• Even if investors can pick a great manager once, doing it several times in a row is nearly impossible.

• Anyone investing in actively managed funds pays a TON to do so -- far more than what they'll likely earn back.

Let's look at some highlights from the piece -- the first highlighting the inability of anyone to pick a great fund manager:

If Fidelity, with all its savvy and resources, can't pick a winning manager [as evidenced by Magellan's fall], just what do you think the chances are of you or me doing it? What do you think are the chances that the average investment adviser can do it? In fact, the odds are poor, whoever does it.

Then, if you somehow do luck upon a great mutual fund manager, chances are he'll move funds and you'll need to find a new one (in another fund or maybe just hope the new fund manager is good.) How likely is this? Not likely at all:

Worse, picking a fund manager isn't a once-in-a-lifetime decision. It's a decision that has to be made again and again. Fund managers, on average, don't stay at the same fund very long. According to the Morningstar database, for instance, the average duration of all fund managers at a particular fund is only 4.5 years. Restrict your sample to the largest funds -- those with at least $1 billion under management -- and the average tenure rises to 6.6 years.

This means a 30-year-old worker probably will need to make a fund decision six times before retirement and three more times after retirement. Each time he makes that decision, or pays a professional to make that decision, the chances of doing better than an index fund is about 30%. Those aren't very good odds.

In fact, the odds are dismal. The probability of making two good decisions in a row is only 9%. Try to make three good decisions in a row, and the probability of success is only 2.7%. By the fourth decision, the probability of making a winning choice each time is less than 1%.

And not only is it nearly impossible to pick a winning fund manager, but all the time you're trying to do so, you're incurring fees:

Meanwhile, the fee meters are running, transferring billions of dollars from the return on our investments to the financial services industry. This happens year in and year out. The financial services fee machine does incredible damage to retirement security.

And these fees are not inconsequential:

Excessive fees, in other words, can do as much damage as a major bear market. Worse, while the 28% lost in a bad market may eventually be recovered in a rising market, the money lost to a lifetime of excessive expenses is gone forever.

However, there is hope for investors:

Fortunately, there are signs we're beginning to understand that this is a no-win game. Today, eight of the 28 funds that are larger than Magellan are index funds. Money follows performance, and low-expense index funds routinely trump the expensive pride of our fee-bloated financial services industry.

So, it's pretty much a fool's game trying to pick a fund (and manager) that can beat an index fund. Of course you could pick the stocks yourself, but do you really think you can do better than the best, brightest minds that have 70-hours-a-week, full staffs, and millions of dollars available to pick the best investments?

Let's finish with a quick example of how an index fund actually beats the market even though it delivers only "average" results. These aren't actual numbers, but simply serve as an example of a sample year's performance results:

• Return of the market: 10%

• Return of a stock index fund: 10%
• Cost of a stock index fund: 0.1%

• Return of an actively managed stock fund: 10.5%
• Cost of an actively managed stock fund: 1.0%

• Net return of a stock index fund: 9.9%
• Net return of an actively managed stock fund: 9.5%

As you can see, an actively managed fund can still beat an index fund (though many don't, making them even worse investment options) in total return, but once expenses are deducted they underperform when compared to index funds. This is how index funds can "only" deliver the market "average" and still end up beating most active/y managed funds on a net return basis (the measure that counts.)

Investment Strategies Part 1: Rebalance into Stable Investments in an Appreciating Market

The following is a guest post from Marotta Wealth Management.

Diversifying your portfolio means finding assets that have value on their own merits but do not move exactly alike. A critical investment metric called "correlation" is used to construct a portfolio most likely to meet your personal financial goals.

Correlation measures how much two different investments move together, measured on a scale of positive one (+1) to negative one (-1). A perfect correlation (1.00) would mean that both investments always move in the same direction with the same magnitude. A perfect inverse correlation (-1.00) would mean that two assets always move in opposite directions.

Correlation comes into play at three levels of investment allocation: stocks and bonds, asset classes and sectors of the economy. At each level it can provide you with a better chance of boosting your returns and protecting your investments. But the way correlation is used is different at each level. In this column we will cover its use at the highest level.

The most basic allocation in your portfolio is between investments that offer a greater chance of appreciation (stocks) and those that provide greater portfolio stability (bonds). These two categories have the largest negative correlation. Thus decisions made at this level are the most important in determining how well behaved your portfolio returns will be.

Not only do these two categories have the largest negative correlation, but they also have very different expected average returns. Stable investments like bonds have an average return of about 3% over inflation. Appreciating assets like stocks have an average return of approximately 6.5% over inflation.

If your portfolio is 100% in stocks, it will have the greatest long-term appreciation, but it will also be the most volatile. Consequently, it may not give you the best chance of meeting your goals. For example, a long-term average return around 10% from U.S. stocks certainly sounds appealing. But they also have a 19% standard deviation. So about six or seven times a century, you will experience a decade of flat or negative returns.

These awful returns happen even more frequently than a Gaussian function (or bell curve) would predict because stock market returns are not well-behaved Gaussian statistics. They behave more like fractal power laws, which in lay terms means the curve has lumpy tails far from the average.

We all know, at least experientially, what a lumpy tail looks and feels like because we just lived through one in 2008. According to Gaussian statistics, you should not experience such terrible years in the U.S. stock market as frequently as you do. Sometimes such events are called "black swans," or outliers. Sometimes we just say that the markets are inherently volatile.

This wild volatility may threaten the fulfillment of your financial goals. Aiming for a 10% return with wild volatility doesn't make sense if you only need a 7% return to guarantee meeting your financial goals. So sometimes slightly lowering your expected return can vastly lower your expected volatility. As a result, you increase the odds of exceeding the modest return you need to meet your goals.

Because of the difference in returns between stocks and bonds, they won't rebalance themselves over time. Left to itself, the allocation to stocks will grow larger and larger until it represents close to 100% of your investments. As this happens your portfolio will also grow more and more volatile and your goals more susceptible to market corrections.

Due to the difference in expected returns and the need to handle withdrawals during retirement, we consider the categories of stability and appreciation to be larger than asset classes. Correlation at this level will not boost returns because stocks normally outperform bonds. But it will definitely protect your investment. Consistent rebalancing by selling stocks and buying bonds helps protect your net worth and consequently your lifestyle. The reverse, selling bonds and buying stocks, is not as necessary and only appropriate for younger investors who are still adding to their portfolio.

Older investors should have at least five to seven years of their safe spending rate allocated to stability. For them, replenishing the allocation to stability during times when stocks are appreciating helps secure future years of spending.

Only younger investors who are still a number of years away from retirement or who have more stability than they need to support their lifestyle can afford to rebalance from stability back into stocks after a market correction. Doing this can help boost returns somewhat, but it has risks if the markets continue to decline. Therefore never shift more than you can put at risk back into uncertain appreciating assets.

All investors should set a limit to their losses and allocate that limit to stability. That limit generally should be five to seven years of safe spending, but it could be eight to 10 years for very conservative investors. If an investor is frugal enough, he or she can afford to be 10 years in stability. Forgoing the chance of appreciating won't endanger a sufficiently frugal lifestyle.

Using the negative correlation between stocks and bonds properly means trimming stock market gains regularly to keep portfolio risk and volatility under control. This discipline gives you the best chance of supporting your safe withdrawal rates during retirement.

And Yet Another Reason to Hate Etrade

I've detailed previously that I hate Etrade because they closed their index fund leaving me high and dry. Not only that, they closed it at the end of March. Do you know what's happened since the end of March? It's up about 15%. That means I would have an extra $4,000 in my Etrade accounts if things had stayed the same and the index fund had not been closed. Ugh!

So anyway, I'm in the process of transferring my Etrade accounts to Vanguard. Here's a brief history of what's happened on that front:

• I got the forms from Vanguard to initiate the transfer. On the forms it tells me that I may need a medallion signature guarantee if the firm that I'm transferring the assets from requires it.

• So I call up Etrade to see if they require a medallion signature guarantee for a transfer.

• I get a snot-nosed kid (sounded like he was 15 years old) Etrade customer service rep who cuts me off in mid-explanation to inform me that I have to initiate the transfer with the company that I'm transferring to, not from, so why am I calling Etrade?

• I tell him I know that and if he'd let me finish, he'd know why I was calling.

• I tell him the rest of the story and ask if Etrade requires a medallion signature guarantee or if I can simply sign it myself and that will be fine.

• He says something to the effect of, "Oh. Let me ask." He puts me on hold.

• He comes back a few minutes later and says that as long as the name and address on the new account is exactly the same as that on the Etrade account, I do not need a special signature to transfer.

• Since I plan to keep everything the same title-wise, I follow Etrade's advice and sign the forms. I send them in to Vanguard.

• Last night, I get a notice from Vanguard saying they'd love to transfer my accounts but that the company I'm transferring from requires a medallion signature guarantee.

Ugggggggggghhhhhhhhhhh!!!!!! I HATE Etrade!!!!!!!!!!!

So now I'm back to square one. I'll go get the signatures needed and send in the forms again. I'm betting Etrade socks me with a huge "transfer fee." At this point, I don't care -- I simply want to be as far away from this company as possible.

What's Your Favorite Broker and Why?

Smart Money recently came out with their list of the top brokers as follows:

1. Etrade
2. Fidelity
3. Schwab
4. TradeKing
5. TD Ameritrade
6. Muriel Siebert
7. Scottrade
8. Firstrade
9. OptionsXpress
10. Banc of America
11. Just2Trade
12. WellsTrade
13. ShareBuilder
14. WallStreet*E
15. Zecco
16. SogoTrade

Here are my thoughts on this list and brokers in general:

1. I don't trade stocks a lot (I currently own one individual stock.) I'm almost 100% in various mutual funds now (with Vanguard) as well as a good chunk of cash waiting in case we buy a new home.

2. That said, I do have accounts with a few of the brokers above as follows:

• Etrade - I'm currently getting out of my Etrade accounts (transferring them to Vanguard) since they shut down their S&P 500 index fund (right before the recent stock run-up I might add.)

• Fidelity - My 401k is with Fidelity and I contribute to it every month. As I've stated before, my Fidelity money is in the Fidelity Spartan Total Market Index Advantage Class (FSTVX). Overall, I like Fidelity and have been pleased with their service (they automatically saved me money) and their website.

• Schwab - I used to have a Schwab account back in the early days of online trading, then I realized they were way over-priced. I think they've taken care of much of that problem. I'm opening a brokerage account with them as part of getting their new credit card, but I don't plan to buy/sell stocks through the account, just get my cash back rewards there.

• TD Ameritrade - The one stock I own is with TD Ameritrade and hence I'm keeping my account with them for now. I like to have one account that allows me to buy stocks (just in case I want to), but I could eventually switch this to Schwab and close down Ameritrade.

How about you? Anyone out there have any of these brokers that they either really like or really don't like?

Review: Sound Mind Investing Website

For those of you new to Free Money Finance, I post on The Bible and Money every Sunday. Here's why.

Today, we have a guest post from ChristianPF. You can learn more about ChristianPF by subscribing to his RSS feed http://feedproxy.google.com/ChristianPF or by following him on Twitter.

Sound Mind Investing (SMI) is a Christian Investing newsletter that now has a full featured website as well. The paper subscription costs $79/year and the web only subscription goes for $8.95/month. This review is of the website and the services offered by it.

A few of the features offered on the SMI website

Articles by topic

One of the first things I noticed when using the site is the plethora of great and helpful articles divided by topic. They are written by a wide variety of authors, many of which are some of the most respected writers in the Christian Financial realms: Larry Burkett, Howard Dayton, Ron Blue, Austin Pryor and a lot more. These articles alone provide enough great reading material to fill up a couple books.

Back issues of the newsletter

As a web subscriber you have access to all of the back issues of the newsletter - back to 2006.

401k fund tracker

They have a tracking tool that allows you to plug in the funds contained within your 401k or other retirement account. Each month you can access the "Fund Performance Rankings" for each of your funds to be sure they are on par.

Recommended Funds List

They also have a list of funds that SMI recommends divided up by 5 Stock Risk categories that allow you to get some ideas for which funds to purchase.

Message Boards

The SMI message boards are also a wealth of information as well. They currently have over 10,000 members and it is a great place to get investing related questions answered.

The performance

Not having the privilege of using the SMI information for an extended period of time, I can't comment on the performance of their recommendations. However, from the stats they show, they do seem to be doing a nice job of beating the market.

In the graph below, you can see the performance of the last 10 years. The dark shaded area shows the the return received from following their Upgrading Portfolio. And the green area indicates the stock market average.

A few of the things I like about the SMI newsletter

Biblical Perspective

As a Christian I appreciate that everything they do is with the end goal of helping users become better stewards and give more. After all, what benefit is it to gain the whole world only to lose your soul? Matthew 16:26

Objectivity

They do not accept any paid advertising - which enables them to avoid the conflict of interest that advertising can play on recommendations. As they mention, "If we evaluate two competing mutual funds, do you want one of those funds to be paying our salary via advertising? Of course not. Sound Mind Investing does not accept any paid advertising."

Investment Returns

Using past performance as a guide, it does seem that if the SMI program is followed that returns will likely beat the market. Of course there are no guarantees, but the performance of the last 10 years has been a whole lot better than the S&P 500.

Note from FMF: If you'd like to learn more about the Sound Mind Investing website, you can do so here.

I'm in the Buy and Hold Hall of Fame

Ok, so this is a blatant attempt at getting free links from larger-sized blogs, but I'm a sucker for a compliment so I'm falling for it. :-)

ETF Database lists the Buy and Hold Hall of Fame as follows:

Real Life Buy and Hold Legends

• Warren Buffet
• Charlie Munger
• Benjamin Graham
• John Bogle
• Sir John Templeton

Web Buy and Hold Legends

• FMF
• J.D. Roth
• Ramit Sethi
• Trent
• Jim

It's not every day that I'm listed in the same group as Buffett, Bogle, and Templeton (not to mention the great group of bloggers), so you can see why I'm drawing attention to it. ;-)

Specifically, here's what the piece says about this blog:

Free Money Finance regularly writes about a long-term investing strategy. Indeed, FMF has been rather forward in the past about using index funds instead of actively managed funds to build a better investment portfolio. FMF goes to great lengths to illustrate how the average investor can do well, on his or her own, by choosing low cost funds. His common sense approach to investing focuses on the long term, and avoiding short-term decisions that can sap yields through expenses, fees and commissions.

It's a pretty accurate statement. I do invest for the long-term (I have about a 20-year time horizon), I do like index funds because they both perform well and keep costs low, and I do avoid short-term decisions (like bailing out on the market altogether because the economy tanks) that can really hinder results.

If you want some more detail on these as well as my other thoughts on investing, check out these posts:

• Why I Like Index Funds

• How I Easily Improved My Investment Returns Using Vanguard Admiral Shares

• Costs Matter If You Want to Maximize Investment Returns

• More Reasons to Invest in Index Funds 

• Frugal Millionaires Love Index Funds

• Warren Buffett Tells How to Invest $1 Million

Top 10 Investing Rules of Thumb

ETF Database lists the top 10 investing rules of thumb as follows:

• Rule of 72. The Rule of 72 states that you can divide the number 72 by whatever yield you are getting to see how long it would take for your investment to double.

• “120 Minus Your Age” Rule. The old rule of thumb was to take your age and subtract it from 100. That is your percentage of stock allocation. However, with the new life expectancies, that rule is rather conservative. Instead, the suggestion is to change that 100 to 120.

• The Long Term Inflation Average Is 4%.

• Very Few Years Are “Average”.

• You Need 20x Your Gross Annual Income to Retire. This rule is a great starting point for your retirement planning.

• 4% Withdrawal Rule. In order to protect your principal during when you start withdrawing from your investment portfolio, use the 4% rule to figure out how much you can take out.

• Retirement Plan Priorities: 401(k) ’til match, then Roth IRA, then 401(k) ’til max.

• Save and Invest 10% of Your Pre-Tax Income.

• 10, 5, 3 Rule. This is a handy rule that states that you can expect a nominal return of 10% from equities, 5% return from bonds and 3% return on highly liquid cash and cash-like accounts.

• Required Return. There is an interesting formula to help you figure out your required return (this is a bit more advanced than our other rules, but it’s a useful one). It looks as follows: Required return = risk free rate + beta (historical market return - risk free rate).

Here's my take on these:

1. I round off to 70 for a rough guess of how long it will take an investment to double. At 10%, it takes 7 years. At 7%, it takes 10 years. So if I have 20 years before I retire, my current investments will double three times (21 years) at 10% or double twice at 7%. Pretty simple.

2. I'm probably more like 130 minus my age, but I'm overly aggressive anyway. I'm moving towards paring that back and moving more into bonds.

3. Yep, I use 4% in my estimates.

4. I don't really use the averages when thinking about my investments other than to add some context to my "rule of 70" noted in point #1.

5. I prefer 20 times LIVING EXPENSES. We live below our means and can retire on much less than 20 times our income.

6. 4% is a good retirement rule-of-thumb IMO.

7. I'm over the Roth income level, so I completely fund my 401k and supplement it with a SEP IRA.

8. We're well over 10% right now -- closer to 30% -- which goes to retirement, college for kids, savings for next car purchase, etc.

9. I know many of you are going to jump on the "10% return for equities" comment. ;-)

10. Don't use it much.

Here's my general investing rule-of-thumb that's worked fairly well so far:

Save and invest as much as you can as soon as you can and for as long as you can.

Do this (and allocate it correctly) and all the other rules-of-thumb won't matter much. :-)

What is Forex Investing?

Almost any financial website these days (this one included -- through the Google ads on the site) have ads for Forex investing/trading. I see them all over. In addition, I fight them quite often as it seems sites that are into Forex investing like to leave spam on other websites to increase their search engine rankings. But in all of this visibility for Forex investing, I have just one problem: I don't know what it is.

So I went to Google and found a couple of sites that educated me. Here's the first piece I ran into -- from Yahoo -- and their summary of Forex trading:

The Forex market is a non-stop cash market where currencies of nations are traded, typically via brokers. Foreign currencies are constantly and simultaneously bought and sold across local and global markets and traders' investments increase or decrease in value based upon currency movements. Foreign exchange market conditions can change at any time in response to real-time events.

Here's a bit more from Wikipedia:

The foreign exchange market (currency, forex, or FX) is where currency trading takes place. It is where banks and other official institutions facilitate the buying and selling of foreign currencies. FX transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another.

The purpose of FX market is to facilitate trade and investment. The need for a foreign exchange market arises because of the presence of multifarious international currencies such as US Dollar, Pound Sterling, etc., and the need for trading in such currencies.

This piece, in particular, then goes into detail on how banks, hedge funds, and others can invest/trade in the Forex market. My very limited layman's viewpoint is that Forex trading is simply trading in currencies. Like with other investments, I assume that the goal is to trade when you expect your currency to increase in value relative to currencies you are selling (while others buying what you're selling are betting the other way.)

That said, how does an individual invest in the Forex market? And, the bigger question, why would anyone want to? It seems like it's VERY speculative and akin to commodities -- you can lose a TON real fast if you don't know what you're doing.

I bet there are some of you out there that know at least the basics of Forex investing. If so, please share your thoughts with the rest of us -- I'd love to hear your insights.

More Reasons to Invest in Index Funds

US News gives us more reasons to invest in index funds as follows:

According to the just-released S&P Indices Versus Active Funds Scorecard for year-end 2008, the S&P 500 generated higher returns than 72 percent of actively managed large cap funds from the beginning of 2004 to the end of 2008.

Results were even worse for active managers in other major asset classes. Over that five-year period, the S&P MidCap 400 beat 79 percent of mid cap funds, and the S&P SmallCap 600 beat a whopping 86 percent of small cap funds. S&P found similar results in actively managed non-U.S. stock funds and in the majority of actively managed bond funds.

You might wonder if bear markets like this one sway the results. S&P says no: "The belief that bear markets favor active management is a myth. A majority of active funds in each of the nine domestic equity style boxes were outperformed by indexes in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes."

A few thoughts from me:

1. As you know, I love index funds.

2. I've set up my index funds to save me as much money as possible (and thus maximize my returns.)

3. So much for the "index funds perform poorly in a bear market" comments I hear often, huh?

4. I've continued to invest in index funds (mostly stocks, but some bonds) throughout the stock market's fall and I'm counting on the fact that they'll do quite well when the rebound occurs.

If you want to read more about index funds, check out these posts:

• An Investment Portfolio Using Only Three Index Funds

• Warren Buffett Tells How to Invest $1 Million

• Warren Buffett Bets on Index Funds

Getting Started With Investing

The following is a guest post from Marotta Asset Management.

There isn't a better time to invest than today. The way to build real wealth is by living well below your means and then saving and investing the difference. The poor buy things; their homes are cluttered with them. The middle class buys liabilities like second homes and boats, and then they are obliged to make payments and upkeep on them for years. In contrast, the rich buy investments that appreciate and pay them dividends and interest for decades.

Despite recent market turmoil, historic long-term returns still average 10% to 12%. At a 10% rate of return, your investments should double every seven years. So $100 invested today becomes $200 in 7 years, $400 in 14 years and $800 in 21 years. Even at a modest 7% rate of return, your investments should double every 10 years.

Getting started may seem as daunting as embarking on any new hobby, but on average this kind of hobby pays you money rather than costing you. Every hour you spend learning about investments is an hour of free entertainment. It is an hour you are not spending money at the mall or on a more expensive pastime. And ultimately investing will be your engine of income and appreciation. It will subsidize what might otherwise be a subsistence lifestyle based solely on Social Security checks during retirement.

The first step is getting some money together. In the beginning, the amount you save is most important. Later, after you have amassed a significant multiple of your annual spending, the amount you make on your investments becomes much more significant. At that point (at age 40 or when you have five times your annual spending to invest), it's time to seek a personal fee-only financial planner in your area. Visit the website of the National Association of Personal Financial Advisors at www.napfa.org. for information.

In step 2, open an account where you can do your investing. E*Trade (www.etrade.com) is a discount firm. Account minimums are $2,000 with less than $50,000 in combined assets, and stock trades cost $12.99. TD Ameritrade (www.tdameritrade.com) offers accounts with a $2,000 minimum and trades of $9.99 each. Scotttrade (www.scottrade.com) offers $7.00 per trade with a minimum of just $500. Charles Schwab (www.schwab.com) offers trades at $12.95 with a $1,000 minimum account size. Fidelity (www.fidelity.com) charges $19.95 per trade with a $2,500 minimum.

Competition continues to force brokerage companies to adjust their charges on a regular basis, so verify the fees before signing up. Be sure to ask about any monthly inactivity charges. Avoid any account with monthly or annual fees. You plan on investing in a balanced portfolio and then going fishing. You don't want to be charged for the 11 months between now and your annual rebalancing. Make sure you know what the account minimums are too. They should never be more than a few thousand dollars. Although you don't plan on transferring your account, ask what the charges are to do so, and make sure they are reasonable, typically about $75.

Each broker has special promotions that may offer free trades, cash or electronic goods. Taking the best promotion is tempting, but evaluate brokers without considering the promotion.

Setting up an account is easy, and you may be able to do it online. If you need to sign account agreements, read them carefully. Not only should you understand what you signing, but this is the first step in your financial education, and your goal is to gain wisdom and experience.

Half of any area of expertise is learning the vocabulary, which gives you both a shorthand for discussing finance and possibly a new a way of thinking about the world of investments. If you don't understand something, check it out at Investopedia (www.investopedia.com) or call your broker's toll-free number.

In step 3, get money into your investment account. Many brokers allow you to link your checking account to your investment account electronically so you can transfer money at any time. Better yet is setting up a monthly automatic transfer. A day or two after your paycheck is deposited into your checking account, an amount you have designated is automatically transferred into your brokerage account.

The principle is to pay yourself first. You deserve to build wealth, and wealth is what you save and invest, not what you spend. Think of a rich person simply as a poor person who has saved a lot of money. Save and invest as little as $100 a month for 46 years earning 10%, and you can retire with a million dollars. And $500 a month grows to an astounding $5 million.

Those 46 years of saving ideally take place between ages 20 and 66. If you are beginning later in life, you may have to invest more to save the same amount. In fact, for every seven years you delay saving and investing, you cut your retirement lifestyle in half.

Today is the day to decide if you want to be financially free. I can't emphasize enough that time in the markets is more crucial than timing the markets. Who among us doesn't wish we had invested as much as possible in the markets at the prices 46 years ago?

Push yourself to save as much as you can automatically each month. No one should save less than $100 a month in their taxable savings, and this taxable savings is in addition to any work-related retirement accounts.

After you have begun adding money into your taxable savings account, it's time for step 4, actual investing. Knowing the best mix of investments requires a great deal of research and analysis. Investment advisors can add significant value for large portfolios. But for small amounts when you are just getting going, how much you save each month is more critical than the asset allocation you select.

To pick a fund, go to www.maxfunds.com. This is an excellent laymen's site for fund analysis. In the drop-down box "Show me these funds" select the category you want to purchase. I will tell you which categories to purchase later, but for now assume you know. Next, in the drop-down box "That are sorted by," select "Highest MAXFunds Rating." Finally, click "Go."

The tool lists many investment choices, ranked from their highest score downward. If you can invest at least $2,000, buy an exchange-traded fund. These funds are purchased with a transaction fee ($8 to $20). The amount you are purchasing should be significant enough so the transaction costs to purchase the fund are well under 1% of your initial investment. For amounts less than $2,000, consider waiting and accumulating more to invest or else purchase a no-load mutual fund without any transaction fee.

The site puts a yellow star next to their favorite fund, which is a good place to begin. If you are evaluating funds on your own, look for a fund where the TYPE is ETF and the expense ratio (EXP) is as low as possible. That is often the best choice of a fund. The lower the costs, the more you will keep of the return.

Finally, let's talk about investment categories. Start with a fund that follows U.S. large-cap stocks, and then as you gather additional investment money add funds in the order in which they are least correlated with each other. Here is the order for your first five investments.

Launch your investment portfolio with a "Large Cap Value" fund or better yet a "Blend" fund such as Vanguard Total Stock Market ETF (VTI) or iShares Russell 1000 Index Fund (IWB). Make your first investment in this fund at least $3,000. This should cover all the stocks in the S&P 500 and more.

Second, add an "Intl. Diversified" fund like iShares MSCI EAFE (EFA) or Vanguard Europe Pacific ETF (VEA). Third, add a "Natural Resources" fund like iShares Natural Resources (IGE). Fourth, add a "Small-Cap Value" fund like iShares Russell 2000 Value Index Fund (IWN) or Vanguard Small Cap Value ETF (VBR). Fifth and finally, add an "Emerging Market" fund like iShares MSCI Emerging Markets Index (EEM) or Vanguard Emerging Markets ETF (VWO).

After investing in these five funds, you will probably know enough to evaluate your asset allocation with more sophistication than this simple allocation. If you want, go back and add another share to the "Blend" and "Intl. Diversified" allocations. By then you should have over $20,000 and be on your way to growing rich. Getting started can be intimidating, but these simple steps will help you through your first few years of investing.

One Reason the Rich Get Richer

In a recent piece, Wise Bread notes several reasons why the rich get richer. But they leave one reason out -- one that I've been thinking about for some time now:

The rich network with other rich people and as a result get opportunities that other's don't have.

Why have I been thinking of this lately? Because I've experienced it firsthand.

My wife and I have friends that are pretty well off. They own their own business and make a good income. In addition, they save and invest wisely and hence their fortune continues to grow.

As they invest, they've met more and more people who are also wealthy and that invest in opportunities most of us never get the chance at -- the "ground floor" opportunities. Now these aren't the "ground floor" opportunities that your Uncle Larry used to tout, but are instead investments in real businesses that have the potential to offer an exponential return on the money invested. Sure, they are risky, but if you have enough money, you simply invest in 10 or so hoping that two or three earn you 10 times your money (or more.) Three hold their value and the rest are worthless. Even at these odds, you're doing quite well investing this way.

Since our friends are on the inside among these sorts of investing groups, they've opened up opportunities for us. Now we're not plopping down $50k on ten different investments, but they have opened the door for us to some less risky but still much-better-than-most-people-can-do sorts of investments that are doing quite well for us. And our qualification for being allowed to invest in these opportunities? Simply that we know some rich people who opened the door for us.

So I'd suggest that one reason the rich get richer is that rich people know other rich people and get much more profitable and exclusive investment opportunities as a result. Make sense to you or am I off the deep end on this one?

The Six Investing Safeguards

I recently ran a series of guest posts on safeguarding your investments that was very well received. Throughout the course of the series, I received many positive comments. As such, I thought it would be useful for those of you who missed the series, to see all of the posts in one place, so here they are:

• Safeguard #1: Do Not Allow Your Advisor to Have Custody of Your Investments

• Safeguard #2: Walk Away from "Too Good to Be True"

• Safeguard #3: Insist on Publicly Priced and Traded Investments

• Safeguard #4: Buy Investments That Trend Upward

• Safeguard #5: Understand Your Investment Strategy

• Safeguard #6: Recognize and Avoid Financial Hooks

Click on the one(s) you'd like to read. Or if you want to start at the beginning and read them all, click on the link at the bottom of the first post and keep going.

Timing Doesn’t Work -- Or Does It?

The following is a guest post from Rob Bennett, blogger at A Rich Life.

Timing doesn’t work. Everybody knows that.

Right?

Maybe not.

In fact -- certainly not!

The reality is that one form of timing does not work. Another form of timing always works and must be employed to achieve long-term investing success. It’s important to know the difference between the type of timing that doesn’t work and the type that does.

The claim that timing doesn’t work is rooted in studies showing that short-term timing doesn’t work. You are engaging in short-term timing when you change your stock allocation with the expectation of seeing a benefit within six months or a year or two years. The studies showing that this form of timing doesn’t work advanced our understanding of how to invest effectively in a big way.

Unfortunately, too many investing experts have fallen into the lazy habit of saying that timing doesn't work without making the distinction between short-term timing and long-term timing. Long-term timing is when you change your stock allocation in response to big price changes with the understanding that you may not see a benefit for doing so for five or even ten years. The same historical data that shows that short-term timing never works also shows that long-term timing always works.

If you think about it for a few moments, you will see why this must be so. Like all other assets that can be bought or sold, stocks must offer a better long-term value proposition when purchased at good or reasonable prices than when purchased at insanely inflated prices. But the only way to take price into consideration when buying stocks is to go with a higher stock allocation when prices are low or moderate than when prices are high. That’s long-term timing. For long-term timing not to work, stocks would need to offer the same long-term value proposition at all prices. That obviously cannot be so. Long-term timing obviously works.

The strategic implications are huge. Investors who understand that long-term timing works knew to lower their stock allocations when prices went to insanely dangerous levels in the late 1990s. Thus, they protected themselves from the worst effects of the huge price crash. Since long-term timers took less of a hit in the crash, they have more assets to invest now that stocks are again reasonably priced. They’ll be earning the benefits of compounding returns on their larger portfolios for decades to come.

Why does long-term timing work when short-term timing doesn’t? It is primarily emotions that influence changes in stock prices in the short term. Emotions are irrational and therefore unpredictable. In the long term, though, the market must push prices back to reasonable levels if it is to continue to function. In the long run, it is the economic realities that determine stock prices.

It turns out that stocks are not always the best choice for the long run. Purchase stocks at good prices, and you can be assured of a good result in the long term. Purchase stocks at bad prices and the opposite is so.

What you can be sure of is that prices will move in the direction of moderate prices over time (John Bogle calls this “Reversion to the Mean” and describes it as an “iron law” of stock investing). Purchase stocks when they are overpriced and the move to moderate price levels works against you. Purchase stocks when they are underpriced and the move to moderate prices works in your favor.

Timing never works. Except when it does. Which is always!

The Unrelenting Power of Compound Interest

The following is an excerpt from the book The Sound Mind Investing Handbook - A Step-By-Step Guide To Managing Your Money From A Biblical Perspective 5th Ed. FYI, the levels referred to below are the various levels within the Sound Mind Investing strategy. Level 1 is getting debt free, Level 2 is saving for future needs, Level 3 is investing your surplus, and Level 4 is diversifying for safety.

Sometimes, Level Two folks feel they can’t do anything very exciting from an investing point of view.

The folks at Levels Three and Four seem to have all the fun. Meanwhile, you’re still trying to save $10,000 for those “contingencies.” It can seem like an impossible task. If you feel that way, you’re short-changing the impact you can make. The power of compounding works to help you as you save.

For example, let’s assume you’re starting today with nothing in the bank. If you can save $10 each week and put it in a savings account, it will grow to $10,000 in 14 years. Admittedly, that seems pretty far away. How about working harder on your budget and increasing your savings from $10 a week up to $30? That gets you to your $10,000 goal in just 5.7 years. That’s much better. And if you start out with $4,000 in the bank rather than from scratch, the time required drops to only 3.2 years.

You can alter the variables to fit your particular situation (see table at left). Just keep in mind that every dollar in additional savings and interest earned contributes to the compounding process and gets you to your destination that much faster. You can achieve your Level Two goal sooner than you think through commitment and careful planning.

Many years ago, I came across a book with a rather unforgettable title: Money Makes Money, and the Money Money Makes Makes More Money.

As you might expect, it was about the power of compound interest. The word “compound” refers to something composed of two or more parts. Familiar examples include a chemical compound (a substance composed of two or more elements) and a hospital/medical compound (a building where two or more functions, like surgery, doctors’ offices, nursing care and laboratory, are combined into one large facility).

In financial terminology, “simple” interest refers to interest being paid on the principal only. Assume you deposited $1,000 in a one-year bank CD that paid simple 7% per year interest. After the first month, you would have “earned” a small amount of interest, around $5.83. But the bank isn’t going to pay it to you until the year is up; it is going to hold onto it. And even though it’s yours, it is not going to pay you any interest for having it around to use over the coming year. The bank is obligated to pay you interest only on one part of your account—your principal. After the year, you’d have earned $70.00 in simple interest.

Now, let’s change the terms of the CD to one of “compound” interest, where interest will be paid on both the principal and the monthly interest earned as the year goes along. The first month, the bank pays you only on your principal, just as before, because you haven’t earned any interest yet. But after the first month, it credits your account with that $5.83. Now, for the coming month, you’re going to earn interest on $1,005.83 instead of your original $1,000.00 of principal.

The second month you earn $5.87 in interest, only 4¢ more. By the end of the year, you’ve earned total interest of $72.29. That’s $2.29 more than simple interest would have paid, and it came your way just by changing one word in the CD agreement and without increasing your risk. Suppose we change the CD to pay weekly compounding. Instead of giving you credit for your earned interest just once a month, the bank will do it once a week. It turns out that at year’s end you’ve earned $72.46 in interest.

Daily (or “continuous”) compounding has become the most common offer. If we used daily compounding in our CD example, the total interest earned would have been $72.50. That’s the same as a simple interest rate of 7.25%. So, by changing from simple interest to daily compounding, you would have effectively improved your return by ¼% per year.

Does it seem too small an amount to really matter? For just $1,000 and for only one year, perhaps so. But when you consider how much you will have on deposit in a savings account over your lifetime, the difference of ¼% per year in return can amount to tens of thousands of dollars.

The unrelenting power of compound interest is one of your greatest investing weapons.

Consider this updated version of the saga of Jack and Jill. Jack started a paper route when he was eight years old and managed to save $600 per year. He deposited it in an IRA investment account that earned 10% interest. Jack continued this pattern through high school and “retired” from the paper-
delivery business at the ripe old age of 18. All told, he saved $6,600 during that time. He left his savings to compound until he reached 65 and never added another dollar during the entire intervening 47 years.

Jill didn’t have a paper route, but waited until her post-college days to start her savings. At age 26, she was sufficiently settled to put $2,000 into her IRA retirement fund. This she continued to do each year for 40 years. She also earned a 10% compounded return on her savings. Now, the question is which fund was larger at age 65—Jack’s IRA into which he put $6,600 or Jill’s into which she put $80,000?

Surprisingly, Jack is the winner. His IRA has grown to more than $1,078,700, an amount equal to more than 162 times what he put in as a child. Jill also did quite well with hers, which grew to $973,700. But Jack’s earlier start, even with smaller amounts and deposits for far fewer years, was too much to overcome thanks to the tremendous power of compounding. That’s because when Jack was 26, the age at which Jill began her IRA savings, the interest earned in his account was more than the $2,000 Jill was putting in. The moral is: invest early and often—even small amounts can make a big difference!

Your Most Important Investing Decision

The following is an excerpt from the book The Sound Mind Investing Handbook - A Step-By-Step Guide To Managing Your Money From A Biblical Perspective 5th Ed. I've had to modify it a bit since the chart it used to refer to wasn't showing up in the post.

Investing is actually quite simple . . .

 . . . because you only have two basic choices: investments where you become a lender to someone and investments where you become an owner of something.

Investments where you lend your money are generally the lower-risk kind. Assuming you do a good job of checking out the financial strength of the borrower, the primary risk is that you might get locked in to a poor rate of return for many years.

Investments where you own something are generally the higher-risk kind. The primary risk here is that the value of what you own could fall, so the economic outlook and its effect on your holdings is of great importance.

What I’m about to tell you is very important, so please pay close attention: The way in which . . .

. . . you divide your investment capital between these two basic choices of “loaning” or “owning” has a greater impact on your eventual investment returns than any other single factor.

Think of your investments as being like a garden. Some people like to grow flowers and others prefer to grow vegetables. Some enjoy doing both. The one decision that has the greatest influence over what your garden looks like and the kind of harvest you’ll ultimately have is this: How much of your garden should you devote to flowers and how much to vegetables? Once you decide that, you know a lot about what to expect in terms of the risks involved and the potential results even if you haven’t yet decided which kinds of flowers or vegetables you’re going to plant. Once you decided how you were going to allocate your space, the kind of harvest you were going to have was, to a great extent, already predetermined.

Now, let me shift your thinking to the investment arena. Studies have shown that 80% or more of your investment return is determined by how much of your portfolio is invested in stocks (flowers) versus bonds (vegetables), and only about 20% is determined by how good a job you did at making the individual selections. This surprises most people, because the investment industry gives far more attention to telling you about hot stocks and mutual fund performance rankings than to explaining the critical importance of asset allocation (that is, how much space you make in your investment garden for stocks versus how much room you allocate to bonds). We’ll look at this in great detail in chapter 16 where I’ll teach you a very simple strategy which puts your focus on “how much you put where” rather than “which ones.”

For now, I just want you to recognize that the economic forces that influence the two basic choices are different. It’s possible for you to invest-by-lending your money to a financially strong company like General Motors in return for one of its bonds and, even in the midst of a deep recession, earn a nice return. On the other hand, it’s also probable that if you chose to invest-by-owning stock of the same corporation and thereby become one of its part owners, the same recession would have caused serious harm—hopefully temporary—to the company’s earnings and dividend payments. As a part owner of the business, you would have likely watched your investment in the company lose value even while its creditors (like the investors who bought GM’s bonds) were happily collecting their interest payments.

Of course, that’s just looking at the risk part of the equation. The other side of that coin is that the owners of a company can enjoy great prosperity during those times in the business cycle when the economy is healthy and growing. The creditors, meanwhile, continue receiving only the interest payments to which they are due.

Consider the five-year period from 1987 to 1991. Investors who allocated 100% of their capital to being owners (by investing in the shares of stocks in those blue-chip companies that are part of the Standard & Poor’s 500 Stock Index) would have received a total return of 15.4% per year during that time. This is despite the fact that the crash of 1987 occurred early in the period. Furthermore, with a few exceptions (notably during the bear markets of 1973-74 and 2001-02), stockholders who hold for at least a five-year period typically do far better than bondholders during the same period.

Investors who decided to allocate 100% of their money to becoming lenders would have earned 10.4% per year during the 1987–1991 period. (This assumes their returns were similar to the bonds included in the Salomon Brothers Long-Term High-Grade Corporate Bond Index, which is an average of more than 1,000 publicly issued corporate debt securities.) They would have made less money and taken less risk. Investors who don’t want to cast their lot entirely with either camp, but choose to split their capital equally between the two basic choices—50% in stocks and 50% in bonds -- have consistently been profitable.

All investing eventually finds its way into the American economy. It provides the essential money needed for businesses to be formed and grow—for engineering, manufacturing, construction, and a million and one other services to be offered and jobs to be created. You can either be a part owner in all this, tying yourself to the fortunes of American business and sharing in the certain risks and possible rewards that being an owner involves. Or, you can play the role of lender, giving your money to others in order to let them take the risks and knowing you are settling for a lesser, but more secure, return on your money.

How to divide your funds between these two kinds of endeavors is your first and most important investing decision. Everything else is fine-tuning.

Safeguard #6: Recognize and Avoid Financial Hooks

The following is a guest post from Marotta Asset Management.

To safeguard your money, you must be able to extricate yourself from any bad investment quickly. Of course, the companies that sell mistakes don't want you to be able to do that, so they use financial hooks to hold your money captive.

Any financial product with a surrender value significantly different from the net asset value has financial hooks. For example, take the different classes of mutual funds from the giant American Funds: Growth Fund of America.

Shares come in five different sales classes. Class A shares have an expense ratio of 0.65% in fees and expenses. Additionally, there may be a front-end load of 5.75%.

If you invest in class B, there is no upfront sales charge. But if you sell shares before you have owned them for seven years, you must pay a sales charge that starts at 5%. And while you are holding class B shares, the expense ratio is 1.39%.

Class B shares are the most gut wrenching. If investors have been holding them for nearly three years, they are still hit with a 4% redemption if they sell them early. It doesn't matter if they should sell large-cap U.S. stocks and diversify into another asset class. It doesn't matter that the company has already collected 4.17% in ongoing expense ratios.

Investors are still faced with the decision of holding the fund another four years, at an ongoing expense of 5.56%, or selling the fund and paying a contingent deferred sales charge of 4.00%. The angst of these kinds of hooks in their investments deters many people from selling, even though they know diversification is critical to their portfolio.

In this example, because the fund has been held just under three years, waiting a few months until the third anniversary lowers the redemption charge to 3%, probably the wisest decision. There is an obvious 3% hook if you sell, and a hidden 5.56% hook if you hold the investment.

Class C shares have a contingent deferred sales charge of 1.00% in the first year and an even higher expense ratio of 1.44%. Needless to say, we don't recommend A, B or C shares. These are all loaded shares, meaning they are laden with sales charges.

Fee-only financial planners recommend two classes of shares at American Funds that are no load. The F1 class has no front- or back-end sales charges and an expense ratio of only 0.63%. The F2 class is used in retirement plans and eliminates the 12b-1 marketing fee. It has the lowest expense ratio, only 0.43%. A fair comparison can be made between C shares with an expense ratio of 1.44% and F1 shares with an expense ratio of 0.63%. The savings of F1 shares is 0.81%.

Mutual fund salespeople claim this difference is less than the 1% of assets under management that many fee-only financial planners charge. But you are not getting any real value for a mutual fund sales charge. A different way of looking at it is that fee-only financial planners could earn 81% of their fee simply by reducing your expense ratios. Given an 81% discount, that would make their comprehensive financial planning available at a cost of the other 19% of their fee.

Our example only looked at the five different share classes of Growth Fund of America. A fee-only financial planner has the entire world of investment options to choose from and may find better selections available at even lower expense ratios.

B shares are just one example of the many investment choices with financial hooks. Whole life insurance also has a surrender value significantly lower than its fair market value. And annuities are sold with financial hooks that can lock your money up for several years.

Private equity investments require even longer commitments of capital. Once you are invested, it is very difficult to get your money out until the fund liquidates many years later. During those years you may not even know if your investment was a good one.

Because no public pricing exists for private equities, they continue to be priced to investors at their initial cost. That cost, minus fees, expenses and write-offs, typically produces a negative return over the first half of the investment. Private equity also may require you to commit to additional investments through the life of the investment. So not only is your initial investment held captive, but you must keep a sizable chunk of cash liquid to pay the private equity's capital calls. Finally, the fees are charged on the basis of this committed capital, not just the amount you have already invested.

It was these capital calls that recently hurt the investment strategy of the University of Virginia endowment. Having had significant investments in private equity, after the drop in their regular investments, much of the remainder will be needed to satisfy capital calls on their private equity. The result will be a much higher than desirable portion of the endowment in private equity investments.

Private equity may be acceptable for an endowment with an infinite time horizon, but it is not for average investors who want access to their money during retirement.

Hedge funds are poor investments for similar reasons. They typically require your investment to be committed for years, called a lockup period. During that time, managers not only take 1% to 2% of assets annually, but they also collect 20% of returns, both realized and unrealized. These extra fees are collected any time the fund exceeds its high-water mark.

This compensation scheme is ripe for abuse. Many of the hedge funds that opened after the fall of 2002 hit their high-water marks in the summer of 2008. When the markets are behaving themselves, hedge fund managers enjoy the ride up, gaining 20% of the profits of markets trending upward. During this time, your money is held captive during the lock-up period, and redemptions are not allowed.

If a typical fund charges 2% plus 20% of profits, and gains average 10% to 12% because the markets generally go up, the average fees being paid are in excess of 4%. You might imagine that would be enough money to keep hedge fund managers loyal to their captive customers, but it is not.

But when the market winds blow south, fund managers defect. Many hedge funds are now closing. There is no sense running a fund that is 50% below its high-water mark. Without the incentive of proximity to the high-water mark and a good chance of making 20% of the profits, many hedge funds are not interested in merely serving the client.

So hedge funds can hold your money captive when they are making high fees and abandon you and start a new fund after a significant market correction. This explains why hedge fund companies often have several different hedge funds, each with a different inception date. They can drop those that have poor returns and advertise those with good returns.

As a result, the average life of a hedge fund is only three years. Every three years a market downturn provides the incentive for hedge fund managers to close the current fund and reboot to a lower high-water mark. Three years is also the average lockup period after which disappointed investors can finally get their money out.

To add insult to injury, hedge funds are unregulated, which means the reporting of a hedge fund's return is completely voluntary. There is a hedge fund index that aggregates these voluntarily reported returns, but the number isn't reliable. Hedge funds with poor returns don't report, and hedge funds that fold and go out of business stop being included.

Unrealistically high reporting of returns to attract customers, a three-year lockup period and exorbitantly high fees sounds like a way to make money for the fund but certainly not for the average investor.

My final example of financial hooks involves captive trustee accounts. Sometimes estate trusts are established in legal documents that name a bank or other financial institution as the trustee with no method to change that trustee. The banks call these "captive" accounts for a good reason. Beneficiaries cannot take their business elsewhere and may have to suffer poor service or high fees.

Banks may charge fees as high as 4.5% while better service options are available for a fraction of a percent. A bank here in Charlottesville pushed one of our clients to get their estate documents drawn up by an attorney who charged the client thousands of dollars and then wrote the bank in as the trustee in the estate's legal documents.

I've learned through experience that the more financial hooks keep you captive to a particular financial services company, the poorer the service. And without a way to extricate your investment, you are stuck receiving inferior returns for years. It's a simple but powerful lesson: Avoid anything that puts financial hooks on your investments.

Fidelity Takes Automatic Steps to Save Me Money

I've already talked about how I switched from regular Vanguard shares to Admiral shares to try and save on some investing costs. I took those steps proactively -- I called them and made the switch. But one of their competitors made the switch for me -- without me even asking.

As I've recently reorganized all of my investments, I now have a high concentration of dollars in a few funds. I also made these changes in my Fidelity 401k, moving from a handful of funds to one fund that has all my company retirement money in one place (I have other retirement money in IRAs that I've rolled over from previous 401ks -- the money I'm talking about here is just for my current 401k.)

When I made the changes at Fidelity, I put all my money in Fidelity Spartan Total Market Index Investor Class (FSTMX) shares. In short, this is a total market index fund. Here's a description of it from Yahoo:

The investment seeks to match the total return of the Wilshire 5000 index. The fund normally invests at least 80% of assets in common stocks that are in the index. It includes all of the stocks in the S&P 500 index, excluding foreign securities. The advisor uses sampling techniques to replicate the returns of the index while investing in a smaller number of securities. To select stocks, the advisor takes into consideration capitalization, industry exposure, dividend yield, price/earnings ratio, price/book ratio, and earnings growth.

The expense ration from the fund is a very low 0.10%.

But my consolidation put me with over $100k in this fund. A week or so after I made all the transactions, I got a note from Fidelity telling me they were automatically converting me to Fidelity Spartan Total Market Index Advantage Class (FSTVX) shares. The assets are EXACTLY the same as with FSTMX. The only difference is that the new shares have an expense ratio of 0.07%. In other words, the old fund would run me $100 in expenses per year at $100k invested while the new one runs me $70. I'll take $30 per year for doing nothing different, thank you very much! Over 20 years, that's $600 at $100k, but since I'll be adding to the amount, my savings will be much greater over time.

Ok, it's not a fortune, but I was impressed that Fidelity took the steps on their own to make the change, save me some money, and take care of a customer. Kudos to them!

BTW, Vanguard may have done this as well -- I don't know. As soon as I transferred the money there I made the change myself. If anyone has had experience with them in this sort of change, please let me know.

Index Funds Win Again

Here's yet another piece that touts the advantages of index funds -- this time from the NY Times. The conclusion:

There's yet more evidence that it makes sense to invest in simple, plain-vanilla index funds, whose low fees often lead to better net returns than hedge funds and actively managed mutual funds with more impressive performance numbers.

Basic stock market index funds generally aspire to nothing more than matching the returns of a market benchmark. So in a miserable year for stocks, index funds may not look very appealing. But it turns out that, after fees and taxes, it is the extremely rare actively managed fund or hedge fund that does better than a simple index fund.

The piece goes on to detail the work and findings of Mark Kritzman, president and chief executive of Windham Capital Management of Boston and professor of financial engineering at M.I.T.’s Sloan School of Management, where he compared index funds to actively managed funds and hedge funds. The simplified summary: actively managed funds perform better before expenses are subtracted. But once expenses are deducted, index funds are the better choice. Their words:

Expenses were the culprit. For both the actively managed fund and the hedge fund, those expenses more than ate up the large amounts — 3.5 and 9 percentage points a year, respectively — by which they beat the index fund before expenses.

If such outperformance isn’t enough to overcome the drag of expenses, what would do the trick? Mr. Kritzman calculates that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year.

As I've said before (probably a hundred times now on this site), costs matter BIG TIME when it comes to investment returns (that's why I've taken extra steps to get my investing costs as low as possible.) And that's one reason I like index funds -- they keep investment costs to a minimum and thus keep total returns as high as possible.

For more thoughts on index funds, see these posts:

• Warren Buffett Bets on Index Funds

• Index Funds Get Even Better

• More on Costs Killing Your Investments

• An Investment Portfolio Using Only Three Index Funds

• How Fees Eat Your Lunch -- It Still Adds Up To Dollars

Safeguard #5: Understand Your Investment Strategy

The following is a guest post from Marotta Asset Management.

I often write about the importance of a financial advisor being a fiduciary and the responsibilities accompanying that legal obligation. But clients also have their part to play in financial planning. Certain responsibilities cannot be delegated to others. Understanding and maintaining your role in the process is critical to safeguarding your money and consequently your financial freedom.

Advisors are coaches, not players. They motivate and assist their clients in completing all the actions necessary to implement the plan and thus achieve their financial goals. Most clients have a vague list of worries that reflect more anxiety and frustration than direction. A good coach on your team can make a big difference in the outcome of the game, but the contest is still ultimately in the hands of the players. Your active participation is necessary to secure your financial future and cannot be delegated.

As fiduciaries, we strive to act as you would if you had our time and expertise. But without you taking a real role in the process, we would be unable to gather the information and resources needed to help you set and meet reasonable and realistic goals. Without committed participation, the process of assisting clients to meet their stated financial goals can end up frustrating both parties.

This scenario is very different from dealing with brokers or agents, who may only be interested in satisfying the suitability rule in order to sell their products and services. Without the burden of acting in their clients' best interests, they may be personable to work with, but wealth management isn't just about the relationship. It is about reaching your goals, and sometimes the most effective coach can't be your best friend too.

The best advisors are quantitative and analytical. They may buy you lunch or send you a birthday card, but their genuine strengths lie elsewhere. Expert advisors have substantial knowledge and offer sophisticated services.

To extend the sports metaphor, if a fiduciary advisor is a coach, then brokers and agents are there just to sell you equipment. But a shin-guard salesperson isn't going to help you play a better game of soccer. Personality can be an effective sales tactic because salespeople know you are most likely to say "yes" to someone you like. In contrast, a good coach is not your buddy but rather someone who asks things of you. But he or she is also going to support you with a winning team and help you interact with that team to score goals.

A player can't sit back in the bleachers like a fan and cheer the team on. When you as the client are not interested in understanding enough of the investment strategy to play your position, you won't be able to achieve your goals.

Don't trust any investment strategy you don't understand, and don't trust any advisor who won't or can't take the time to explain exactly why and how he or she operates. An advisor's investment philosophy is the most important and valuable resource you are purchasing. If you don't trust your advisor's knowledge and techniques, you shouldn't entrust your financial future with them. In other words, don't invest in anything with anyone that you either do not understand or with whom you feel uncomfortable.

"Distressed emerging market risk arbitrage" may be a surefire way to make loads of money, but if you don't understand the process and feel at ease being part of the team that executes that move on the field, you would be better off sitting on the bench and investing in Treasury bills.

Note that I am not advocating "invest in what you know," which is called familiarity bias and can cause your portfolio to be inadequately diversified. Only investing in what you know may help you avoid some crazy investment schemes, but the resulting concentration can be dangerous in other ways.

Instead, the better rule of thumb is "know what you are investing in," which requires active participation by both you and your advisor. It is best to have an advisor who is a patient and skilled teacher or mentor at heart. And to be a good coach, your advisor should be willing to contradict you when it will help you better meet your goals. At the end of the day, your coach will still be your coach, but you should also be a better player as a result of the relationship.

With a good advisor, your investment approach should be simple and straightforward enough that you understand why the approach is being taken and how it is being implemented. It should never be a black box where you put your money in the top, let the advisor crank the handle and hope the return that comes out the bottom is good enough to meet your goals.

The box should be sufficiently transparent so you know these three simple pieces of information. You know how others are making money off your investments, you know what your investments are composed of and you know how and by what measure your portfolio will be monitored and reviewed.

Sales pitches are notorious for trying to confuse investors about the real composition, execution and compensation structure of the underlying investment. They generally ask investors not to worry about the details and to trust the reputation of brainy academics or else look at the pictures in the glossy four-color brochures instead.

Don't be fooled and don't be foolish. Understanding your investment strategy is critical to safeguarding your investments against reckless schemes. With a good coach and mentor, you can become a better team player and help your family achieve both their financial goals and peace of mind.

Click here to read part 6 of this series.

Frugal Millionaires Love Index Funds

Here's an excerpt from the book The Frugal Millionaires: 70 millionaires anonymously share their ideas about money to help each other and you. Today we're seeing what the millionaires have to say about index funds. You all already know that I love index funds (I'm almost exclusively in them now) and it seems frugal millionaires do too. Makes sense, since I'm one of them.

FYI, these are some representative tips from The Frugal Millionaires. There are over 800 tips in the book. The frugal millionaires are only referenced by their initials. The author signed a confidentiality agreement that the millionaires' identities would never be disclosed in exchange for them saying whatever they wanted. If they chose not to have their initials used they were given the initials AFM which is an acronym for Anonymous Frugal Millionaire.

Here's the excerpt -- they start by defining what an index fund is (in case readers don't know):

DEFINITION: An index fund is a collective investment scenario (usually a mutual fund or an exchange-traded fund) that aims to replicate the movements of an index of a specific financial market. An index fund is created by trying to hold all of the securities in the index, in the same proportions as the index. Many index funds rely on a computer model with little or no human input in the decision as to which securities to purchase and is therefore a form of passive management. The lack of active management (stock picking and market timing) usually gives the advantage of lower fees and lower taxes in taxable accounts. (SOURCE: Fidelity Investments, with edits)

EXAMPLE: An S&P 500 Index Fund takes all the stocks in the S&P 500 and buys enough shares in each company to represent the dollar value of that each company represents as a percentage of that market. So, if the Acme Company represented 2% of the value of all the S&P 500 companies combined then an S&P 500 Index Fund would have 2% of its dollar value in Acme stock.

Since markets generally (meaning almost always) outperform managed funds, and have significantly lower management fees than managed funds, they are a better investment alternative. This is why the frugal millionaires like them as part of their portfolios. Their success/failure is also easier to track. If the S&P 500 went up 1.5% over a one week period so did your S&P 500 Index Fund. The same would be true if it went down.

Index funds are part of a balanced stress-free portfolio. You can use them to buy an overall “market” position. But you should also be considering other options with a portion of your portfolio in more risky investments (only to the degree that you can afford to lose that money) and some conservative options as well. It will all depend on your personal risk profile.

AFM – Index Funds are lower cost and perform better than almost all other similar funds, plus the managed funds have high fees that typically eat into your earnings. Over time that could ruin you. Managed (not indexed) funds that do well often have money rush in and then under perform while new investments are made.

AFM – In nearly every investor letter that Warren Buffett writes he talks about putting your money in Index Funds. Who can argue with that? If you must buy a mutual fund, never buy a “loaded” one (just say no to upfront commissions!).

AFM – Buy Index Funds since personal or even broker stock picking falls behind Vanguard or Fidelity Index Funds about 80% of the time. Don’t sell them.

Safeguard #4: Buy Investments That Trend Upward

The following is a guest post from Marotta Asset Management.

Crazy volatile markets push people toward irrational investment schemes. Methods to safeguard our investments won't prevent loss, but ideally they will prevent us from putting our money in investments where we should have known better. Let me give you an example.

There's always a way to make money in the markets. I'm going to tell you how you could have made a lot of money last year. Some investors used this technique to capture huge gains in 2008 while most investors were losing their shirts. What was their secret? Halfway through the year they bet oil prices would drop.

As oil approached $147 a barrel and everyone else thought it was going to $200 a barrel, these wily investors sold it short. That is, they bet on oil going down. Because they were right, their investment earned sizable returns.

They accomplished this feat by purchasing "put options," the right but not the obligation to sell a certain number of barrels of oil for a certain price for a specified period of time. If the price of a barrel of oil drops significantly, as it did, they could sell their put options for a profit.

Does this scenario sound enticing? Do you find yourself wishing you had your investments in oil puts last year? Envy and regret are powerful motivators in the investing world. But you must tame these emotions if you are going to learn how to safeguard your money.

Just because some investors made significant gains in commodity futures doesn't mean that is where you should have been invested. Most of the time when you purchase a put option, the underlying commodity does not drop significantly in price and your put option expires as worthless.

On average, commodity prices rise rather than fall. If you stop and think for a minute, you could assume that commodity prices would at least increase along with inflation every year. They rise reflecting inflation and they fluctuate along with the supply and demand of economic expansion and contraction.

If a commodity rises an average of 5% just for inflation, most of the time investments in commodity puts will lose money. You can purchase put options at various prices, but they all have to overcome strong tailwinds to move backward. The commodity has to drop more than inflation plus the price of the option itself just to break even and start making money. Just because they sometimes make money doesn't make them a good bet.

Imagine you are standing next to the roulette wheel in a Las Vegas casino trying to decide which bet you want to make. You can either bet on red or black, but you are getting confused because the last spin came up green: zero.

Just because the ball happened to land in zero the last turn doesn't mean zero is a good bet. On average, it is a losing bet. In fact, on average, so are red and black. Never invest in something that on average is a losing bet. Never invest in something that on average goes down. You don't want to be a gambler in Las Vegas at all.

Instead you want to be the house.

The house loses lots of bets. In fact, the house loses more bets than investors do over a year in the stock market. The house edge is small, but on average the house wins a steady stream of gains.

Any investment that, on average, doesn't go up shouldn't be an asset class in your portfolio. There are a lot of so-called investments that fit this description. They are best described not as "investments" but as "speculations." I concede there is a place in specific portfolios to invest in something that doesn't go up on average. But this situation is the exception, not the rule, and these decisions are warranted most commonly because of a large investment that needs to be protected. In this case, what you are really buying is "insurance," not an "investment."

Here's another way to look at short investments. If the markets appreciate 10% per year, then investments against the market lose 10% per year. Predicting market drops with such accuracy as to overcome a 10% headwind plus the transaction costs of shorting the market is difficult, to say the least.

And whereas investments that are long in the market can only drop a finite amount (to zero), short investments can lose an infinite amount because there is no limit to how much a stock can rise.

Gold is another example of an investment that on average does not appreciate in value.

Jeremy Siegel, author of "Stocks for the Long Run," analyzed investments over the past 200 years. Gold, on average, maintains its value over time. If you bought a dollar's worth of gold 200 years ago, after adjusting for inflation, it would be still be worth about $1 today.

Although gold generally holds its purchasing value, it still fluctuates wildly based on other factors of supply and demand. While it does so, the part of these movements that is not just random noise is simply an inverse reaction to the value of the dollar.

Over the long term, gold holds its purchasing power, but it has not for almost three decades. In January 1980, gold reached its high of $850 an ounce. The following year my wife and I became engaged and chose modest wedding rings that were still very expensive. Note that $850 in 1980 had the same buying power as $2,191 in today's dollars. Gold trading at $850 an ounce then was like gold trading at more than twice its current price. In other words, those people who purchased gold in 1980 have lost more than half their buying power during a 28-year investment. Even considering the October 2008 stock market drop, the tailwind of appreciation pushed stock investments to significant gains over the past 28 years. That tailwind is a powerful force for investment growth.

Investments that bet on stock market corrections are more dangerous than the market itself. Perhaps they should come with the following warning: "The stock market can go up as well as down!"

Holding investments for the long term makes sense because millions of people are working in thousands of publicly traded companies on your side of the investment. Your interest is congruent with theirs, and their very livelihood depends on your investment making a profit.

So look for great well-financed companies that deliver products or services of real value in order to make the trend of the investment upward. If the investment bets against that trend or simply holds its value, it should not be a major component in your allocation. There may be a place for options like insurance, but these are rare. As a rule of thumb, put your money only in investments that on average go up.

Click here to read part 5 of this series.

Three Investment Maxims from Vanguard

I like Vanguard. I have a good amount of my portfolio with them and they are one of the companies I enjoy telling people about. Of course part of this love affair is based around index funds (of which Vanguard is the king), but it's also because they've always treated me well as a customer of theirs. Therefore, when they talk about investments, I think it's worth listening to them. That's why I'm sharing the three investment maxims they recently detailed. They are:

• Respect risk. Investments with the potential for great returns also carry great risks.

• Save aggressively. For 2009, investors of all types need to save aggressively, or even "oversave."

• Be balanced and diversified. Creating a portfolio with a mix of different asset classes (stock, bond, and money market funds) is critical to limiting volatility.

I'm surprised they didn't mention anything about costs and the impact they have on investing. I'm also surprised that this list is not as comprehensive as the one from Vanguard founder John Bogle.

Overall, I think we all learned a lot in 2008 and as a country, as well as individually, we're working on ways to try and dig ourselves out of it. Once we do, I hope the lessons stick so that we aren't forced to repeat these mistakes (or have our kids/grandkids repeat them) in the future.