Free Money Finance

Full-Service vs. Discount Brokers

Here's a piece from the Motley Fool that describes the differences between full-service and discount brokers. First they detail what full-service brokers offer:

Full-service brokerages traditionally offer everything from stocks and bonds to annuities and insurance. As their brokers profit largely from commissions, they're sometimes motivated to encourage a lot of buying and selling that may not be in your best interest. Other times, they might just toss your money into a mutual fund and forget about it. There are many good brokers at full-service brokerages, though, who keep your best interests in mind and do a bang-up job for their clients. If you're taking the full-service route, you simply need to determine just how good a job your broker is doing for you, and if the cost is worth it. If you have a broker you like who's doing well for you, sticking with her might be a good idea.

As you might imagine, I'm not a big fan of full-service brokers -- too much cost for too little reward in my opinion. And since I invest mostly in index funds, why would I need one?

Here's their description of discount brokers:

Discount brokerages have traditionally offered a narrower range of services, but they've been adding significantly to this range in recent years. Indeed, the distinction between full-service and discount brokers is much murkier than it was just five years ago. Today, many discounters offer mutual funds, banking services (such as checking accounts), IRAs, mortgages, and more. Some even offer fee-based portfolio consultation and investment advisor services for wealthier clients. Others offer research reports and stock analysis. Discount brokerages compensate their brokers mainly with salaries, not commissions, making their money through high-volume trading.

This is more to my liking. When I want to make a trade, I simply want to buy the stock I want and to do so quickly at a great price. I don't need any other kind of assistance. This is why I prefer discount brokers and have accounts set up with a couple of them.

The Five Signs of Bad Financial Advice

Here's a list of five signs of bad financial advice from Suze Orman:

1. You own a mutual fund with the letter "B" in its name.

2. You pay the advisor through commissions rather than a flat rate.

3. Your life insurance is a cash-value policy.

4. You own a variable annuity inside of an IRA.

5. You're saving for your kid's college education rather than for your retirement.

Oh, yeah! I'm TOTALLY with her on these!

None of these apply to me, but I know several people who have one (or several) of them that they're dealing with. Probably the most common one is #3. Yeah, I know I'll get comments on how great a tool cash-value insurance is, how it is the perfect solution to financial issues in certain situations, and on and on. But for me (and for most people) the right decision is to buy term and invest the difference.

The piece ends with some advice from Suze that I also agree 100% with. Here it is:

Take the time to become educated about your finances so you can make your own informed choices rather than relying on someone else. At the end of the day, no one will ever care about your money more than you. You're your own best financial advisor.

Well said!

How to Make Your Child a Millionaire

Here's an interesting piece from Money Central on how to make your child a millionaire. The details:

A newborn has nothing but time -- and that's something this strategy exploits to the fullest. Let's say a 30-year-old manages to save up and then invest a lump sum of $10,000. At an annual return of 8%, by the time she's 65, that $10,000 will have grown to nearly $150,000. Not bad, right?

But then compare it to what a 5-year-old could make from the same $10,000. The extra 25 years of growth would give him over $1 million by age 65. A newborn would need just $6,700, less than the cost of a decent used car.

This is all about the power of compounding, folks. Take some money and a lot of time and you can become very, very wealthy. It's just the formula I detailed in How to Get Rich in Three Easy Steps.

That said, I'm still constantly amazed by the power of compounding and how much of a difference it can make. I'm just starting to see some really big benefits from compounding personally as my portfolio is now in a position where compounding is really kicking in. It's a nice friend to have on your side. ;-)

The article goes on to highlight what kids at various ages need to invest in order to be millionaires by age 65. It gives three alternatives: a lump-sum investment, a monthly investment until age 18, and a monthly investment until age 65. Here are the results for the various age levels:

Newborn

• Lump sum invested now to be a millionaire at 65: $6,721
• Monthly contribution until age 18 to become a millionaire at 65: $56
• Monthly contribution until age 65 to become a millionaire at 65: $38

Age 5

• Lump sum invested now to be a millionaire at 65: $9,875
• Monthly contribution until age 18 to become a millionaire at 65: $98
• Monthly contribution until age 65 to become a millionaire at 65: $57

Age 10

• Lump sum invested now to be a millionaire at 65: $14,511
• Monthly contribution until age 18 to become a millionaire at 65: $200
• Monthly contribution until age 65 to become a millionaire at 65: $85

Age 15

• Lump sum invested now to be a millionaire at 65: $21,321
• Monthly contribution until age 18 to become a millionaire at 65: $662
• Monthly contribution until age 65 to become a millionaire at 65: $127

Very, very, very interesting -- and compelling -- information. Imagine socking away $6,721 when your child is born, knowing he/she would be a millionaire at age 65. I know, $1 million would not be worth as much then as now, but it still would be a decent amount for such a small initial investment. Besides, what if instead of $6,721, you set aside $20,000? Or $30,000? That's when the pot at 65 would be REALLY big money!

Why It Matters Which Index Fund You Own and How You Buy It

Here's an interesting press release I received recently. I'll highlight portions of it, then comment throughout. We'll start with the headline and summary:

Mutual Fund Study:  Huge “Broker Penalty” Sees Unwary Index Fund Investors Paying 3 Times More in Fund Expenses

See why this one caught my attention? We go on:

One Scenario:  Over 20 Years, Paying $2,582 Versus $7,600 in Fund Operating Expenses; Bottom Line is that Brokers Work for Index Fund Companies …and Against Investor’s Bottomline.

No new news here -- at least for me. But hopefully someone will visit this site and "see the light." The details:

WASHINGTON, D.C.///November 30, 2006///If you think “plain vanilla” index mutual funds are all pretty much the same, think again.  Investors who buy index mutual funds through brokers are paying a steep “broker penalty” by being sold funds with much higher operating expense fees even before adding the distribution fees related to the cost of using the broker, according to a major new study by the Zero Alpha Group (ZAG) and Fund Democracy.  The bottom line for investors: The extra operating costs paid over time for broker-sold load index funds are triple those paid by investors in true no-load mutual funds. 

Authored by Edward (Eddie) O’Neal, assistant professor, Babcock Graduate School of Management, Wake Forest University and Fund Democracy President Mercer Bullard, the Zero Alpha Group/Fund Democracy study finds: “On a $10,000 investment earning an annual return of 10 percent over 20 years, the average investor in no-load, no 12b-1 fee index funds would pay approximately $2,582 in operating expenses.  The average investor holding a no-load fund that charges a 12b-1 fee would pay $3,744, while the average investor holding load index funds would pay $7,600 in operating expenses. Although one would expect using a professional adviser to improve an investor’s performance, instead the investor pays a significant penalty … We found that load index funds charged substantially higher fees – even before counting the fees paid to the broker – than true no-load (no 12b-1 fee) funds.  In other words, when investors used brokers they paid twice: first, they paid the broker; second, they paid a broker penalty in the form of higher fund fees.”   

J. Christopher Kerckhoff, Jr., vice president, Plancorp, Chesterfield, MO., said: “These findings show that brokers are serving as agents of fund companies, not in the best interests of their investor clients. Our study is troubling for investors who use brokers to purchase load index funds.  We would fully expect such investors to incur distribution costs associated with compensating their broker or advisor.  However, there is no valid reason for such investors to have to foot the bill over and above what true no-load investors do for other, non-distribution services.  Indeed, if one presumed benefit of distribution services is the selection of lower-cost index funds, one would expect no-load and load funds to have lower – not higher – operating expenses than true no-load funds.” 
   
Mercer Bullard, president and founder, Fund Democracy, said:  “Brokers are supposed to work for their clients, but when recommending a generic product such as an index fund, they refer their clients to more expensive funds and then collect sales charges to boot.  Federal law requires that brokers charge the commissions that funds tell them to charge.  It is time to end price fixing in the fund industry and cut the cord between mutual funds and the brokers who sell them.”

Richard Bennett, principal and financial advisor, Savant Capital, Rockford, IL., said:  “This study is a powerful illustration of why investors who are dealing with glorified commissioned salespeople need to find a fiduciary …and fast. You can think of the index mutual fund ‘broker penalty’ this way:  If a consumer spends $4 for a loaf of bread when an identical loaf on the same shelf cost $2, it is no defense for a ‘bread broker’ who recommends the $4 loaf to argue that it cost more because the baker has higher production costs than the baker of the $2 loaf.  The extra $2 paid by the consumer is a broker penalty, and the fact that the consumer pay for that advice simply adds insult to injury.” 

The study found that true no-load fund investors pay no distribution expenses and an average of 21.5 basis points in operating expenses, no-load fund (12b-1 fee/no commissions) investors pay 12.6 basis points in distribution expenses and 31.8 basis points in operating expenses.  Load fund investors pay 15.6 basis points in distribution expenses and 70.4 basis points in operating expenses, which means that in return for an additional 15.6 basis points worth of distribution services they pay an extra 48.9 basis points for operating services over the amount true no-load investors pay.  As such, the study concludes that the use of a broker results in investors being placed in higher cost funds – in effect, the imposition of a “broker penalty” – even after excluding the cost of the broker’s services.

The “broker penalty” observed in the ZAG/Fund Democracy study more than doubled when the analysis was asset-weighted.  That is, when fund expenses were weighted by the amounts actually invested in different funds, the true no-load investor paid an average of 21.5 basis points in operating expenses, in comparison with the load investor’s average operating expenses of 70.4 basis points.  As the study notes:  “Adding insult to injury, the load investors paid sales charges to their broker, on top of the additional 48.9 basis points they paid to the load index fund in operating expenses.”

Index mutual funds are essentially commodities.  They hold identical or almost identical sets of securities.  Differences in their investment performance are explained almost entirely by fees, which are highly predictable.  Index fund fees, however, vary widely. The expense ratios of the S&P 500 index funds reviewed in the Zero Alpha Group/Fund Democracy study ranged from .07 percent to 1.45 percent.   

The Zero Alpha Group/Fund Democracy analysis is based on 141 index funds pegged to the S&P 500.   The study dataset was gathered from the Morningstar Principia Pro Plus for Mutual Funds database, June 2006 version.      
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Ok, let me jump in here. There are several points I want to make:

1. I love index funds. Overall, they are GREAT investments in my opinion.

2. That said, costs matter (a lot) if you want to maximize your investment return -- even with index funds. So why add a bunch of extra expenses to your index fund without any extra benefit? There's no reason to do so.

3. The information above just gives another example of how some "financial advisors" simply work to turn your money into their money. Proceed with caution when finding and hiring one. My preference is that you learn to manage your own investments -- then you don't need to worry about a planner taking a huge chunk of your earnings.

Why You Shouldn't Listen to the Financial Media (and What They Don't Want You to Know)

Here are some thoughts from the wonderful book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on why you shouldn't listen to the financial media:

Whether it's newspapers, TV, radio, or whatever, all media have one primary goal: to attract and hold an audience. That's the key to making money in a media business. However, when it comes to investing, it's not always a win for the audience.

A few thoughts here:

1. This is one thing I hate about much of the printed personal finance publications out there. They often seem like investment hype-fests. They run through "The 10 Must-Own Mutual Funds," "Hot Stocks for the New Year," and the like issue after issue. It gets old quickly.

2. Listening to and acting on all the advice out there is a recipe for disaster. Not only will it throw you off from your investing strategy, but it will rack up significant investing costs (due to frequent trading), which hamper your overall results.

3. I try to avoid all this noise, but it's hard. When someone makes a compelling argument for an investment, it's in many people's nature (including mine) to want to jump on it. I have to remind myself that by the next issue, they'll have forgotten about this investment and moved on to another one. I can't afford to do that with my portfolio.

4. I often wonder what the total return would be if every paper, magazine, TV show, etc. went back five years and calculated the return for all the investments they'd recommended. I'm sure it wouldn't be pretty. I've seen pieces where magazines went back and reviewed their "recommended" list of investments that were detailed in one article previously, but I've never seen a comprehensive review of all the investments recommended.

5. I try to eliminate investment hype on this blog, but the same rules that apply to other media also apply to Free Money Finance. If what I'm saying doesn't jive with your investment strategy, then it's ok to consider what I say, but don't act on it without thinking whether it's right or not. After all, your money is your money (it's not mine), and you have the ultimate responsibility for it.

Later on in the chapter, the book lists three quick bulletpoints on what the investment media don't want you to know -- all centered around the fact that effective investing can be incredibly simple if you:

• Create a simple, diversified asset allocation plan.

• Invest a part of each paycheck in low-cost, no-load index funds according to your plan.

• Check your investments periodically, rebalance when necessary, then stay the course.

Good advice from the Bogleheads. For mort thoughts on investing, see Best of Free Money Finance: Investment Posts.

What is Investment Rebalancing and Why You Need to Do It

Here are some thoughts from the wonderful book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on what investment rebalancing is and why we all need to do it. Let's start with a quick summary of what it is:

Rebalancing is simply the act of bringing our portfolio back to our target asset allocation after market forces or life events have changed the percentages of our various asset classes and segments of those classes.

Ok, let me take a minute and back up here a bit.

Asset allocation is simply the way you've decided to divide up your various investments based on your objectives, age, risk tolerance, etc. and it's a key part of maximizing your overall investment return. To find out more about asset allocation, see these links:

• Why Asset Allocation is Important and Market Timing Doesn't Work

• 4 Rules for Asset Allocation

• Using the Eighty/Twenty Rule for Asset Allocation

Now let's say you set your asset allocation at the beginning of 2006. At that point, you have all your investments divided up into the percentages you want in each investment category. But then, throughout the year, some go up, some go down and the percentages get all out of whack. So, you need to rebalance your portfolio (by putting more money in some investments and taking money out of others) to get back to your desired mix.

So, why should we rebalance? Here's what the book has to say:

• Rebalancing controls risk. It brings our portfolio back to the level of risk that we determined was appropriate for us and that we were comfortable with when we first established our asset allocation plan.

• Rebalancing forces us to sell high and buy low. We're selling the out-performing asset class or segment and buying the underperforming asset class or segment. That's exactly what smart investors want to do.

• Although it might be hard for some investors to understand why they shouldn't simply let their winners run, by doing so they'd be letting the market dictate the makeup of their portfolio, and thus their risk level.

• Rebalancing may also improve your returns, since asset classes have had a tendency to revert to the mean over time. By rebalancing, you're selling a portion of your winning asset classes before they revert to the mean (drop in price) and you're buying more of your underperforming asset classes when their prices are lower, before they revert to the mean (increase in value.) So, you're selling high and buying low.

This is an area I've been working on this year and will work on more in 2007. I'm in the process of rebalancing my entire portfolio (which hasn't been done in awhile) without killing myself in capital gains (accumulated over the years.) It might take a few years to get me EXACTLY where I want to be (I'm not so far off that it's a problem), but I'll get there eventually.

For more on making the most of your investments, see Best of Free Money Finance: Investment Posts.

Another Vote for Index Funds -- They Save Money and Time

Here's a piece from USA Today that suggests the best portfolios are as simple as pumpkin pie. In it, the author recommends, as you may have guessed from the title of this post -- index funds. Here are his main thoughts:

Over time, fees add up. Suppose your fund earned 11.5% before expenses. A $1,000 investment would become $26,000 in 30 years. But you actually earned 10%, after your fund took its 1.5 percentage points, so your $10,000 became $17,500 — an $8,500 difference.

Rather than holding a dozen average funds, you'd be better off owning a single highly diversified low-cost index fund as your core holding.

He's singing my song. ;-)

Seriously, these are just a couple reasons I like index funds.

The piece ends with a short and simple comment I want to highlight:

Keeping your portfolio simple can save time and money.

Most people understand the "save money" portion of this statement because they realize that costs matter if you want to maximize investment returns. However, most don't understand the impact investing in index funds has on time. Consider the following:

• Investing in index funds -- There's initial set-up time to select the funds and have automatic deposits routed to them, but after that, the time commitment is minimal.

• Investing in stocks/other mutual funds -- This takes time and effort -- and a good amount of it, especially if you're buying individual stocks. You need to do the proper research (much of which is wasted -- most people only buy a fraction of the stocks they research), buying, tracking, selling, paperwork, etc. to keep watch over your stocks. Even if this only takes a couple hours a week, it still costs you over 100 hours (over five days!) each year. Yikes!

With index funds, you not only get a great return, but you save a bunch of time as well. Want more details? Check out why I like index funds.

How to Pay Yourself First

Here's a great comment left on my post titled How to Find Money to Invest. The reader shares some good (and simple) steps we all can take to automate our savings/investment plans. His thoughts:

Good list! I think the easiest way to accomplish this is simply by doing number 1 and pay yourself first. I know it has almost become a cliche, but it really is true. This is exactly how I am able to scrape together money for investing also.

If you have direct deposit of your paycheck, then there is no excuse for not paying yourself first. All you need to do is set up a separate account at your bank, checking or savings, whatever is free and doesn't have weird minimum or withdrawal limitations. Then change your direct deposit to put a little money into this account as well. Maybe it is $10 per pay, maybe it is $20, or even $100. Whatever you decide to do, make sure that the account isn't linked to your debit/atm card so it is hard to get access to.

Next, just link up your brokerage account to this bank account and you are all set. As you build up the account you can easily make investment purchases from that separate account. You can even go one step further as most mutual funds allow for systematic purchases as low as $25. So you can then setup a systematic buy that coincides with your deposits and then everything is automatic. Not only are you paying yourself first, but you've created an automatic process towards building wealth.

This is what I do, though my process is slightly different. My steps:

1. My entire paycheck is placed into my checking account (after money has been deducted for my 401k, of course.)

2. I have a set amount that gets transferred to Vanguard automatically each month.

3. The Vanguard money is then automatically invested in a handful of funds according to my investment objectives.

It's simple, easy, and once it's set up, it's all on auto-pilot. I'm saving/investing without even doing anything!

Five Keys to Investing Success, Key #5: Diversify

Here's part 5 of Kiplinger's five keys to investing success. Today, we'll be covering key #5, diversify. Their thoughts:

There are at least three good reasons to diversify your investments:

• As the adage goes, you shouldn’t put all your eggs in one basket.
• No investment performs well all the time; when one thing is down, another thing tends to be up.
• You may be able to increase your return by diversifying.

Yet another reason I like index funds -- they are diversified among many different stocks.

For more thoughts on investing your money, see these links:

• How to Find Money to Invest

• Index Investing Out-Performs Most Actively Managed Funds, Costs Taxes are Why

• Take These Steps before You Start Investing

• Learn from Millionaires and Others -- Don't Trade Frequently

Five Keys to Investing Success, Key #4: Keep Time on Your Side

Here's part 4 of Kiplinger's five keys to investing success. Today, we'll be covering key #4, keep time on your side. Their thoughts:

The time value of money works against you if you’re the one waiting to collect the money, but it works in your favor if you’re the one who has to pay. Success often lies in being able to identify the proper side of the equation. You just need to keep in mind this principle—a dollar you pay or receive today is worth more than a dollar you pay or receive tomorrow.

While they don't say it specifically here, they're talking about the power of time and the power of compounding. If you put these two to work for you in the right way, you're on the road to becoming rich.

For more thoughts on investing your money, see these links:

• Take These Steps before You Start Investing

• Learn from Millionaires and Others -- Don't Trade Frequently

• Index Investing Out-Performs Most Actively Managed Funds, Costs Taxes are Why

• How to Find Money to Invest

The Two Benefits of Diversification

Here are the two benefits of diversification as listed in the wonderful book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details):

• Diversification helps reduce risk by avoiding the "all the eggs in one basket" scenario.

• Diversification helps increase your return at the same time.

Then they give a brief paragraph on why you want to diversify your investments:

In order to diversify your portfolio, you want to try and find investments that don't always move in the same direction at the same time. When some of your investments zig, you want other parts of your portfolio to zag. Although diversification can't completely eliminate market risk, it can help to reduce that risk to a level where you feel comfortable enough to sleep well at night.

The book then continues and states that diversifying your investments is rather easy -- it can be done with a handful of funds quite simply.

I know I've gushed on this book quite a lot, but I want to say one more time how valuable I think it is. If you're an investor, you're thinking of becoming an investor, or have a friend, family member, etc. who fits either of these descriptions, The Bogleheads' Guide to Investing is a must read. Even if you don't take all the advice in the book, there still will be plenty in it (like the toll costs and taxes take on your investments) that will benefit any type of investor.

For more thoughts on investing, see Best of Free Money Finance: Investment Posts.

Five Keys to Investing Success, Key #3: Don't Take Unnecessary Risks

Here's part 3 of Kiplinger's five keys to investing success. Today, we'll be covering key #3, don't take unnecessary risks. Their thoughts:

How Much Risk Should You Take? Controlling risk means more than being “comfortable” with an investment. Too many investors seem perfectly comfortable with too much risk. The basic thing to remember about risk is that it increases as the potential return increases. Essentially the bigger the risk, the bigger the potential payoff. (Don’t forget those last two words; there are no guarantees.) That might sound exciting, but turn it around: the bigger the potential payoff, the bigger the risk of losing.

What is a prudent risk? It depends on your goals, your age, your income and other resources, and your current and future financial obligations. A young single person who expects his or her pay to rise steadily over the years and who has few family responsibilities can afford to take more chances than, say, a couple approaching retirement age. The young person has time to recover from market reversals; the older couple may not.

I'm probably one that takes a bit too much risk, but given my age, it's not that big a deal. I'm highly invested in stocks, but my time horizon is 10 years minimum, so I'm fine. Basically, the closer you are to needing your money, the less risk you can afford to take. That's why many people recommend that your investment in bonds increases as a percentage of the total as you get older.

For more thoughts on investing your money, see these links:

• Index Investing Out-Performs Most Actively Managed Funds, Costs Taxes are Why

• How to Find Money to Invest

• Take These Steps before You Start Investing

• Learn from Millionaires and Others -- Don't Trade Frequently

Five Keys to Investing Success, Key #2: Set Exciting Goals

Here's part 2 of Kiplinger's five keys to investing success. Today, we'll be covering key #2, set exciting goals. Their thoughts:

Investment goal-setting is an intensely personal affair that will be guided by your own style and preferences. But if you set generalized goals, such as “financial security” or “a comfortable retirement,” you’re going to have trouble measuring your progress along the way. You may even struggle to maintain interest in the project. Vaguely defined investment goals can lead to halfhearted efforts to achieve them.

Better to set goals you can grab onto, goals that excite you. Instead of “financial security,” why not “$500,000 net worth by age 60?” Instead of “a comfortable retirement,” why not “an investment portfolio that will yield $2,000 a month to supplement my pension and social security?” Now those are real goals. You can put a price tag on each and use that as an incentive to keep up your investing discipline.

I think I'm on the same page with them, but their wording is throwing me off. Instead of "set exciting goals," I'd say "set meaningful and realistic goals." Why? Because "having $1 billion" is an exciting goal for many people -- but it's not going to happen for most. Instead, I'd suggest people develop meaningful goals and shoot for them. What's meaningful? Well, finding your retirement number and using that as a goal would be meaningful.

Also, the goal needs to be realistic. If you get your retirement number and there's no way you can reach it, what use is the goal? Instead, decide what's a realistic goal -- one that you can reach (which may mean you need to work longer, rely less on your retirement savings, etc.) Now this does not mean that you should keep from stretching yourself -- from cutting costs now, from saving now, etc. -- but a goal needs to be in the realm of reason to be worthwhile.

For instance, if I set $1 billion as my retirement number, that's not realistic no matter how much I try to increase my income, cut spending, etc. -- it's just not going to happen. But if I want to save $3 million for retirement, I'll still need to save, cut expenses, invest wisely and the like, so it'll still be a challenge to hit it, but it's certainly realistic as long as I'm disciplined.

So go ahead and set goals. I'm a big fan of them. However, don't worry about them being exciting, just make sure they are meaningful and realistic.

Minimize Taxes to Maximize Your Investment Return

Here are some thoughts from the wonderful book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on how taxes play a big role in determining the performance of your investment portfolio.

They start by recognizing that costs matter if you want to maximize your investment returns. They then note that the biggest costs of all -- and ones you must control if you want to maximize your return -- are taxes. Then they review three studies that show the dramatic impact taxes have on total investment returns. Here are summaries of the studies they cite:

• A high-bracket taxpayer who invested $1.00 in U.S. stocks would have $21.89 at the end of the study period (30-year term) in a tax-deferred account. If it had been a taxable account, the $1.00 would have only been $9.87.

• Over a 10-year period, The Lipper Company found that the average stock fund surrendered approximately 23.5% of its load-adjusted return to taxes.

• Over a 15-year period, the average mutual fund shareholder had an average annualized pretax return of 10.0%. However, after federal taxes, that 10.0% return was reduced to 7.7% -- a reduction of 23 percent.

Yikes! What a big bite taxes can take! This is the reason I try to get as much money in tax-advantaged accounts as possible (401k, IRA, etc.) My biggest problem in this effort is that I have more money to invest than what I can shelter from taxes -- hence I have a good amount that's subject to taxes each and every year.

In the next chapter, the book lists 13 tax-reducing ideas. Here are my favorites:

• Use tax-advantaged accounts.
• Use taxable accounts for short-term goals.
• Use index or tax-managed funds in taxable accounts.
• Keep turnover low.
• Place funds for maximum after-tax return.

Honestly, I think I could do a lot better in this area. Though I have a good amount invested in index funds, I do own other funds that I'm sure aren't very tax-advantaged. I'm adding them to my list for replacing next year.

For more thoughts on investing, see Best of Free Money Finance: Investment Posts.

More Quotes about the Effectiveness of Index Funds

Here are some more quotes from the wonderful book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on the effectiveness of index funds:

• "The fund industry's dirty little secret: Most actively managed funds never do as well as their benchmark." Arthur Levitt, former chairman of the Securities and Exchange Commission

• "Only about one in four equity funds outperforms the stock market. That's why I'm a firm believer in the power of indexing." Charles Schwab, founder and chairman of the board of The Charles Schwab Corporation

• "Why waste your time trying to select and manage a portfolio of individual stocks when you can replicate the market average returns (and beat the majority of professional money managers) through an exceptionally underrated and underused investment fund called an index fund?" Eric Tyson, author of Investing for Dummies and Mutual Funds for Dummies

• "If you buy -- and then hold -- a total stock market index fund, it is mathematically certain you will outperform the vast majority of all other investors in the long run. Graham praised index funds as the best choice for individual investors, as does Warren Buffett." Jason Zweig, senior writer and columnist at Money magazine

Add these to the list of reasons why I like index funds.

For more thoughts on investing, see these links:

• Best of Free Money Finance: Investment Posts

• Take These Steps before You Start Investing

• Costs Matter If You Want to Maximize Investment Returns

• Why Asset Allocation is Important and Market Timing Doesn't Work

Five Keys to Investing Success, Key #1: Make Investing a Habit

Kiplinger's recently listed five keys to investing success, giving their thoughts on the best practices associated with investing. I thought I'd cover each of these points in detail over the next week and give my thoughts along with theirs. Today, we'll be covering key #1, make investing a habit. Their main thought:

For most people with a small amount to start with, the best chance to acquire measurable wealth lies in developing the habit of adding to your investments regularly and putting the money where it can do the most for you.

It's a pretty simple tip, but it's a powerful concept. If you start investing early in your life, even if it's a small amount, and keep doing it for years, you will become wealthy due to the power of compounding. Want examples of this? Then see these posts:

• The Richest Man in Babylon: Save a Portion of All You Make

• Getting Rich is Simpler than You Think

• Start on Your First $1 Million at Age 16

• The Power of Compound Interest

• Key #2: Set Exciting Goals

Quotes about the Effectiveness of Index Funds

Here are some quotes from the wonderful book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on the effectiveness of index funds:

• "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals." Warren Buffett, Chairman of Berkshire Hathaway

• "I am a huge, huge, huge fan of index funds. They are the investor's best friend and Wall Street's worst nightmare." Jonathan Clements, author and writer of the popular Wall Street Journal column "Getting Going"

• "An index fund dooms you to mediocrity? Absolutely not: It virtually guarantees you superior performance." William Berstein, Author of The Four Pillars of Investing

Just a few more reasons I like index funds. It's hard to argue with Warren and the rest.

For more thoughts on investing, see these links:

• Best of Free Money Finance: Investment Posts

• Take These Steps before You Start Investing

• Costs Matter If You Want to Maximize Investment Returns

• Why Asset Allocation is Important and Market Timing Doesn't Work

Some People Think a 100% Return on Your Investment Isn't Enough

Here's a comment left on my post titled The Best 401k Plan that I really, really like and thus wanted to share it with all of you:

The best 401k plan is simply one that you participate in!

It is a shame more people do not see the value in the wealth building tool that most employers provide them with. I help manage a 403(b) plan for a company and it is my job to get people enrolled, help them with their investment options, and hopefully secure a better retirement. Unfortunately, it is still difficult to have enrollment top 75%. We even offer a match like yours, dollar for dollar with a 3% max, and people will still turn down a 100% return, I don't know why.

Luckily I have one of the best jobs I could think of having, and I am in a position to hopefully convince people the importance of enrolling in their plan. I get to speak at all of the new employee orientations to talk about the plan and outline why it is so important.

My biggest roadblock right now is getting through to the younger people, who of course are the least likely to enroll. It doesn't matter how you explain it, or paint a picture of what retirement will be like without social security or a pension, a lot of people under 30 just refuse to have any concern.

Some employees I talk to about the match, even though it is free money, they still don't want to enroll. Yet, I'll ask them if their bank offered a savings account of 100%, would you put your money in that bank? They always say yes, but then I immediately say ok, sign up for the retirement plan and that can happen. They still won't sign up.

Oh well, hopefully with help from all the finance bloggers out there we can help encourage people to take advantage of a wonderful tool at their disposal.

It always amazes me why/how people turn down the free money associated with a 401k. There's simply no other investment that will return anywhere near what a company match to a 401k will return.

How Much of Your Salary You Need to Save

Here's another item on Money magazine's list of 25 rules to grow rich by. Today's tip gives some thoughts on how much of your salary you need to save:

If you're not saving 10% of your salary, you aren't saving enough.

The earlier you start saving, the less you'll need to set aside every year to meet your goals. That's because you allow your money more time to grow -- the gains on your invested savings will build on the prior year's gains. That's the power of compounding, and it's the best way to accumulate wealth.

Saving at least 10% of your annual salary for retirement is recommended, but the older you start saving, the more you'll need to save. If you start at 50, you may need to put away 30% a year and still postpone retirement by a few years.

Personally, I'm a big fan of the "save more earlier" strategy. That's what I've done -- tried to put as much away as possible as early in my life as possible so then the power of compounding do it's magic. It's just starting to kick in for me in a big way -- my investments are just now starting to deliver substantial increases from year to year by themselves (even if I didn't keep contributing to them.)

So, how have I managed to save this much? It starts with spending less than you earn. If you do this through the years, you can become quite well off. (By the way, if you're having trouble spending less than you earn, you may want to check out my past posts on how to save money and how to make more money.)

I then take the money I've saved and invest in my 401k (where I get free money from my employer in the form of a match) as well as in taxable accounts. My preferred investment vehicle is index funds.

Simply do these simple steps over and over again for years, and you're bound to get rich.

Why Indexing is So Effective

Here are some thoughts from the wonderful book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on why indexing is so effective:

1. There are no sales commissions.
2. Operating expenses are low.
3. Many index funds are tax efficient.
4. You don't have to hire a money manager.
5. Index funds are highly diversified and less risky.
6. It doesn't matter who manages the fund.
7. Style drift and tracking errors aren't a problem.

Good stuff! Very similar to the reasons I gave when I detailed why I like index funds.

For more thoughts on investing, see these links:

• Best of Free Money Finance: Investment Posts

• Take These Steps before You Start Investing

• Costs Matter If You Want to Maximize Investment Returns

• Why Asset Allocation is Important and Market Timing Doesn't Work

What's Going on with DIS?

As I've said before, I own Disney (DIS) stock and so far, it's had a decent return for me. But what am I supposed to think about the latest reports about the company? For instance, there's good news:

• Disney still has the magic - The media and entertainment company should perform at the top of its peer group for years to come, says analyst William Drewry.

No, the news is bad:

• Get Disney treasure while you can - It was another magical quarter for the Magical Kingdom, thanks to across-the-board success in films, TV and theme parks. Yet for the stock, the good times are about over.

No, the news is mixed:

• Disney Doubles Quarterly Profit - The media giant's earnings sailed past analysts' forecast, but the stock slumped as some analysts worry that the performance may not be repeatable.

So what's an investor supposed to do/think with this mish-mash information?

A couple thoughts on it:

1. No wonder so many actively-managed funds perform so poorly. These "experts" don't have any idea what's going on.

2. Just another reason I like index funds. At least I can understand them. ;-)

How Investing is Different from Most of Life

Here are some thoughts from the wonderful book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on how investing is different from most of life. Here are the principles we learn in life that serve us well in many areas (but not investing):

• Don't settle for average. Strive to be the best.

• Listen to your gut. What you feel in your heart is usually right.

• If you don't know how to do something, ask. Talk to an expert or hire one and let the expert handle it. That will save you a lot of time and frustration.

• You get what you pay for. Good help isn't cheap and cheap help isn't good.

• If there's a crisis, take action! Do something to fix it.

• History repeats itself. The best predictor of future performance is past performance.

Applying these principles to investing is destined to leave you poorer.

Why is this? Let's take each one in order:

• Actually, "average" funds (like an index fund) outpace most actively managed funds in total return.

• Listen to your brain. Index funds consistently outperform most actively managed funds.

• Asking an expert is ok in some instances, where specialized knowledge is needed (for instance, I use a CPA to do my taxes), but when it comes to financial planning, it's often better to get basic information yourself and manage your own finances.

• With investing, it's often the lower-cost options that perform best.

• Again, listen to your brain. Don't panic in crisis times -- simply keep investing through dollar-cost averaging.

• As the experts say, "past performance is no guarantee of future returns." It's true.

For more thoughts on investing, see Best of Free Money Finance: Investment Posts.

The Two Most Important Things Any Investor Can Do

Here some thoughts from the great book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on the two most important things any investor can do:

The two most important things any investor can do are to start saving early and invest regularly.

See why I love this book? ;-)

Coincidently (or maybe not so coincidently), these thoughts mesh nicely with the Free Money Finance Guide to Getting Rich. Funny how that works, huh?

As I've said before, the path to financial independence is a fairly easy one. Easy from the standpoint that the concepts leading to prosperity aren't that complicated. However, implementing them into a financial plan and making sure they are followed day after day, week after week, month after month and year after year is pretty hard for most people. Why is that? It's because they require discipline -- something many people would rather do without when it comes to managing their money.

How Much to Invest in Stocks

Here's another item on Money magazine's list of 25 rules to grow rich by. This time we'll be sharing their thoughts on how much money to invest in stocks:

To figure out what percentage of your money should be in stocks, subtract your age from 120.

A few thoughts from me:

1. This rule seems overly aggressive to me. For instance, this suggests that a 40-year-old person should have 80% of his/her investments in stocks. This works for me personally, but it seems to be a bit high for those with less tolerance for risk. There are certainly different investment temperaments and not everyone can handle the highs and lows of having 80% of their investments in stocks.

2. To expand on the above point a bit, the rule gets even dice-ier (is that a word?) as a person nears retirement. Given this example, a 60-year-old person should have 60% of his/her investments in stocks. Seems high to me. A 70-year-old would have 50% in stocks. Seems even more out of balance.

3. The first two points lead to this one: If you need part of the money within a few years, you're going to want a larger percentage out of stocks and in more conservative investments than what this formula suggests.

For more thoughts on saving for retirement, see Best of Free Money Finance: Investment Posts.

Index Investing Out-Performs Most Actively Managed Funds, Costs Taxes are Why

Here's a piece a reader pointed to that details many of the benefits of index investing from the NY Times. I'll highlight a couple of their main points including how indexing out-performs most actively managed funds on a regular basis:

This year through September, only 28.5 percent of actively managed large-capitalization funds — which try to beat the market through stock selection — were able to outpace the S.& P. 500 index of large-cap stocks, according to a new study by S.& P. In the third quarter alone, it was even worse, with only one in five actively managed large-capitalization funds beating the index.

Over the five years through the end of the third quarter — a span that included both bull and bear markets — only 29.1 percent of large-cap funds managed to beat the S.& P. 500. What’s more, only 16.4 percent of mid-cap funds beat the S.& P. 400 index of mid-cap stocks, and 19.5 percent of small-cap funds outpaced the S.& P. 600 index of small-company shares. “The long term does seem to favor the indexes,” Ms. Pane said.

There are many advantages of index funds, but the biggest is that they simply perform better than most other options. Why is this? Well, let the master of index fund investing tell us:

For John C. Bogle, founder of the Vanguard Group, which started the first retail stock index fund 30 years ago, the recent success of indexing is self-evident. “The reality is, fads come and go and styles of investing come and go,” he said. “The only things that go on forever are costs and taxes.” And by simply buying all the stocks in an equity benchmark and holding them for the long run, traditional index funds minimize the transaction costs and capital gains taxes associated with investing, he said.

Yep, costs matter if you want to maximize returns. Quite simply, a fund with a .3% expense ratio starts with a 1% advantage over a fund with a 1.3% expense ratio. It's a big lead that most more-expensive funds simply can't overcome. And it's one that makes a big difference in your overall return through the years.

If you want to know more about index fund investing, I recommend the books The Bogleheads' Guide to Investing and The Smartest Investment Book You'll Ever Read: The Simple, Stress-Free Way to Reach Your Investment Goals. Both of these would make great presents this holiday season for those on your list interested in investing -- or for yourself, as a way to spend some of that holiday money you receive this year.

How to Find Money to Invest

Here some tips from the great book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on how to find money to invest:

1. Pay yourself first.
2. Commit future pay increases to investing.
3. Shop for used items.
4. Don't drive yourself to the poor house.
5. Move where the cost of living is cheaper.
6. Create a side income.

Good tips! These are just some ways to save money and free up funds for investing. I've written a lot on each of these in past posts (in one way or another), so let me give you my thoughts on the items above by linking to posts I've done on each topic:

1. The Richest Man in Babylon: Save a Portion of All You Make

2. Do-It-Yourself Pay Raise for the Holidays

3. Go to the Right Garage Sales

4. 20 Ways to Save Money on Your Car

5. How Moving to a Cheaper Cost-of-Living City Can Make You Rich

6. Free Money Finance Guide to Making More Money