Free Money Finance

How to Save $1 Million by 65

CNN Money tells a 28-year-old reader how to save $1 million by 65. Their thoughts:

I don't care how brilliant an investor you are. If you're not putting away a decent amount of money on a regular basis throughout your career, your chances of accumulating a million bucks are lower than LeBron's chances of getting elected mayor of Cleveland.

My point is to show that the more you save, the less you have to count on lofty returns. It's important to keep that in mind because ultimately we have more control over how much we save than the investment returns we earn.

That said, you don't want to invest so conservatively that you end up having to save so much that you live like an ascetic. You should be willing to take prudent risks, especially when you're young, in hopes of earning a higher rate of return and making your savings burden manageable. But you don't want to invest so aggressively that you're left in the lurch late in life if you don't get the rosy investment performance you'd hoped for.

This is very similar to what I said when I talked about the most important way to grow your investments (which, by the way, is to invest for the longest amount of time possible.) Right after that is "saving as much as possible".)

Having to count on 15% (or even 10%) returns in order to reach an investment goal is risky and, in most cases, unreasonable (15% is certainly unreasonable.) So I invest in index funds (Vanguard funds to be exact) to get a "decent" return, but count primarily on my ability to save a bundle of money over a long period of time as the main way of growing my total portfolio.

Now for those of you who are chomping at the bit to say "$1 million is not enough", CNN Money covers that issue too:

I'm not sure how you arrived at $1 million as your goal. Maybe it's just a nice big round number. Remember, though, having a million bucks 37 years from now isn't like having that sum today. In fact, assuming a modest 2.5% inflation rate, $1 million in 2047 would be the equivalent of having about $400,000 now. Or, viewed another way, you would need about $2.5 million in 2047 to have the purchasing power of $1 million today.

Finally, rather than shooting for a big lump sum, I think you're better off thinking about how much income you'll eventually have to replace to maintain your standard of living in retirement, and then figuring out what combination of saving and investing, along with other resources like Social Security, gives you a reasonable shot at hitting your goal.

Pretty good advice in my opinion...

Should You "Sell in May and Stay Away"? Revisited

The following is a guest post from Marotta Wealth Management.

Last May I wrote a column asking if you should "sell in May and stay away." I suggested it would be better simply to "rebalance in May and call it a day." Looking backward it wasn't bad advice. Looking forward, I suggest saving and investing significantly between now and next May.

The original saying began in Britain as "Sell in May and go away, stay away till St. Leger Day." The final horse race of the British equivalent of the Triple Crown takes place on St. Leger Day, in the second week of September. In the United States, September and October historically are considered dangerous months to invest. In addition, St. Leger Day is unknown here. So the date of reentering the markets has been pushed to the end of October, causing the rule to also be known as the "Halloween indicator."

Since 1950, September has been the only month averaging a negative return, due to severe losses in 1974 and 2002. This year September was the best month for the S&P 500, which appreciated 8.92%.

October, contrary to popular opinion, is a typical month with an average return of +0.82%, despite the 21.5% loss in 1987 (Black Friday) and the 16.8% loss in 2008. This year October had a nice gain of 3.8% for the S&P 500.

The traditional wisdom suggests selling on May 1. But since 1950, May has performed well with an average return of 0.80%. This year May was terrible, dropping 7.98% on the S&P 500. Selling on May 1 would have avoided the worst month for the year.

My own study shows that since 1950, May through October has contributed a 3.16% return; November through April has contributed 8.44% for an annual return of 11.60%. If you sell in May, you have to be able to get a six-month Treasury return better than 3.16%. Considering trading costs and capital gains taxes, that's difficult.

This year the S&P 500 only appreciated 0.74% in May through October, underperforming the historical averages. You could not have done better in Treasury bills or money market. You would only have earned 0.06%.

Although the S&P 500 did not do very well over the summer months, other indexes performed better. After dropping 11.37% in May, the MSCI EAFE Foreign Index regained all that and more, ending the period up 5.97%. Despite the meltdown of the euro in May, foreign investments have still outperformed U.S. stocks. Emerging markets have performed even better. Between May and October they were up 10.15%.

Although the return of the S&P 500 has been disappointing, a more broadly diversified portfolio fared better. Year to date through the end of October, the S&P 500 is up 7.84%, the MSCI EAFE Foreign Index is up 5.12% and the MSCI Emerging Markets Index is up 14.24%. A diversified portfolio of half U.S. stock, a third foreign and a sixth emerging markets averaged 8.00% for the year on a buy-and-hold strategy. But rebalancing once at the end of May boosted your return to a whopping 13.94%. The reason is that these three indexes have not moved in sync this year. The S&P 500 did the best for the first four months, appreciating 7.05%. Even in May the S&P 500 did not drop as much as foreign investments. Rebalancings at the end of May meant selling out of the U.S. stock, which was only down 1.50%, and buying into the EAFE Index, which was down 12.08%, and the Emerging Market Index, which was down 5.36%. These foreign indexes rebounded heartily. Asset allocation means always having something to complain about. This past summer it was the S&P 500. Meanwhile your rebalanced portfolio allocated more to foreign stocks.

When the markets are volatile, the bonus on account of rebalancing is greater. Rebalancing every month does not produce the greatest bonus. Rather the greatest bonus is produced by rebalancing just after large movements, such as the foreign meltdown in May. And then the bonus is only gained by diehard contrarians eager to buy what everyone else is selling.

Rebalancing is not a magic bullet. Rebalancing at the beginning of May was 0.45% worse than the 8.00% buy-and-hold strategy, but rebalancing at the end of May was 5.94% better. On average, rebalancing boosts returns by about 1.6% annually.

If a seasonal ebb and flow to market returns really exists, it may be as simple as observing when cash is tight and not flowing into the markets. In February bills from the holidays arrive, and many people are gathering cash to pay their taxes. Summer vacations strap many families, resulting in high expenses in September. Only after bills are paid can money flow back into the markets.

In contrast, December sees large profit-sharing bonuses put into the markets, and pension funds are often invested in January. In the early spring, people are funding their retirement accounts.

Whatever the reasoning, this is the season to be invested. Returns from November through April are historically more than twice those of May through October.

The lessons are clear. Save. Invest. And rebalance regularly.

The Truth about Market Timing

The following is a guest post by Michael A. Gayed, CFA, Chief Investment Strategist, Pension Partners, LLC. We've discussed this line of thinking previously, but I think it's good every now and then to re-stir the pot. ;-) 

The post titled Market Timing Doesn't Work. Yes, It Does. No, It Doesn't. Yes, It Does addresses conflicting opinions about the validity of market timing.  The big question, however, is WHY it does or doesn't work.  To answer this, let's take a look at some actual hard facts about the nature of equity price movements by taking a look at the S&P 500 ETF (Symbol: SPY).  Take a look at the chart below (click to enlarge):

 
What I did here was download the daily price data for the SPY ETF since inception (1993), ranked the daily returns, and came up with different returns patterns based on whether you were in the market in the best or worst performing days.  The blue line represents a simple buy and hold strategy (with no market timing).  The red line represents what the return would have been if you had timed the market and happened to have missed the 10 best days of performance.  The yellow line is the return you would have seen if you had timed the market so perfectly that you were not exposed to the 10 worst days.  Finally, the green line shows what would have happened if you had missed the 10 best and 10 worst days of performance.

Here's how the performance ends up:

• Growth of $100,000 from 1/29/1993-8/30/2010
• Buy and Hold: $324,330.15
• 10 Best Days Removed: $156,354.12
• 10 Worst Days Removed: $692,693.90

The difference in performance is enormous.  We're talking about timing just 0.2% of the days in the sample period.  Think about this for a moment: 10 days account for most of the return!  Market timing becomes extremely difficult because the odds are against you – you have to be in the market's best performing days, and out of the market's worst performing ones.

But what is the risk?  I argue that the risk is NOT the yellow 10 worst days removed line, i.e., not in outperforming, but in missing the best days.  The truth is buy and hold appears to work in an almost lottery type fashion—you have to be in it to win it for those low probability, high impact (Black Swan-ish) days for the compounding effect to really make a difference cumulatively.

What's the takeaway for you?

• Recognize that equity price pops and drops are largely unpredictable, yet account for most of the cumulative return
• Don't over-trade and try to pick up pennies in front of a steamroller since performance is driven by the rare $100 bill trades (10 best days)
• It’s okay to vary your exposure to equities, but do so with a broader asset allocation plan in mind
• Being contrarian is a lot easier said than done—be honest with yourself in terms of what can and can not be accomplished through active trading.

Strategies and Metrics of the Warren Buffetts Next Door

Yesterday I gave my thoughts on the book The Warren Buffetts Next Door: The World's Greatest Investors You've Never Heard Of and What You Can Learn From Them. I had some questions about it (mainly the assertion that since ten people can outperform the market, then anyone can do it), but overall liked the book. Today I want to share the investment strategies, key metrics, and performance statistics for each of the ten WBNDs (Warren Buffetts next door) to give you all a flavor of what the book profiles and how diverse each of these ten are.

Here are the specifics:

WBND #1 - Investment strategy: Deep value, special situations; Key strategy metric: Tangible asset value; Performance since October 2000: Average annual return 25 percent versus 0.21 percent for the S&P 500.

WBND #2 - Investment strategy: Income investing for total return using put and call options; Key strategy metric: Yield; Performance since September 2005: Cumulative return of 287 percent versus 11 percent for the S&P 500.

WBND #3 - Investment strategy: Turnarounds and other special situations; Key strategy metric: Intrinsic value; Performance since February 2001: Average annual return 34 percent versus 1 percent for the S&P 500.

WBND #4 - Investment strategy: Eclectic mix of leading academic quantitative theories; Key strategy metric: The F-Score; Performance since February 2003: Average annual return 17 percent versus 7 percent for the S&P 500.

WBND #5 - Investment strategy: Micro-caps and yield-oriented stocks; Key strategy metric: Relative P/E; Performance since July 2005: Cumulative return of 1,026 percent versus 28 percent for the S&P 500.

WBND #6 - Investment strategy: Value investing, biotech stocks; Key strategy metric: Cash; Performance since July 2002: Average annual return of 36 percent versus 7 percent for the S&P 500.

WBND #7 - Investment strategy: Value with a global macro twist, "Warren Buffett meets John Templeton"; Key strategy metric: Enterprise value/Ebitda; Performance since July 2000: Average annual return 19 percent versus -0.70 percent for the S&P 500.

WBND #8 - Investment strategy: Junior gold stocks, oil, gas, hard assets; Key strategy metric: Cash flow; Performance since September 2004: Cumulative return of 237 percent versus 11 percent for the S&P 500.

WBND #9 - Investment strategy: Active trend trading; Key strategy metric: Percentage gainers, relative strength; Performance since January 2003: Average annual return 33 percent versus 6 percent for the S&P 500.

WBND #10 - Investment strategy: Technical analysis, Elliott Wave; Key strategy metric: moving averages, resistance and support levels; Performance since May 2001: Average annual return of 10 percent versus 1 percent for the S&P 500.

Here's what's interesting to me about these: There are many different strategies and many different metrics, yet they are all doing well as investors (some REALLY well.) So there must be many roads to investing success, huh? Either that, or these ten are really, really, really good guessers. ;-)

How about you? For those of you who buy your own stocks, what are your investment strategies and key metrics? Do you mirror any of the WBNDs listed here?

The Warren Buffetts Next Door

I recently finished reading the book The Warren Buffetts Next Door: The World's Greatest Investors You've Never Heard Of and What You Can Learn From Them. Here's the summary from the book's back cover:

How 10 ordinary people consistently achieve extraordinary returns on their investments (and how you can, too).

There are the famous investors whose names you know—Buffett, Bogle, Soros, Lynch, and Templeton. And then there are the Warren Buffetts next door, those successful investors you've never heard of—Rees, Krebs, Koza, Petainen, and Weyland. The Warren Buffetts Next Door describes how these "regular" people—tractor-trailer drivers, radio DJs, and college dropouts—utilize an armament of online information, tools, and resources to routinely outperform professional brokers and Wall Street's Ivy League–educated investors.

So, the author found 10 "average Joes" who are investing geniuses and he profiles each of them -- telling their investment strategies, key metrics, performance stats, etc.

I love the fact that the book tells real-life stories of investors who are earning outstanding returns. It's a fascinating read -- and actually makes investing fun/interesting! ;-)

What I don't like is the implication (in some cases) or outright claims (in other cases) that because these 10 guys can do so well, so can anyone else (including you). If all it takes to "prove" something is to find 10 people who have done it, I can "prove" a lot of things that aren't actually true. And lest we forget, the Millionaires Next Door (where this book gets part of its title) was based on research, not on a very small sample of 10 people. Maybe it's true and maybe it isn't (I don't think it is) that anyone (or even most people) can become excellent investors, but please don't insult my intelligence by claiming that because 10 people can do something that anyone can.

Here's an example of what I'm talking about. It's the last paragraph of the book's introduction:

My hope is that you will read about my 10 Warren Buffetts Next Door and realize that the only real prerequisite to becoming a good investor is committing the time to do so. In other words, invest in yourself. You can achieve great investment returns, meet your financial goals, and beat the professional investors you would otherwise entrust your capital to.

Really? Is time (to educate yourself) the only requirement? If that was true, wouldn't the "professional investors" that the book claims everyone can beat be the best investors of all? After all, they have spent years (or even decades) trying to be better investors. And they have the added advantage of huge financial resources, staffs to help make/execute decisions, and so on. So simply by taking the time to learn about investing I can outperform them? Hmmm.

We have our own Warren Buffett Next Door who reads FMF. If you recall, I shared some of his thoughts on investing earlier this year. The summary: People can be excellent investors but the time, experience, and personality traits that are required to do so are held by very few. In other words, only a small percentage of people can hope to achieve stellar returns. For the vast majority, even investing the time (which is substantial) to be a great investor is not even close to guaranteeing a successful performance.

The book is balanced out a bit in the foreword written by Steve Forbes. Here's what he says about it:

The book both inspires and cautions. As always, there are no quick, easy roads to riches. But now people have unprecedented opportunities to create meaningful wealth over time -- if they have the stick-to-itiveness and the maturity to know there will be plenty of bumps along the way.

Forbes also gives a great summary of what can be learned from these ten investors. His thoughts:

• There is no one way to achieve success. Each of these people has developed his own particular approach.
• They do share two characteristics: hard work and iron discipline.
• These next-door Buffetts make mistakes -- but they actually learn from them.
• Every one of them has suffered a searing market setback.
• What also becomes clear here is how the Web allows individuals, regardless of their circumstances, to develop talents that otherwise would have lain dormant.

This is something I can believe. In particular, the "iron discipline" requirement alone will eliminate most wannabe Buffetts -- because when they start losing real money, especially their own real money, most people's "iron discipline" melts like wax in a hot flame.

All this said, I did enjoy the book and would recommend it to those of you who pick your own stocks (or those who want to.) Reading how these ten investors use their individual strategies to significantly outperform the market (and most of the rest of the world) is really quite compelling. Even if you don't learn anything that you will apply yourself, you'll still get an enjoyable read out of this book.

Tomorrow I'll share highlights about the ten investors so you can see for yourself the diverse ways these people became Warren Buffetts next door.

Why I Think Gold is a Loser Investment

In my recent interview with a gold and silver expert, I tried to get at the fact that it seems easy to buy gold at full retail price (or even higher -- much higher when you add in some fees) but not as easy to sell it at a good price. I didn't develop the concept fully in my questioning (my fault) and it was still lingering when I ran into these thoughts from the Wall Street Journal:

It is a lot easier to buy gold than to sell it—at least for a good price.

Some will give you as little as 10% of the meltdown value for gold jewelry and coins. Many jewelry stores, including Kay Jewelers, a unit of Signet Jewelers, pay about 50% of the meltdown value. Coin shops tend to pay more: up to 80%—assuming the coins don't have a higher collectible value—and a few online players may offer as much as 90%.

Let's make a few assumptions and see how this plays out:

• Jimmy buys one ounce of gold (a few years ago -- I'm using round numbers, not today's prices, for ease of illustration) for $450. In addition, there are fees that bring his total costs to $500.
• The price of gold doubles to $900.
• Jimmy wants to cash in so he goes to a local coin shop and gets $720 (80% of market value).
• So while the price of gold has gone up 100%, Jimmy's gain is only 44% ($720-$500)/$500.

This is not the formula for a winning investment IMO.

Sure, Jimmy could have done a few things better (like having lower buying costs and selling for more.) But even in an almost optimal situation where he incurs 1% costs of buying and gets 90% of market value for his gold, he still only makes 78%.

Yeah, making 78% is still good -- especially if it's within a year. Or two. Or three. Or even four. But doesn't it seem like the investment isn't all that it should be? He's losing 22% along the way! Or maybe I'm not looking at the situation correctly (he does, after all, still make a good return.) You tell me.

Or look at it this way. Under the original scenario of fees and 80% selling price, the price of gold needs to increase by 39% (from $450 to $625) just for Jimmy to BREAK EVEN!!!! Even with the second, more generous assumptions, the price of gold still needs to increase 12% for Jimmy to be in the black. This is simply crazy!!!!! What investment would you want to go into knowing that you had to make 12% to 39% just to get back to even? Answer: none. IMO, this is why gold stinks as an investment.

Now if you could sell gold easily and much closer to market value, then it would become a better investment. But it seems to me that the cards are stacked against all but the most sophisticated investors here, so only "experts" will get anything close to market value. Again, maybe I'm wrong. Those of you who know better can enlighten me if that's the case.

So until I'm convinced otherwise, gold is out for me as an investment. That said, there are other reasons for buying gold -- for the "insurance" factor. The following was noted in part 3 of my gold/silver interview:

The first allocation [of gold] should be under the mindset of never selling it. It is the “insurance” against dollar default.

To me, this seems like a valid reason to purchase gold -- if you believe in the total collapse of the economy/gold will hold it's value while inflation runs rampant theories. But for purely investment reasons, I don't see how gold represents anything but an investment that must increase in value SIGNIFICANTLY for you to earn anything resembling a reasonable return.

Again, please tell me where I'm wrong -- I'm open to being corrected/learning more...

5 Ways To Either Make A Fortune Or Lose Your Shirt

The following is a guest post by Mark from Buy LIke Buffett.

Everybody would love to strike it rich quick. Many investments are touted as a way to make easy money quickly. There is no such thing as easy money. The same investments that have the power to make you money have the exact same potential to lose your money as well. It’s important to be aware of the risks and rewards that come with different types of investments.

Let’s take a look at 5 investment strategies that could make you money or cost you a fortune.

1. Daytrading stocks.

Television shows like CNBC’s Fast Money and Options Express glorify the gains that can be made from rapidly buying, selling stock and option positions. There is serious money that can be made by trading these securities on a daily or weekly basis but trading these securities is not for the novice. Daytrading requires lots of time to keep up with the movements of stocks during the day. It also requires a sophisticated knowledge of technical analysis and the ability to properly plot entrance and exit points. Even with all of this advanced preparation, it is still difficult to time the movement of the market as a whole.

2. Buying foreclosed properties.

There are a ton of late night infomercials proclaiming the benefits of buying foreclosed properties. You can buy a home for $10,000 or less and flip it a few months later for a substantial profit. This all sounds good but foreclosed homes often have more problems than buyers bargained for. Foreclosed homes are often money pits that require thousands of dollars in repairs just to bring them up to code. Many homeowners have left their houses in deplorable conditions. Another danger is that foreclosed homes may not be the bargain that you think they are. You have to do your homework and make sure that you are not catching a falling knife in a neighborhood whose prices will continue to drop.

3. Speculating on currency.

George Soros was catapulted into the billionaire stratosphere due to his good fortune in currency speculation. Soros made a huge bet against the pound sterling. His gamble paid off and Soros netted a $1 billion dollar profit. Trading currency can either net you a tidy sum of profit or leave you flat broke depending on the movement of foreign currencies. The truth is that the average investor will lose money trading currencies. Not only are you trying to beat professional investment banks, you are also trying to outsmart foreign governments. The Forex currency market may sound like a way to quick profits but most speculators will find themselves drowning in trading losses.

4.  Trading futures contracts.

If you want to know what the futures market is like, think back to the movie Trading Places. In that movie the Duke Brothers bet their entire fortune on a crop report and ended up broke. These highly sophisticated derivatives were only available to professional investors at one day. Today, due to online brokers and exchange traded funds just about any investor can gain access to the futures market. Futures contracts rely heavily on leverage to amplify the returns of the underlying commodity. This is great if you guess right on the price movement because you can make a lot of dough. However, if you guess incorrectly, be prepared to pay up. You might find that you would have better luck playing blackjack at a casino than guessing the price movement of pork bellies. 

5. Short selling a stock.

Short selling a stock is basically borrowing shares from an investor that owns them and betting that the stock’s price will continue to decline. Short selling was once reserved for hedge funds that wanted to take long and short positions on separate stocks. Short selling has become popular today amongst regular investors due to the profit potentials. Some professional investors made a fortune during the financial crisis by shorting individual banks and financial institutions. The danger of short selling is that you could fall prey to a short squeeze. A stock’s price could move against you and you could find yourself scrambling to cover your position as the price soars higher and higher.

What do you think of these different types of investment strategies? Do you know of any others that have high risk/reward potential?

Market Timing Doesn't Work. Yes, It Does. No, It Doesn't. Yes, It Does.

I've made it clear what my take is on market timing (I invest every month like clockwork whether the market is high or low). That said, I have taken some cash off the sidelines when the market has dipped, so some people could consider this market timing. But I'm not an in-the-market then out-of-the-market sort of investor.

I realize that there's a lot of debate on what the best strategy actually is. This fact was highlighted by three recent articles that took different sides of the issue. I thought I'd share them with you and get your comments.

The first is from MSN Money which says timing the market works. But the piece starts with a reason why it DOESN'T work:

A remarkable new study from TrimTabs Investment Research shows that regular investors needlessly lost billions more than they should have on the stock market. Why? It's the old story: They invested more money in their equity mutual funds during the booms . . . and then sold them during the panics.

So even though Wall Street overall ended the decade pretty much level (when you include dividends), average investors lost a bundle.

TrimTabs puts the losses at $39 billion. "It cost them about 20% to buy high and sell low," says TrimTabs' Vincent Deluard.

However, MSN Money sees these results as an argument for market timing:

Yet the TrimTabs numbers show, instead, that over the past decade it was actually quite easy to time the market. All you had to do was buy when the public was selling and sell when the public was buying.

Even during a flat decade, people could make money just by going against the herd. They didn't need to know anything else. They didn't need quantitative models, astrophysics Ph.D.s from M.I.T., inside information or privileged access. All that money spent on equity research? All you had to do was look at the latest numbers from the Investment Company Institute, showing whether the public was putting money into their stock market funds or taking it out. And then do the opposite.

Maybe I'm missing it, but I don't see where the author says how much better this strategy would have been -- 10% better? 20% better? If you find it, let me know.

Kiplinger's disagrees and says that investors lose big with market timing. Their thoughts:

Market timing seems so easy in hindsight. What’s more, plenty of professionals -- including brokers, advisers and investment newsletters -- stand ready to offer you guidance on when to trim your exposure to stock funds and when to boost it.

But a groundbreaking study by Morningstar shows what a terrible price investors pay for market timing. During the past decade, the average investor’s return trailed the average fund’s return by 1.5 percentage points. And it came during a decade when the major market indices either suffered losses or produced paltry returns.

Ironically, investors are good fund pickers, the study shows. On average, investors tend to shun high-priced funds and to invest in funds that, over time, beat their category averages. On average, about two-thirds of funds fail to even match their benchmark index. But Morningstar finds that investors, in aggregate, buy above-average funds.

Bad market timing, however, overwhelms skillful fund picking.

Finally, the Wall Street Journal says that the old adage "you can't time the market" is false. Their thoughts:

This hoary old chestnut keeps the clients fully invested. Certainly it's a fool's errand to try to catch the market's twists and turns. But that doesn't mean you have to suspend judgment about overall valuations.

If you invest in shares when they're cheap compared to cash flows and assets -- typically this happens when everyone else is gloomy -- you will usually do very well.

If you invest when shares are very expensive -- such as when everyone else is absurdly bullish -- you will probably do badly.

Again, they go back to the "do the opposite of what everyone else is doing" philosophy. Anyone reading this using that method? How are you doing?

Personally, I worry much more about time and amount invested than I do return rate -- and for good reason. That said, I'd rather earn a higher return than a lower one. Wouldn't everyone?

Ok, now's your chance to chime in. What's your take on this issue?

The Future of the Stock Market

The following is reprinted with permission from Generation Earn: The Young Professional's Guide to Spending, Investing, and Giving Back. Copyright © 2010 by Kimberly Palmer, Ten Speed Press, an imprint of the Crown Publishing Group, Berkeley, CA. You can find out more about Kimberly at the Alpha Consumer blog.

The 1990s are over. And they’re not coming back.

That’s good news for those of us who were never fans of the grunge look, but bad news for anyone hoping to earn 10 percent returns every year. Books, magazines, and other sources of personal finance expertise continue to push the notion that we shouldn’t worry about the fact that, after we factor in the recent down market, the stock market has returned next to nothing over the past ten years.

On average, these stock market cheerleaders say, returns have always historically returned to around 10 percent a year. But it’s very possible—probable, some might say—that they are wrong, and that 10 percent average returns were an anomaly unique to the twentieth century.

Since 2000, returns have been significantly lower. Some prominent sources, including the Economist and Wall Street Journal, have even referred to the 2000s as a “lost decade” for investors. Anyone trying to estimate their returns for the next few decades might want to consider using a more conservative estimate of 6 or 8 percent returns, and even that feels a bit optimistic. After all, Japan’s stock market is still struggling to return to levels it experienced two decades ago.

But rather than wallowing in potential doomsday scenarios or lamenting how unlucky our generation is that the stock market started sinking as soon as we began investing in it, we can consider ourselves fortunate that the crash of 2008 didn’t come later, when we were closer to retirement.

Or we can simply be grateful that it happened. As Suze Orman has pointed out, if the economy had kept on going the way it did in the 1990s, we would still be buying expensive stocks and overinflated real estate. The financial crisis, she says, is the greatest thing that has ever happened to our generation. (Suze, of course, says this with the knowledge that most of her money is safely ensconced in bond funds.)

People who are just starting to invest have had a unique opportunity to buy into the stock market at the lowest prices in years. And plenty of experts are quick to point to the data on historical returns, which suggest that there’s no way we could possibly have two “lost decades” in a row, and market returns will surely rebound back to twentieth-century levels before too long. Meanwhile, we can take steps to make the most of the post-credit crunch markets, starting with these pieces of advice:

• Accept reality. The heyday of easy returns and overnight millionaires is probably over, at least for now. We can’t count on the stock market returning to 10 percent returns anytime soon. That means you’ll need to save more to achieve the same long-term wealth goals.
• But don’t give up on the market. It still offers the potential of steep rewards. Selling stocks after the market has plunged only guarantees you one thing: losses. As long as your investments are well diversified (index funds and mutual funds that are exposed to a broad range of sectors) and age appropriate (more aggressive when younger, more conservative when older), then you should just sit back, relax, and try to think about something other than the stock market.
• When the market drops, rebalance your accounts. Dramatic losses often mean you have a greater percentage of your money in safer investments, such as bonds, and a smaller percentage in more aggressive, longer term stocks, since your stocks have lost so much value. For example, if you had half of your savings in stocks and half in bonds, after the market plummeted you would suddenly have most of your money in bonds.

Rebalancing can mean buying into a weak stock market, which goes against instinct, but it’s often a winning strategy. Research suggests that investors often fail to make these adjustments, which costs them in the long run. One ING DIRECT study found that two in three Americans made no adjustments to their investments in the wake of the most recent recession.

• Learn from your mistakes. Even professional investors make mistakes, especially at first. J.D. Roth of Get Rich Slowly lost money investing in Sharper Image before deciding to stick with index funds. Even after studying the basics of investing, most of us are pretty much destined to make mistakes, especially at first. That’s another reason to start investing as soon as possible.

How to Buy and Sell Physical Gold and Silver, Part 3

This is part 3 of my interview with Doug Eberhardt, author of Buy Gold and Silver Safely: The Only Book You Need to Learn How to Buy or Sell Gold and Silver. As with yesterday's post (and the one two days ago), I'll include my questions in bold/red and Doug's answers below each one. And at the end of the post, I'll add in some commentary to add perspective to why I asked the question and/or what I think of the response.

We ended yesterday with Doug starting to talk about pricing when buying physical gold and silver. We start today with a continuation of that topic.

What should I expect to pay (How do I know if I'm getting a "good" price or not)?

The price you pay for gold or silver bullion should be anywhere from 1% to 13% over the ask price. This will come out to about 5% to 13% over spot for gold and a smaller percentage for silver. The best thing to do is check around with the various dealers and ask what the spot price is at that moment and what they are selling the gold and silver you want for based on that spot price. Then you can decipher how much of a mark-up they have. But in comparing dealer to dealer, one has to use the same spot price (apples to apples).

Can you give an example? Say I buy an American Eagle coin (pick a spot price). Can you show what the coin is worth, what I'll pay for it, what additional costs, fees, shipping is added to it, etc.?

What I do, based on the spot price at the time of purchase, is add my 1% fee to my ask price. The price of gold as I type this is $1318.60. The ask price is $1366.69. My fee of 1% ($13.67) would be added to this ask price bringing the total to $1380.36, for a total of less than 5% over spot. I also guarantee my prices as being the lowest as I’m not too worried of someone undercutting me by too much because they would be breaking the law set forth by the U.S. Mint pricing practices. Since I don’t do the advertising on TV and radio like these other companies, I can keep my prices low and am just looking for a win/win experience for my clients.

I still don't get how the ask price is determined. I understand the spot price (basically the value of the gold) and the 1% of the ask price, but where does the ask price come from? Do you simply set it yourself? If so, does this mean all companies set their own ask price?
 
In determining ask price, the amount of spread between the spot price and the ask price consists of the premium charged by the U.S. Mint to the gold dealers and any other mark-up by major gold dealers or 3rd party intermediaries. The ask price will not vary by much from company to company, but the premium charged by gold dealers will. The 1% my company charges ranks as one of the lowest. The main difference with me, as I said, is I don't try and bait and switch investors into gold and silver they don't need to own like rare coins or semi-precious European coins. 

Where should I store my physical gold and why?

This is going to vary from person to person. I don’t recommend bank safe deposit boxes, because well, they’re banks. FDIC takes over a bank and your safety deposit box is frozen till they sort things out. If the economy collapses, and I’m not a Chicken Little who claims such, but I do paint a lousy economic future based on the data, you’ll want access to your gold and silver bullion.

A safe buried in your home would be a good place to start. But also have a secondary safe filled with $1 bills and fake jewelry as a dummy safe to fool the thief’s. Just point them to this safe if ever in trouble. Lastly, don’t tell anyone you bought gold and silver. The old saying of “loose lips sinks ships” applies here. I know it’s difficult not to tell everyone how well you are doing with your investments to show them how smart you are, but someone may just be knocking down your door if the economy did implode. Perhaps an investment in Smith and Wesson hardware would be advised as well.

How do I sell my gold if I want to (it seems like the market is highly illiquid and full of fees/spreads on both the buying and selling side -- so isn't it difficult to make money on gold unless the price goes up dramatically)?

There should be two types of gold you own, depending on your own personal wealth. The first allocation should be under the mindset of never selling it. It is the “insurance” against dollar default.

The second allocation would be the type of gold that can be delivered at a moment’s notice and/or sold at a moment’s notice with just a phone call, depending on the economy.

How do I sell the gold I want to sell at a moment's notice? Who do I call exactly, what sort of price will I get (spot? spot less something? spot plus something?), how do I get the gold to them, and when and how do I get paid (after they receive it via wire transfer?)

There are many places to sell gold, but the primary one would be the place you bought it from. Gold dealers will buy back the metal and cut you a check after they have received it. With gold moving higher right now, dealers are offering $30 over spot for one ounce American Eagle coins.

The gold has to be shipped to the dealer at your cost before any funds are dispersed. You can request to have the funds wired or sent by check.

Other places to sell would be Ebay, although you need to know what you’re doing as I explain in my book, and Craigslist. Ebay is good for selling coins but there are fees involved that if one doesn't understand them, they can end up getting burned. Craigslist is just a dangerous way to sell gold coins so if people use it, I just recommend only doing transactions in a public place with security, like a local bank.

Is there a way I should or shouldn't handle gold or silver? For instance, are the coins sealed and if I open/handle them, do they lose value?

The handling of pure bullion, like the American Buffalo gold one ounce coins or the Canadian Maple leafs have the problem of losing value and they should be handled with care. American Eagle gold coins have one ounce of gold, but actually weigh more than an ounce as they contain other base metals, including even silver, to allow for less wear and tear.

Isn't it true that buying gold and silver isn't tracked by the government like holding stocks, bonds, etc. is? Is this about to change in any way? (I think you may have mentioned this in your book.)

It is true that certain gold and silver coins are not tracked today, unless of course purchased with more than $10,000 in cash. This doesn’t mean that an investor is not required by the IRS to report gains via a 1099 upon selling them. Many gold dealers imply certain coins are not reported by them, but it is still the citizen's responsibility to report the gains.

Yes, as part of the current health care bill, all sales $600 and more will have to be reported by the gold dealer. There are some in congress who are trying to take this out of the bill as it also requires any company selling any product over $600 to send a 1099 off to big brother, erm, the IRS.

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Is it just me or is the pricing system for buying physical gold and silver both complicated and expensive?

BTW, I asked the last question because I've seen people recommend gold because it's "not tracked by the government." It's advocated by those who don't want the government knowing everything they do -- not because they are trying to avoid taxes.

Personally, I really enjoyed interviewing Doug because he cleared up several issues for me. If you want to read more of his stuff, you can find his blog here.

How to Buy and Sell Physical Gold and Silver, Part 2

This is part 2 of my interview with Doug Eberhardt, author of Buy Gold and Silver Safely: The Only Book You Need to Learn How to Buy or Sell Gold and Silver. As with yesterday's post, I'll include my questions in bold/red and Doug's answers below each one. And at the end of the post, I'll add in some commentary to add perspective to why I asked the question and/or what I think of the response.

We ended yesterday with Doug telling us the types of items he recommends people buy when they purchase physical gold and silver. Today, we get into detail on these, especially where to buy and a bit about how pricing works (more on this in the next post).

Assuming I decide I want to buy one (or more) of the above, how do I locate a reputable place to buy them? And can you give me some examples of the "best" places to buy them in your opinion? 
 
My company, “Buy Gold and Silver Safely” sells the gold and silver I recommend in my book at a 1% flat fee. Other companies I recommend are APMEX, and Tuvling. There might be more, but the one issue that I hear people complain to me the most is the push by some of these low cost companies into the rare coins, or other coins where the dealer makes more profit. That’s why my book is clear in “asking the right questions” of dealers to begin with.

What does "1% flat fee" mean? Does that mean that if gold is at $1000 per ounce then a coin with one ounce of silver in it would cost $1,010 if purchased from you? (Editor's note: we'll cover the topic of pricing in greater detail tomorrow.)

The 1% flat fee is the fee that is added to the ask price. So technically you have the spot price, plus the fee that goes to the U.S. Mint, and any dealer fees are added to what the base price is. A gold dealer legally cannot sell bullion gold for less than what they get from the U.S. Mint for. 
 
Is 1% good? What do others charge? Can't I buy American Eagle coins cheaper directly from the government?

1% is the lowest in the industry. Others will charge anywhere from 1% to 13% or even more if they can get away with it. On IRAs for example, I know of a broker at one gold dealer who told me they have leeway to charge up to 30% for bullion.

One cannot buy American Eagle gold one ounce gold coins from the U.S. Mint at a lower price. You can see from their pricing sheet, they are overpriced.

Where do people buy on your site?

I don’t sell gold online, nor do I have plans to do so at present, although, I may incorporate that in the future. I do have a minimum of $20,000, that’s why I give other places to buy in my book. If people want to buy from me they can contact me at:
 
5945 Pacific Center Blvd.
STE 510
San Diego, CA 92121
888-604-6534

What makes you reputable? (Who recommends you, who certifies you, etc.) Not to question your integrity, but people will want to know.

Almost all the gold dealers associate themselves with the rare coin places like ICTA. Since I don’t sell rare coins, I am not associated with anyone (a rare breed).  So I am stuck with getting a BBB rating, which really doesn’t mean much since Goldline, who is under investigation by the city attorney in Santa Monica as well as the FTC has the highest rating by the BBB. I’m presently working on getting that set up. Not much else I can do except write good articles and rely on word of mouth at this point.

My book of course will lead to more possibilities. I have people who have volunteered to be called if necessary. I have to let my reputation develop over time, but the fact I offer gold and silver bullion at the lowest prices and the fact my book and blog articles are all about keeping people from getting ripped off by other gold dealers should add to my credibility as a broker/dealer. They just don’t let anyone become a broker/dealer and sell gold. The places I acquire my gold and silver for my customers also do their due diligence.

Lastly, if people don’t want to do business with my company, they are more than welcome to buy from someone else. There’s plenty of business to go around. I bring value by what I write continually on my blog and I’ve even told people to buy gold in Euro’s (sold for a 30% gain) and am presently recommending buying gold in Yen for trades (dollar cost averaging in). This of course is not investment advice, but just suggestions.

What's the buying process entail (details on ordering, paying, shipping, delivery, etc.)?

What typically has to happen is the money has to be “in-house” before a trade can be conducted. This is typically done by a wire transfer. Once the money is in-house, the trade can occur when the individual decides to pull the trigger and purchase the coins/bars.

The trade is confirmed at the current spot price and the metal is set aside for delivery or storage. Delivery is typically done via either Fed Ex or USPS, both of which insure the metal and have been reliable.

Where can people see/find the "current spot price" (so they can check on the cost/value of their purchase)? Is there an "official" source for the information? Is it as of the exact moment the item is bought or from the value at the end of the preceding day (or something else)?

People can go to various sites and find the price of gold. I eventually will have this on my home page, but don’t want to put another company's widget on there, so am developing my own. www.kitco.com, http://www.bullionvalues.com/, as well as CNBC are good for checking prices.

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The whole physical gold and silver buying process seems fraught with fees and costs that make the cost of investing quite high IMO. And they seem highly illiquid as well (more on that tomorrow.) Then again, if you're buying only to hold and use in case of a total meltdown, there's no need to consider selling.

Click here for the final post in this series.

How to Buy and Sell Physical Gold and Silver, Part 1

A few weeks ago I read a copy of Buy Gold and Silver Safely: The Only Book You Need to Learn How to Buy or Sell Gold and Silver by Doug Eberhardt. I LOVED it! It was the only book I have read on gold and silver investing that gave specifics on the how tos (most gold books cover the why tos) in a way that even I could understand. I contacted Doug and asked if he wanted to do an email interview on the subject and he agreed.

I'll be running the interview over three days in three separate posts. I'll include my questions in bold/red and Doug's answers below each one. And at the end of each post, I'll add in some commentary to add perspective to why I asked the question and/or what I think of the response.

Here we go...

Let's start by having you tell us all a bit about your qualifications and experience.
 
I am originally from Illinois and a graduate of Roosevelt University. After college I moved to California where I was a financial advisor for just over 20 years and subsequently worked for one of the largest gold dealers in the United States. I took some time off to do research from an economic perspective and expose from an investment perspective what I believe to be flaws in our financial services industry, primarily dealing with the Prudent Man Rule and the adherence to Modern Portfolio Theory and the "risk free" asset; U.S. Treasuries and the U.S. dollar. This research has led to my writing a blog which I have been posting articles for 2 1/2 years and subsequently my book; "Buy Gold and Silver Safely," published September 2, 2010 and available on Amazon.com. It has also led me to start my own company as a broker/dealer selling strictly gold and silver bullion at the lowest prices available.
 
I have been a guest on blogtalkradio's "The Optimistic Bear" a couple times, have been covered in the Chicago Tribune, and I was interviewed for an upcoming NY Times article.
 
The media attention seems to be taking off for me, which I am happy about. Of course the media that won't allow me a platform is the kind of media that rakes in the profit from the gold dealers I expose.

Your point of view is that physical gold and silver should be held as a safety net/insurance policy in case the economy/government collapses, correct? And you recommend 10% of a person's net worth allocated this way, correct? Do you advocate buying gold/silver for any other reason and if so, why? (simply to earn a good return?)

While no one has a crystal ball and can predict the future, we do know it doesn’t matter who is in congress as to whether or not they will curtail their spending. If you really sit down and crunch the numbers as to how unsustainable big government has become, including the city implosions that will surface more and more, as well as states, the question you have to ask yourself, is how can the Federal Reserve, U.S. Treasury and our government possibly reverse course? The answer is, all they can do is delay things a bit with their quantitative easing, which like Japan’s lost decade plus, is only a temporary fix.

As such, this is going to play out longer than people expect. One shouldn’t go overboard with their investments into silver and gold thinking the sky is falling just yet. There will always be pullbacks, just as there was in 2008 when the junior mining stocks fell 80%. But physical gold and silver actually was higher that year. Holders of physical gold and silver care not that it falls 20% on its way to 100% or more in gains. That’s why I prefer the physical to the paper trades; less volatility.

A 10% allocation to physical gold and silver is good. Another 10% to trade the ups and downs is fine whether physical or through the various paper vehicles like ETFs or mutual funds. Even leveraged accounts can be used for the aggressive traders, although I don’t think this is wise advice after nice runs in the metal like we have just had. Anything more than that, is at your own risk. But I can change this allocation recommendation at any time based on what I see happening. There’s always the threat of war, a country like Ireland for example losing its grip, or even the U.S. changing the rules as they did in 1971 when Nixon took us off the gold standard. Expect the unexpected and there’s nothing wrong with being in cash waiting for the right opportunity, as long as you are hedged with some gold and silver.

I am conservative with my recommendations. I choose the tortoise approach over the hare. Greed is something that can get in the way of common sense. Can someone put more than 20% into these paper and physical vehicle’s? Sure. But they have to realize what risks go along with that.

When buying physical gold or silver, what are the main options you suggest investors consider (coins, bars, etc.) and why? What are options I should NOT consider?

There are different answers for this question, depending on whether you are buying gold or silver and whether you are using money from an IRA or money outside of an IRA.

Gold: The only gold I recommend are 1-oz American Eagle Gold coins. The reasoning stems from first the fact they are easily recognizable and have a low premium above the spot price of gold. With bars there is the possibility of having to assay them when it comes time for use (barter economy). If one is wealthy enough though, the larger bars of gold can be held in storage and liquidated at a moment’s notice or taken in delivery if we get to the point of a barter situation. But of course there is the issue of converting the bars to a form of gold that can be used for barter. I don’t recommend any rare coins, including St. Gaudens or the European coins like the Swiss francs. The premiums are too high in most cases and good luck getting what you paid for the St. Gaudens in a barter economy or using foreign coins here in America for purchasing goods and services.

Silver: For an IRA, I recommend the 1,000 ounce bars and for physical possession, the 90% silver bags. The 1,000 ounce bars offer the lowest cost to spot price and the 90% bags of silver also give a good price over spot, but at the same time I believe these coins will be the major bartering coin should our economy devolve to such a state. The American Eagle silver bullion coins have too high a premium over spot to be considered.

Obviously there are many different products out there with varying levels of gold content/value. What's the difference between them, how do I value one over the other, and how do I know I'm buying one versus the other?

I like sticking with the lowest premium to spot American coins as they are recognizable and the silver coins were once money in the U.S. Bars have to be assayed and one other issue is the place where you bought the bars may not even buy them back from you. If that is the case, then where will you sell them? How will you prove they are real gold or silver? It may have a stamp on them from a reputable company, but I like keeping things as simple as possible.

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We'll stop here today because I'm about to get into a new line of questioning and I want to include it all in one (the next) post.

Not much for me to comment on so far other than to say that the 90% bags of silver he refers to are what his book calls "90% junk bags of silver." These are 90% silver US coins (aka circulated silver coins) minted before 1965. According to the book:

"A 'bag' ($1,000 face value) contains approximately 715 ounces of silver and generally tracks the spot price of silver. These are circulated dimes and quarters that were used by citizens until the government found the silver content to be worth more than the price on the coins."

Click here for part 2 of this interview.

Lesson 1: Pay Yourself First

The following is an excerpt from Lessons to My Children: Simple Life Lessons for Financial Success, Wealth, and Abundance. I especially like this lesson because it shows the power of saving as well as how time is your biggest investment ally.

What is not started today is never finished tomorrow.
Johann Wolfgang von Goethe

You are your own greatest asset. If you invest in yourself by getting an education and maintaining good health through exercise and eating well, you reap the rewards throughout life.  The same is true of finances. So when you receive that first paycheck, rather than asking how much is left over for movies, dinners out, and clothes after rent, gas, and living expenses are paid, consider how much to “invest” in yourself through saving for the future. Because the more you save, the more self-reliant and self-sustaining you become, through both good times and bad.

Why Pay Myself First?

Let’s face it: It’s much easier to not even think about a savings plan, especially when you’re young. Human nature being what it is, most of us prefer the instant gratification of impulse buying – purchasing whatever suits our whims at a particular moment – over voluntarily denying ourselves and putting away money.  So the best way to make sure you save is to automatically put funds into a savings account at the start of each pay period. If it’s already allotted and you can’t see it, then you won’t be tempted
to spend it. 

Before you start saving, however, you’ll need to know how much you can realistically put away. That involves setting up a budget, a plan involving sums of money allocated for a particular purpose, such as gas, rent, and utilities. To set up your budget you’ll need your first paycheck for the full pay period. Having a complete check – whether you’re paid weekly, biweekly, or monthly will give you an idea of how much money you actually have. Ideally, 90 percent of your take-home pay can be used to create the budget, with the remaining 10 percent being used for savings. See Lesson 3 for more details on setting up and living within a budget.

Ruth’s Story

When I started working part-time, my Dad agreed to match my earnings with a contribution of up to $2,000 per year in an individual retirement account (IRA). Although retirement was the last thing on the mind of this 16-year-old, I really liked the idea of money in the bank, so I went along with the plan. Dad would do this for the two years I worked while in high school and all the years I was in college, up to 10 total years.

However, as part of the deal, Dad asked me to figure out how much would be in my retirement account assuming I got a 10 percent annual return and there were no other contributions.  I calculated that at age 65 I would have more than $1.3 million in the IRA. In other words, because of the time value of money, we invested a total of $20,000 and received back $1.3 million 49 years later. How cool was that?

Then he had me calculate how much I would accumulate if I waited 10 years to age 26 and invested $2,000 per year for every year until retirement. The answer was a real shocker – I would only have about $800,000 at retirement! I would be investing $58,000 more and getting half a million less!

Finally, he asked me to estimate how much I would have to invest every year if I were to end up with $1.3 million, but started after college at age 26. That was a little harder to do, but we calculated that I would need to invest $3,238 per year for the next 39 years, or $126,293, to accumulate $1.3 million. I had only invested $20,000 in those first 10 years, but missing those years would have cost me over $100,000 in additional savings to make up for the lost time. When it comes to investing, the early bird who saves regularly really does get the worm!

More on the Cost of Mutual Funds

We've talked about the role cost plays in determining the success of a mutual fund's performance. CNN Money tackled the same issue (and quoted the same Morningstar study) from a different perspective in a recent column. It started with the following question from a reader:

I'm trying to choose between two funds in my 401(k) that invest in the same sector. One has higher fees, but it also performs better. How can I tell if a fund's performance is worth the higher price?

Some of the highlights from CNN Money's answer:

I've been telling investors for years that they're better off sticking to low-cost funds whether they're buying them for a 401(k), IRA or, for that matter, any type of account.

Here's the bottom line: Whether it was domestic stock funds or international, taxable or municipal bond portfolios, low-cost funds beat their high-fee counterparts in every single time period tested in the study. Morningstar even concluded that expenses were a better predictor of a fund's future performance than its widely followed star-rating system.

But does that mean in every fund with lower expenses will outperform every other comparable fund with higher fees? Of course not.

Fact is, it's always hard to tell in the case of actively managed funds what's driving better performance. Is it low fees? Superior stock picking? A more aggressive or conservative strategy? Simple luck or randomness? Market researchers have debated such questions for years -- a recent paper takes on the luck vs. skill question directly -- and no doubt will continue to do so for years to come.

At this point, I think it's fair to say that managers who outperform due to true skill are few and far between and identifying them in advance is extremely difficult. For most investors I think distinguishing between luck and skill is essentially a guessing game, which is one reason I believe most investors are better off opting for low-cost index funds.

All else equal, the bigger the expenses, the higher the hurdle a manager has to overcome to keep pace with similar funds. And just because a manager has been able to clear that obstacle in the past, doesn't mean he or she will be able to do so consistently in the future. If anything, the odds are against it.

Lots to comment on here. My thoughts:

• I'll say it again, costs matter if you want to maximize investment returns.

• Low costs is one reason I invest using index funds.

• Another reason I invest this way because I agree with CNN Money, picking a fund/manager who can out-perform the market is difficult if not impossible to do on a consistent basis. And those who have a chance of beating the market have to commit so much time and effort (time I don't have to commit) -- and still they aren't guaranteed success!

• Whether anyone can pick a manager that beats the market or not (or can pick stocks that do better than the market themselves or not) isn't really the issue anyway. If you want to make the most of your investments, the most important factor is the amount of time you are invested. And since time (as well as amount saved) are factors you CAN influence (while return rate is something you can NOT influence/control nearly as much), isn't this what investors should be spending most of their time discussing (how to save more and do it earlier)?

Avoiding the 10 Most Common Investor Mistakes, Mistakes 8-10

The following is an excerpt from 20 Retirement Decisions You Need to Make Right Now. This is the last post in the series listing all 10 most common investor mistakes.

Mistake 8: Not Understanding the Downside

Many investors are just convinced that their investment portfolios should always go up. When returns don’t meet these unrealistic expectations, they tend to throw in the towel and give up. It’s a mistake to sell good investments just because they are having a sluggish year or struggling through a bear market. You need to invest with your eyes wide open, knowing beforehand what to expect from your investments in both bull and bear markets. In most cases when your investments take near-term dips or fluctuate with the market, you should stay invested and hold on.

Most investors ask only one question before buying a portfolio of investments, “What will my return be?” Usually, they answer this by looking at recently posted one-year returns. Stopping at this question will likely leave you disappointed at some point during your investment journey.

In addition to knowing what the returns of your investments have been recently, be sure to ask the following:

• What has the portfolio returned on average over the past one, three, five, and ten years?
• What was the best and worst three-month period during the past ten years?
• What was the best and worst one-year period during the past ten years?
• What was the best and worst three-year period during the past ten years?
• How has the investment performed during past wars, bear markets, terrorist attacks, and elections?

Once you know the answers to these questions, you can now ask yourself an even more significant question: “If I want the long-term returns this investment or portfolio can produce, can I withstand the volatility?” Without understanding this risk from the onset, volatility will likely get the best of you somewhere down the road. See the asset allocation chart in to examine the ups and downs of various mixes of stocks, bonds, and cash.

Let’s investigate the market’s ups and downs during different periods. Figure 10.6 (not shown here) shows the worst one-year results for different segments of the stock and bond markets from 1970 to 2008. You need to take downturns in context. For example, during the 1973-1974 recession large-company stocks fell 37 percent. An investor would have been shortsighted to sell a portfolio of large-company stocks after this poor performing year. In the following two years (1975-1976) large company stocks provided patient investors with 37 percent and 24 percent returns respectively. A $10,000 investment into an S&P 500 stock index fund starting in January 1970 would have grown to $340,573 by December 2008, a return of 9.5 percent per year. Other Figures review the stock market’s performance during various bear markets, wars, acts of terrorism, and elections.

Despite all the recessions, wars, terrorist attacks, and market crashes, the stock market has been an excellent investment over the long term. The key is to stay invested through thick and thin. When you invest in a portfolio of stocks and bonds, be aware of the potential upside and downside associated with your investments. If you don’t understand the risks at the outset, you are more likely to react poorly during periodic market setbacks and get scared out of the market.

When you buy an investment, you should plan on worst-case scenarios occurring when you invest. If you understand the risk from the outset, you are more likely to stay invested for the long term and realize solid long-term gains. It is true that past performance isn’t guaranteed to repeat, but it does give us an indication of what to expect.

Mistake 9: Focusing on Individual Investment Holdings Rather than Your Portfolio as a Whole

In 2008, I had a client, Marcus Ramsey, who each time we met to review his investments was convinced that he was going to go bankrupt due to the market’s tumble. Why was Marcus so concerned? One of his brokerage accounts was invested in some fairly aggressive individual stocks that were routinely getting hammered. He watched the value of this account drop 50 percent. Because of this one account, he was ready to sell every stock investment he owned and move to money markets and CDs. However, when we evaluated his overall portfolio, including the money he had in his bank, 401(k), IRA, brokerage accounts, and an annuity, we discovered just how well he was weathering the bear-market storm.

When we viewed Marcus’s total investment portfolio, we saw that only 30 percent of it was invested in stocks and stock funds; 40 percent of his money was invested in municipal bonds; and 30 percent was in money markets and CDs. The single aggressive account that caused him so much heartburn (and nearly persuaded him to give up on the stock market entirely) represented less than 1 percent of his overall portfolio.

So how did Marcus do? In 2008, when the stock market, as measured by the S&P 500 was down 37 percent, and the Nasdaq dropped a whopping 41 percent, Marcus lost 7 percent. While everyone else was losing sleep because of their stock losses, Marcus realized he could relax and his money anxiety went away.

If you are properly diversified, I can guarantee you that each year some of your investments will lag behind others in your investment portfolio. If you look at investments in isolation rather in context of your overall portfolio, you will be tempted to make poor decisions. You may get yourself into trouble by getting rid of investments when they’re low in value and replacing them with those that just experienced success. This leads to buying high and selling low. This is often a mistake made by investors who gauge their entire portfolio by the performance of just one account or one investment.

So remember, evaluate your portfolio as a whole rather than by its individual pieces.

Mistake 10: Lack of a Clearly Defined Investment Strategy

Let’s imagine for a moment that you are in charge of investing the $100 million in your state’s retirement pension plan. The money will be used to provide pension incomes and other benefits to thousands of employees who have diligently worked for the state. These employees are counting on you to make good investment decisions to help secure their financial futures. What steps would you take to make sure this money is managed properly?

Most likely you would begin by developing an investment strategy that outlines your objectives and the parameters you will follow as you make investment decisions and manage the money. Then you would use the services of institutional money managers to handle the day-to-day buying and selling of stocks and bonds. You would likely interview many financial professionals, hire the best ones, and then monitor their performance very closely.

Picture yourself in one of these interviews. You would no doubt ask lots of specific questions about each manager’s investment strategy and how successfully each has managed money. How much confidence would you have in a candidate who answered your question with this statement?

“Well, our investment management company doesn’t really have a strategy. We usually read Money magazine and look for hot tips. We always watch CNBC and often get good investment ideas there. Sometimes we even look on the Internet for investment ideas. On occasion, I talk to my doctor or father-in-law to get their thoughts and ideas. We buy a little here and a little there and hope the investments work well and complement each other. Once we purchase the portfolio of investments, we go to the Internet to obtain stock quotes several times each day. When it feels right, we sell. It’s kind of a gut feeling we get. I think you will be happy with our investment management services.”

How much of your state’s $100 million are you going to trust with this money manager candidate? It’s safe to say you would usher him out of your office as quickly as possible.

You are the money manager of your own money. Now, put yourself in the hot seat. How would you respond if asked, “What strategy do you follow in managing your own portfolio?” All too often, investors respond the same way the money manager did in our previous example. If your investment strategy consists of hot tips from television, the Web, and the guy next door, how successful will it be? Can you effectively manage your own money? Not without a well-defined and disciplined investment strategy.

Just as you wouldn’t hire a money manager lacking a clearly defined investment strategy to oversee your state’s pension, you shouldn’t manage your own money without developing a similarly disciplined strategy. A strategy doesn’t work unless it has structure and is carried out with discipline. Investors who do not follow a disciplined investment strategy continue to repeat the same costly mistakes mentioned in this chapter.

Now, more than ever, the size of your retirement nest egg will heavily depend on your ability to turn yourself into a good investor. By following the steps that will be outlined in the subsequent chapters, you will significantly magnify your chances of attaining sound returns and living a secure retirement.

Avoiding the 10 Most Common Investor Mistakes, Mistakes 4-7

The following is an excerpt from 20 Retirement Decisions You Need to Make Right Now. Over the next few days I'll be posting all of the 10 most common investor mistakes, so stay tuned to see them all.

Mistake 4: Chasing Returns

Individual investors are famous for buying last year’s winners. Guess which mutual funds attract the most new money each year? You got it; money flows into mutual funds that have just enjoyed the greatest performance in the previous year. In 2007, for example, investors poured more than $208 billion into international funds, the asset class with the greatest performance in 2006. The returns of the three international funds that brought in the most assets in 2007 provided returns 10 percent higher than the U.S. stock market in 2006. In 2008, however, these same three funds on average lost 42.96 percent. International funds were the worst major equity asset class in 2008. In other words, investors who chased market-beating returns in 2008 got soundly beaten by the market.

It shouldn’t be surprising that chasing returns is a very common investor mistake. There’s an entire financial media industry built around one simple theme: “Don’t Miss Out on the Ten Hottest Stocks,” or some variation of it. For many investors, the lure of phenomenal past returns is just too tempting to pass up. This allure leads to critical mistakes.

For example, in 1999, the Nicholas-Applegate Global Tech I Fund posted an unbelievable 494 percent return, and investors saw instant riches parading before their eyes. An individual investing in this fund at the start of 2000, however, experienced the following returns: -36.37 percent in 2000, -49.26 percent in 2001, and -44.96 percent in 2002. At the end of three years, a $10,000 investment was worth just $1,777.

When the fine print says “Past performance is no guarantee of future returns,” believe it!

Mistake 5: Believing Persuasive Advertising Messages

Many brokerage firms advertise in order to convince you how easy, enjoyable, and inexpensive it is to delve into the stock market and make big money. In fact, the brokerage industry spends hundreds of millions of dollars each year on TV commercials persuading us that it’s easy to be a success in the market.

The most classic example is the series of Stewart commercials run for a large brokerage firm that was touting its online trading system. You may remember Stuart? He was that red-headed, punk rocker who taught us and his boss how easy it is to make money in the stock market. Stuart advised that all you had to do was open an online account, start trading, and watch the money roll in. As Stewart said in the commercial:

“I don’t want to beat the market. I wanna grab it, sock it in the gut a couple of times, turn it upside down, hold it by the pants, and shake it ’til all those pockets empty out the spare change.”

Although the Stuart commercials, like many ads for the investment houses in the late ’90s, were hilarious, they did more damage than good. In fact, the commercial is even funnier in hindsight. In one of the 1999 commercials Stewart recommends that his boss buy one hundred shares of Kmart stock. In 2002 Kmart filed for bankruptcy, and the value of the stock subsequently went to zero. We don’t see Stuart talking about investing anymore, probably because he lost his shirt in the 2000–2002 recession. He learned the hard way that there is more to developing a solid investment strategy than merely opening an online brokerage account and trading.

No question about it, buying and selling stocks can be exhilarating. Many investors roll up their sleeves and play with their money, checking stock prices and market values throughout each day. While this may be a great form of entertainment, most discover it’s also a successful formula for losing money.

Rarely a day passes when a brokerage firm isn’t telling Americans that they can trade stocks for as little as $5 to $8 per transaction. Think about it. By offering such cheap trades, these firms have to make up for it by dealing in quantity. Their goal is to have you trade as often as possible without concern for cost. What they don’t tell you is what it’s really costing you. As we’ve seen, hyperactive trading equals poor performance.

Mistake 6: Poor Diversification

Investors tend to be concentrated in one or two companies or sectors of the market. Overconcentration can hurt a portfolio, whether the market is performing well or poorly. Poor diversification leads to excessive volatility, and excessive volatility causes investors to make hasty, poor decisions.

Suppose in 2008 you had placed the bulk of your portfolio in a big company like Lehman Brothers (-99.18 percent), AIG (96.24 percent), General Motors (-86.86 percent) or Citigroup (-73.40 percent). That year, you would have watched your portfolio head into an unrecoverable tailspin. Many Lehman employees invested a large portion of their retirement plan money in their company stock. You are probably thinking, “Who would invest the majority of their nest egg in just one company?” Surprisingly it is fairly common. A little more than one out of every ten people who have the option of buying shares of their company stock in their retirement plan have invested at least sixty percent of their retirement plan money in their company stock. People who had concentrated the bulk of their portfolios in these companies saw values drop to almost zero. Many were left with no other option but to start from scratch and begin rebuilding an entirely new portfolio.

You would think we’d learn. Many investors who got caught up in the technology craze of the late 1990s suffered a similar fate. Staggering amounts of money poured into technology mutual funds as investors bulked up their investments in this single market sector. This lack of diversification proved fatal for technology investors when the average tech fund fell 30.7 percent in 2000, another 35.2 percent in 2001, and another 42.73 in 2002. By comparison, a well-diversified growth portfolio consisting of 80 percent stocks and 20 percent bonds would have fallen just 4 percent in 2000, 8 percent in 2001, and 13 percent in 2002. When volatility is controlled, it’s easier for investors to maintain a long-term investing outlook.

Another lesson from history shows that poor diversification even takes its toll during rising bull markets. In 1999, the S&P 500 Index recorded a 21 percent return. However, just eight of the 500 stocks in the index accounted for half of its 21 percent gain. The odds were stacked against the investor who bought just a few S&P stocks during 1999. The chances of an investor successfully choosing those eight big winners out of 500 would be a little better than winning the lottery. Most investors would be far more successful by simply diversifying, buying an S&P 500 Index fund, and owning stakes in all 500 companies.

Mistake 7: Lack of Patience

Most mutual fund investors hold their funds for only two or three years before impatience gets the best of them. Individual stock investors are even less patient, turning over about 70 percent of their portfolios each year. You simply can’t realize good returns from the stock market if you invest for only weeks, months, or even a couple of years. When investing in stocks or stock funds, investors must learn to set their investment sights on five- and ten-year periods.

Investors would do well to study the example of the CGM Focus fund, which has the best ten-year annual return for the period ending June 30, 2009, as measured against all large-company U.S. stock funds. During that decade, this stock fund provided investors with a stunning annual return of 16.03 percent. A $10,000 investment in the CGM Focus fund would have grown to $47,250 during this period. Most investors, it’s safe to say, would be very happy with this performance. However, it didn’t deliver huge returns every single year. In fact, during that 10-year period two years were pretty rough, losing -17.79 and -48.88 percent. An investor would have had to endure these two negative years (years when an FDIC bank account would have done much better) to gain the 16.03 percent long-term average annual return. Patient investors were rewarded.

Anne Scheiber is a model of patience that all investors should emulate. She retired from her $3,150-per-year IRS auditor job in 1943. At that time, she invested $5,000—a little over one year’s salary—into a portfolio of stocks. Over the years, she bought and held mostly blue-chip U.S. stocks and some municipal bonds. She didn’t worry about daily market fluctuations and rode out the difficult market periods. When Anne died in 1995, at age 101, her $5,000 had grown to more than $22 million, which she donated to a Jewish university. Patience was at the core of Anne’s stunning investment success.

Avoiding the 10 Most Common Investor Mistakes, Mistakes 1-3

The following is an excerpt from 20 Retirement Decisions You Need to Make Right Now Over the next few days I'll be posting all of the 10 most common investor mistakes, so stay tuned to see them all.

Max Haley has been investing in the stock market for the past twenty years. In 1989, at age forty, he started with $50,000. Since then, he has invested in a number of individual stocks and stock mutual funds. Max prides himself on his “investment expertise.” To determine what stocks and funds to buy, when to buy, and when to sell, he reads Money magazine, subscribes to The Wall Street Journal, frequently visits investment Web sites, and tunes into CNBC several times each day to obtain stock prices and reports.

So how’s he doing? By the end of 2008, his investment had grown to $114,532. Max’s annual return was a meager 4 percent. Had Max simply invested his $50,000 into a balanced stock and bond mutual fund and never looked at it again for the twenty years, he would have more than doubled his returns and ended with $245,118.

If Max retires and wants his nest egg to last thirty years he can withdraw only $6,400 each year. If he annually withdraws 6 percent of his hand-picked portfolio it will kick off about $10,000 per year. If he had simply invested in the balanced fund, assuming returns similar to those the fund produced in the past, he could pull out $20,500 each year. What’s really surprising about his performance is that Max’s 4 percent annual return was better than what the average U.S. stock investor earned during this same period!

After applying so much effort, why did Max do so poorly? Max, like most individual investors, was guilty of making ten mistakes. Had he read and applied the lessons you’ll learn in this chapter when he started in 1989, he likely would be sitting on a much larger nest egg today.

Mistakes Will Cost You

And no doubt about it: You will need a large nest egg to retire on. Social Security is under pressure as more and more baby boomers start tapping into the system. Companies are eliminating traditional pension plans. More than ever before people need solid returns from their own investment portfolios in order to produce a livable retirement income. Plain and simple, your success as an investor may well dictate whether or not you reach your retirement goals.

In the future, savings and investments will take on an even greater importance. This is a huge problem for most retirees. Why? Because most people—including, most likely, you—simply don’t invest very well.

A twenty-year investor study dramatically illustrates the grim lack of success many investors have experienced. According to the study, the average stock-fund investor achieved returns of only 1.87 percent a year from 1989 through 2008. Had these same investors simply invested their money in the S&P 500 Index (composed of large U.S. company stocks) and forgotten all about it, they would have achieved an 8.35 percent annual gain. Even bonds beat most investors, growing 7.43 percent per year. The stock market provided results almost five times better than those experienced by millions of stock mutual fund investors! It should have been easy for even the average investor to make substantial sums of money over this period of time.

Consider for a moment the difference between an investor earning an average annual return of 1.87 or 7.43 percent as opposed to an investor earning an 8.35 percent return.

Over the long run, even during bull markets, most investors struggle to obtain performance better than low-yielding investments, like money markets and certificates of deposit, because they make common investor mistakes. How is it that investors do so poorly at times when investments are doing so well? No single mistake explains this poor performance. Rather, there are a combination of errors repeated over and over—mistakes that can be overcome by simply implementing and adhering to a disciplined investment strategy. (Developing a strategy is discussed in the following chapters.)

In this chapter, you will learn that it’s possible to obtain good long-term returns by avoiding the obstacles that plague so many investors. By avoiding common mistakes, you will be in a better position to reach your retirement goals. Here are the ten most common investor mistakes.

Mistake 1: Excessive Buying and Selling

Like the amateur chef that continually seasons food until it’s inedible, investors who are overactive in their trading undermine their goals.

A study of more than 66,000 households with investment accounts at a well-known brokerage firm found that investors who traded most frequently underperformed those who traded the least. For the study, the investors were split into five groups based on their trading activity. The returns achieved by the 20 percent of investors who traded the most lagged behind the least active group of investors by 5.5 percentage points annually.

Another study showed that men trade 45 percent more actively than women, and consequently, women outperformed men.

Many investors make the mistake of thinking that the more often they trade, the better their returns will be. The advertisements aired by many discount brokerage firms promoting active trading want you to believe this is true. However, the evidence suggests exactly the opposite. So sit back and relax!

Mistake 2: Information Overload

Too much information can be dangerous to your wealth.

Not long ago at the beginning of an investment seminar, I asked the audience how many knew the previous day’s closing level of the Dow Jones Industrial Average. Many hands went up, and these “smart” investors had no difficulty citing the index’s closing value.

Then I asked who in the audience didn’t have a clue where the market had closed. Timidly, a woman with very little investment experience raised her hand. The crowd was surprised as I handed her a $20 bill. I explained that investors who rarely check the market and the value of their investments keep more of their money invested in stocks, thus they often obtain better long-term results. Those who monitor the market too closely have a tendency to undermine their portfolios with self-destructive behavior.

What role should information play in your investment decisions? University of Chicago Professor Richard Thaler, the father of behavioral economics, conducted an experiment to see how much investors would allocate to stocks and bonds based on how often they reviewed their investment performance. Three simulations were developed, each representing a different frequency of investors reviewing their portfolio performance over a twenty-five-year period.

Those participating in the study were assigned to participate in one of three simulation groups. Group A was bombarded with investment performance information. Their test simulated the experience investors would have if they looked at the performance of their investment portfolio every month for a twenty-five-year period. Group B received performance information replicating the scenario of looking at their investments just once each year. Group C received investment updates only once every five years. Which group do you think did the best?

The investors who received the most performance information allocated the smallest amount of their portfolios—about 40 percent—to stocks. They not only maintained the lowest equity exposure but tended also to sell stocks immediately after a loss. The group that received updates only every year devoted 70 percent of their portfolios to stocks, while those who received performance information every five years invested 66 percent of their portfolios in stocks. And, as we all know, based on the history of the market, investors with greater exposure to the equity markets have enjoyed far better long-term performance than those with lesser exposure.

The bottom line: The more closely investors follow the market, the more tentative they become about investing in stocks, which ultimately hurts their returns.

The solution? Develop a fundamentally sound investment strategy and maintain your stock allocation through up and down markets. Stay away from financial sites on the Internet, turn off CNBC, consider canceling The Wall Street Journal, and quit worrying about your investments every day. Professor Thaler said it best: “My advice to you is to invest in equities, and then don’t open the mail.”

Mistake 3: Market Timing

History has shown that the stock market rises about 70 percent of the time. The danger, when investing, is in finding yourself out of the market during the 70 percent of the time it’s going up, all because you’re trying to avoid the 30 percent of the time the market is falling.

Trying to choose the right times to jump in and out of the market is an impossible task. Too many investors make the mistake of thinking they can do it. Investors attempting to time the ebbs and flows of the market tend to jump in too late, missing major upswings, and jump out after the market has fallen. Consequently, many investors end up buying high and selling low, yielding poor results that often lead to the kind of frustration that keeps investors out of the stock market altogether.

If you had invested in the S&P 500 from 1984 to 2008, covering 6,306 trading days, you would have enjoyed a 7.06 percent annualized return. If you had missed the market’s forty best days, your annualized return would have been cut to a negative 0.93 percent! There’s a dramatic difference between an investor who spent 6,266 days invested in the stock market and another who stayed invested all 6,306 days. There is a huge price to pay if you mistime the market.

Market timing is typically driven by emotion. Investors are notorious for buying stocks when they feel good and selling when they feel bad. Think about this; you feel good once the market has run up 20 percent or more and you feel bad when your portfolio is down 20 percent. With the “feel good/bad” investment strategy, you will always buy after the market has gone up and sell when the market has taken a big fall. The biggest days in the stock market normally occur early in a recovery. So if you pull your money out of the market when it’s down and hope that you will be smart enough to get back in the day it hits the bottom and starts to climb, the odds are stacked against you. And if you are late you will likely miss the best days. Following the “feel good” strategy will lead you to poor returns.

The Diversification Decision

The following is an excerpt from The Investment Answer. It's a small, easy read with very nicely designed charts and graphs (which I couldn't put in a post so please use your imagination -- and assume the graphs support what they are saying, because they do.)

Once you and your advisor have decided on the general asset class mix of stocks, bonds, and cash that is right for you, it is time to focus on the specific asset class building blocks to include in your portfolio. While many people understand the idea of “not putting all your eggs in one basket,” most do not understand the concept of effective diversification.

To illustrate, here is a typical situation that we saw during the technology bubble of the late 1990s. A technology executive, in an effort to diversify his large holding of one technology company, bought 10 other technology companies. He thought he was diversifying and was smart to stay with an industry he knew well. Unfortunately, when technology stocks crashed as a group (because they share many common risk factors) his wealth was severely damaged.

The true benefits of diversification are realized when an investor considers the relationship of each asset class to that of every other asset class in his portfolio. It turns out that some asset classes tend to increase in value when others go down (or at least they don’t go down as much). Asset classes that tend to move in tandem, such as companies in the same industry group or those that share similar risk factors, are said to be positively correlated.

Assets that move independently are uncorrelated, and those that move inversely are called negatively correlated.

Figure 3-1 (not shown here) illustrates the benefit of blending two hypothetical asset classes that are negatively correlated. Asset A has different risk and return characteristics than asset B and, therefore, their prices move in opposite directions (when A declines then B rises, and vice versa).

The line labeled AB that runs down the center illustrates a blended portfolio that holds both of these assets equally. The blended portfolio has lower volatility (i.e., lower standard deviation) than either individual asset.

This is an important component of what financial economists call Modern Portfolio Theory. The concept was introduced in 1952 by the Nobel Laureate economist Harry Markowitz. Markowitz first described this idea using individual stocks, but the concept works equally well with mutual funds or entire asset classes.

This concept underscores another very important tenet of investing: focus on the performance of your portfolio as a whole, rather than the returns of its individual components. Do not be discouraged that in any given period some asset classes will not do as well as others.

Domestic Stocks

As a U.S. investor, which specific asset classes should be included in your mix? While this important topic should lend itself to a much broader discussion with your advisor, a reasonable place to start would be to allocate some of your money to domestic large cap stocks, such as the stocks included in the S&P 500 index. After all, these 500 companies account for about 70% of the market capitalization of the entire U.S. stock market.

You can then work with your advisor to identify other domestic equity asset classes that would complement and provide diversification benefits to U.S. large company stocks. We recommend including exposure to U.S. small cap and value stocks, as they can increase your portfolio’s expected return and broaden its diversification. Likewise, real estate investment trusts can serve as a useful diversifier when blended with traditional equity asset classes.

International Stocks

No discussion about investing would be complete without mentioning the benefits of diversifying internationally. Many investors are surprised to discover that the U.S. stock market currently accounts for less than half of the market value of the world’s equity markets. There are many investment and diversification opportunities outside our borders. In addition, with the advances in technology, professional money managers now have upto-the-minute information about developments in countries all over the world, and the ability to move billions from market to market nearly instantaneously. As a result, the long-term expected returns of international asset classes are similar to those of comparable domestic asset classes.

In the short run, the performance of international asset classes can be very different from domestic asset classes. Sometimes international outperforms the U.S., and sometimes the U.S. does better. This is due largely to countries and regions being at different points in their economic cycles, having fluctuating exchange rates, and exercising independent fiscal and monetary policies.

The diversification benefits of international investing are stronger when you include international small-cap and value stocks, as well as emerging market securities (stocks of companies in developing countries). Stocks of these developing countries are especially valuable for diversification because their prices tend to be more closely related to their local economies than to the global economy. By way of contrast, a large international company such as Nestle has operations all over the world, and thus is likely to have a higher correlation with other large companies in the U.S. and abroad.

Domestic Bonds

Remember that the role of fixed income is to reduce the overall volatility of your portfolio. When including bonds in your mix, we recommend using higher quality issues (bonds with higher credit ratings) and those with shorter maturities (less than five years) reduce risk most effectively. These types of bonds are safer, more liquid, and less volatile.

International Bonds

Like international stocks, international bonds can be excellent diversifiers for your portfolio. As with domestic fixed income, consider using shorter maturities and higher-quality issues. An international bond portfolio that blends U.S. bonds with those from other developed countries can have lower risk and greater expected returns than a comparable all-U.S. bond portfolio.

Use Asset Classes

With the help of today’s sophisticated computer programs, an advisor can access the historical risk and return data of different asset classes and construct a portfolio that maximizes expected returns for any given level of risk. Figure 3-2 demonstrates this concept. Higher risk/return portfolios usually have greater percentages in stocks.

Notice that the risk level reduces as the initial stock market exposure (up to about 20 percent) is added to the 100 percent bond portfolio. This is caused by the diversification benefits available from adding riskier assets that do not move in perfect unison with the other assets in your portfolio.

It’s up to you and your advisor to determine how much risk is appropriate for you.

The Active versus Passive Decision

The following is an excerpt from The Investment Answer. It's a small, easy read with very nicely designed charts and graphs (which I couldn't put in a post so I have included them in red below.) Much of what the authors say here are reasons why I choose to invest in index funds. If you've ever wondered why passive investing beats active investing, this article is for you.

Active Investing

Active managers attempt to “beat the market” (or their relevant benchmarks) through a variety of techniques such as stock picking and market timing. In contrast, passive managers avoid subjective forecasts, take a longer-term view, and work to deliver market-like returns.

The Efficient Markets Hypothesis asserts that no investor will consistently beat the market over long periods except by chance. Active managers test this hypothesis every day through their efforts to outperform their benchmarks and deliver superior risk-adjusted returns. The preponderance of evidence shows that their efforts are unsuccessful.

[The list below] shows the percentage of actively managed equity mutual funds that failed to outperform their respective benchmarks for the five-year period ending December 31, 2009. The message here is that most funds failed to beat their respective benchmarks. (If international small-cap managers had been correctly compared to an index that included emerging markets, the rate of underperformance would rise to the 70 to 80 percent range, which is in line with the other categories.)

Active Managers Failing to Beat Their Benchmark (%) - January 1, 2005 – December 31, 2009

• US Large Cap -- 61%
• US Mid Cap -- 77%
• US Small Cap -- 67%
• Global -- 60%
• International -- 89%
• International Small -- 27%
• Emerging Markets -- 90%

Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 30, 2010. Indicies used for comparison: US Large Cap—S&P 500 Index, US Mid Cap—S&P Mid Cap 400 Index, US Small Cap—S&P Small Cap Index, Global Funds—S&P Global 1200 Index, International—S&P 700 Index, International Small—S&P Developed ex.-US Small Cap Index, Emerging Markets—S&P IFCI Composite. Data for the SPIVA study is from the CRSP Survior-Bias-Free US Mutual Fund Database. Results are net of fees and expenses. Indices are not available for direct investment.

Active managers attempt to outperform the market (or a benchmark index) by assembling a portfolio that is different from the market. Active managers think they can beat the market through superior analysis and research. Sometimes, these managers consider fundamental factors such as accounting data or economic statistics. Others will perform technical analysis using charts and graphs of historical prices, trading volume, or other indicators, believing these are predictive of future price movements.

For the most part, in an attempt to beat their benchmarks, active managers will make concentrated bets by holding only those securities they think will be the top performers and rejecting the rest. This approach, of course, comes at the expense of diversification. It also makes it difficult to use active strategies in a portfolio to reliably capture the returns of a target asset class or control a portfolio’s overall allocation.

Studies show that the returns of active managers can be very different from their benchmarks, and their portfolios often overlap across multiple asset classes.

There are two primary ways that active managers try to beat the market: (1) Market timing, and (2) Security selection.

Market timers attempt to predict the future direction of market prices and place a bet accordingly. Because no one can reliably predict the future, it should come as no surprise that the overwhelming evidence suggests market timing is a losing proposition.

Another reason it is so hard to time markets is that markets tend to have bursts of large gains (or losses) that are concentrated in a relatively small number of trading days. [The information below] shows that if an investor misses just a few of the best performing trading days, he loses a large percentage of the market’s total returns. We believe it is impossible to predict ahead of time when the best (or worst) days will occur.

Performance of the S&P 500 Index -- Daily: January 1, 1970 – December 31, 2009 - Growth of $1,000 (Annualized Compound Return)

• Total Period - $43,119 (9.87%)
• Missed 1 Best Day - $38,667 (9.57%)
• Missed 5 Best Single Days - $28,036 (8.69%)
• Missed 15 Best Single Days - $16,281 (7.22%)
• Missed 25 Best Single Days - $10,339 (6.01%)
• One-Month US T-Bills - $10,176 (5.70%)

Data for January 1970-August 2009 provided by CRSP. Data for September 2008-December 2009 provided by Bloomberg. S&P data provided by Standard & Poor’s Index Services Group. CRSP data provided by the Center for Research in Security Prices, University of Chicago. Treasury bills data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago. Indices are not available for direct investment. Performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. There is always a risk an investor will lose money.

The other active management technique is security selection (or stock picking). This involves attempting to identify securities that are mispriced by the market with the hope that the pricing error will soon correct itself and the securities will outperform. In Wall Street parlance, an active manager considers a security to be either undervalued, overvalued, or fairly valued. Active managers buy the securities they think are undervalued (the potential “winners”) and sell those they think are overvalued (the potential “losers”).

You should know that whenever you buy or sell a security, you are making a bet. You are trading against the view of many market participants who may have better information than you do. When markets are working properly, all known information is reflected in market prices, so your bet has about a 50% chance of beating the market (and less after costs are taken into account).

Again, Wall Street and the media have a vested interest in leading us to believe that we can beat the market if we are smarter and harder-working than others. Yet, through today’s technological advances, new information is readily available and becomes almost instantly reflected in securities prices. Markets work because no single investor can reliably profit at the expense of other investors.

The idea that prices reflect all the knowledge and expectations of investors is known in academic circles as the Efficient Markets Hypothesis, which was developed by Professor Eugene Fama of the University of Chicago Booth School of Business.

The Efficient Markets Hypothesis is sometimes misinterpreted as meaning that market prices are always correct. This is not the case. A properly functioning market may get prices wrong for a time, but it does so randomly and unpredictably such that no investor can systematically outperform other investors, or the market as a whole.

Finding the Winning Managers

Still, many investors want to believe that they will be able to beat the market if they can identify a smarter, harder-working, and more talented manager — a Roger Federer or Michael Jordan of money management. Of course, it is easy to find a top performer after the fact. They are then held out as “geniuses” by the media. But how do you identify tomorrow’s top managers before they have their run of good performance?

The most common method is by examining past performance, the theory being that good past performance must mean good future performance. Financial magazines like Forbes, and rating services such as Morningstar, love to publish this data as these are some of their best selling issues. Mutual fund companies are also quick to advertise their best performing “hot funds” because this attracts new money from investors. Despite all of this activity, there is little evidence to suggest that past performance is indicative of future performance.

Passive Investing

A more sensible approach to investing is passive investing. This is based on the belief that markets are efficient and extremely difficult to beat, especially after costs. Passive managers seek to deliver the returns of an asset class or sector of the market. They do this by investing very broadly in all, or a large portion of, the securities of a target asset class.

The best known (but not the only) method of passive investing is called indexing, which involves a manager purchasing all of the securities in a benchmark index in the exact proportions as the index. The manager then tracks (or replicates) the results of that benchmark, index less any operating costs. The most popular benchmark index is the S&P 500, which is comprised of 500 U.S. large cap stocks that currently make up about 70 percent of the market capitalization of the U.S. stock market.

Cash Drag

Because active managers are always looking for the next winner, they tend to keep more cash on hand so they can move quickly when the next (perceived) great investment opportunity arises. Since the return on short-term cash investments is generally much less than that of riskier asset classes like equities, holding these higher cash levels can end up reducing an active manager’s returns. Passive managers are more fully invested, which means that more of your money is working for you all the time.

Consistency

Another advantage of passive investing is that you and your advisor can select a group of asset classes that work well together like the efficient building blocks of a portfolio. Done correctly, the building blocks will have few securities in common (called cross-holdings) and the risk and return profiles of each will be unique.

Sometimes an active manager will change his investment style in an attempt to beat his benchmark. For example, a large cap value manager may suddenly start purchasing large growth stocks if he feels that large growth stocks are about to take off. This “style drift” can be problematic, especially if you already have a large growth fund in your portfolio. In this case, you would now have overlapping risk and less diversification. Trying to build a portfolio using active managers causes you to lose control of the diversification decision.

Costs Matter

One explanation for the underperformance of active management was set forth by Nobel Laureate William Sharpe of Stanford University.

Sharpe ingeniously pointed out that, as a group, active managers must always underperform passive managers. This is because investors as a whole can earn no more than the total return of the market (there is only so much juice in an orange). Since active managers’ costs are higher— they pay more for trading and research — it follows that the return after costs from active managers as a group must be lower than that of passive managers.

This holds true for every asset class, even supposedly less-efficient ones like small-cap and emerging markets, where it is often said that active managers have an edge because information is less available. Sharpe’s observation confirms that because of their higher costs in these markets, active managers should collectively underperform by more than in larger, more widely traded markets — the opposite of convention wisdom.

The higher costs of active management can be broken down into three categories:

1. Higher manager expenses. It is more costly for an active manager to employ high-priced research analysts, technicians, and economists, all of whom are searching for the next great investment idea. Other active management costs include fund marketing and sales costs, such as 12b-1 fees and loads, to attract money from investors or to get Wall Street brokers to sell their funds. The expense differential between active and passive approaches to investing can exceed one percent per year.

2. Increased turnover. As active managers try to provide superior returns, they tend to trade more often and more aggressively than passive managers. This usually means paying greater brokerage commissions, which are passed on to shareholders in the form of reduced returns. It also means that market-impact costs can increase dramatically. When an active manager is motivated to buy or sell, he may have to pay up significantly in order to execute the transaction quickly or in large volume (think of a motivated buyer or seller in real estate).

These higher market-impact costs are more prevalent in less liquid areas of the market such as small cap and emerging markets stocks. It is not uncommon for turnover in actively managed funds to exceed that of index funds by four times or more. The extra trading costs for active management can exceed one percent per year.

3. Greater tax exposure. Given that active managers trade more often, it follows that taxable investors will incur accelerated capital gains as a result. Remember, if your mutual fund sells a security for a gain, that profit may be passed on to you as a taxable distribution. For securities held longer than one year, you would pay the long-term capital gains rate, while short-term capital gains would apply for securities held less than one year. The additional taxes due to accelerated capital gains generated by active managers may exceed one percent per year.

It is important to understand that of these three categories, typically only manager expenses are disclosed to investors. These are usually expressed as a percentage of net asset value in the case of a mutual fund, and is called the operating expense of the fund. For actively managed equity funds, the average operating expense ratio is around 1.3 percent per year. Passive funds, on the other hand, can cost much less than 0.5 percent.

If the additional costs of active management run roughly two to three percent annually, then the active manager clearly faces a huge hurdle just to match the results of a passive alternative such as an index fund.

[The information below] compares the ending value of a hypothetical investment (growing at a rate of eight percent per year before fees) at various rates of annual investment expenses. Notice how every incremental percent in costs can add up and reduce your long-term ending wealth.

Pay attention to the costs you pay!

Costs Matter - Growth of $1 Million: 8% Gross Return for 30 Years

• Annual Investment Expenses 1% -- $7,612,225
• Annual Investment Expenses 2% -- $5,743,491
• Annual Investment Expenses 3% -- $4,321,942

Assumes eight percent return before costs and no taxes paid. Net initial investment of $1 million. For Illustrative purposes only.

12 New Rules for Your Money

Kiplinger lists 12 new rules for your money as follows:

• Renting may beat buying.
• Consider a Roth.
• Invest in stocks that pay dividends.
• Personalize your emergency fund.
• Think McCottage, not McMansion.
• Age 66 is the magic number (for taking Social Security.)
• Cut your credit-card debt, but not your cards.
• Lock in your retirement income.
• Think single-digit returns.
• Retire your mortgage when you do.
• Spread your assets around.
• Save early for retirement.

As one commenter said of the list: "Firm grasp of the obvious and astute hindsight." Ha!

I had the same reaction. It's a good list IMO, but these aren't really "new" rules, are they? Haven't the fundamentals of good finances always been saving (and doing it early), keeping spending in line, eliminating debt, and so on? Yes, I think they have.

The one "new" point that they bring up here (that we all know as well but no one seems to verbalize it) is that the days of counting on 10% investment return are probably gone -- at least for awhile. Personally, it's not a big deal to me because I spend the least amount of time working on (and put the least amount of effort into) getting the best return rate.

As I said in The Best Way to Maximize Your Investment Return, "time invested" makes the most difference in how investments perform, so I focus my attention here. In addition, I also work on the "amount saved" -- socking away as much as I can. These two factors are much more within my control than getting a specific return rate.

Now that doesn't mean I settle for any rate of return. Of course I want to make as much on my investments as possible. But I don't obsess over something I can't control. I do obsess over things I can control (saving a lot as soon as possible). So far, it's working well for me.

For any potential investor out there, I'd suggest the same. Save as much as you can as soon as you can and keep adding to it through the years. Doing these two simple things will separate you from the pack quite quickly and ultimately make you wealthy.

Managing Taxes in Taxable Accounts

The following is an excerpt from Personal Investing: The Missing Manual.

Sometimes, you have to put higher-taxed investments into taxable accounts. For example, if you're saving for a short-term goal, stocks may be too risky, so you put your money in bonds or bond funds, or in a savings account. Or you may be saving for a goal that doesn't have a tax-advantaged account option. Don't worry. Although you shouldn't make investment decisions purely to avoid paying taxes, you can keep your investment taxes low with the following tactics:

• Buy and hold individual stocks and bonds instead of stock or bond funds. You don't pay capital gains on individual stocks and bonds until you sell them; fund managers may trade within stock or bond funds frequently, and you pay taxes on any gains from those trades. Sell individual securities in taxable accounts only to rebalance your asset allocation or because an investment hasn't panned out as you hoped.

• Buy municipal-bond funds or municipal bonds. If you want more bonds in a taxable account, purchase municipal bond funds. The federal government doesn't tax municipal bond income. In addition, you don't pay state taxes on municipal bond income if you buy municipal bonds issued by your state.

• Delay selling until the capital gains are long term. If you sell an investment before you own it for a year, you earn a short-term capital gain, which is taxed at ordinary income rates (for someone in the 25% tax bracket, that rate is 25%, versus the 15% for long-term capital gains). If you're close to the 1-year mark and the investment isn't in mortal danger, hold off on the sale until you pass the 1-year mark.

• Wait until the next calendar year to sell. If the end of the year is close, delay a sale until January. That way, you don't pay tax on the capital gain until the following year, which means you have a full year to use that money, for example, to earn interest on savings or invest in something else.

• Offset capital gains with capital losses. If you have capital gains and also have some losers you want to unload, sell the losers in the same tax year as the winners. Your capital losses offset your capital gains. This tactic is particularly effective for short-term capital gains, taxed at higher, ordinary income rates.

Note: If you have more than $3,000 in long-term capital losses, you can use those losses to offset long-term capital gains. However, if you don't have enough long-term capital gains to offset all of your long-term capital losses, you can deduct no more than $3,000 of a long-term capital loss in one tax year and must carry the remaining loss over to future tax years.

How to Pick a Great Mutual Fund

Here's an interesting piece on how to pick a top-performing mutual fund. The summary:

A new study reinforces time-tested advice for investors shopping for mutual funds: Look first for funds with low fees, then go from there.

The study concluded that investors should make expense ratios a primary test in fund selection, because they are still the most dependable predictor of performance.

Ha! I'm sure this will get a few people riled up! ;-)

In particular, someone is bound to say, "Forget about costs -- you should consider performance before anything else."

I'm assuming they mean "performance net of costs", which is something I'm also interested in. The only problem is that performance is difficult to judge in advance, costs are not.

In fact, Morningstar, the company that rates the performance of mutual funds, even has a hard time picking funds that out-perform a simple "low cost fund" strategy:

Morningstar's star system measures a fund's past performance while weighing how much risk a fund took to achieve its returns. For example, a fund that produced far-better-than-average results over 10 years won't necessarily secure a top rating if its performance was unusually volatile during that period.

Fund expenses are a slightly more important factor in predicting how well a fund will perform than the one- to five-star system that Morningstar uses to rate funds, the company said in a study it published in August.

Ha again!

As I wrote four years ago, costs matter if you want to maximize investment returns.

And for those of you interested in how I invest, I'm still putting the majority of my money into these funds.

Understanding Investment Risks

The following is an excerpt from Personal Investing: The Missing Manual.

You can't avoid risk no matter how you invest your money. You worry that your nest egg will spoil from stock price gyrations or mayhem in the markets. At the same time, you know inflation is picking away at your boiled nest egg every moment. Some risks decrease over time, while others get worse. Here's a quick review of the different types of investment risk and how you can manage them:

• Inflation risk. Chapter 1 showed just how dangerous inflation (the steady increase in prices) can be. It's the one investment risk that gets worse with time. The higher returns of owning stocks long-term are the sure antidote to inflation risk.

• Economic risk. This is the risk of losing money in investments because the economy tanks. The economy tends to cycle up and down every 5 years or so. The down cycle, known as a recession, can last from a few months to, occasionally, a few years. As with inflation, owning stocks for longer than the typical economic cycle helps overcome economic risk. You can also avoid economic risk by keeping near-term spending money in safer investments like short-term bonds or a savings account.

• Market risk. Sometimes, perfectly good investments go down in value just because the market as a whole goes down. And sometimes, mediocre investments go up because the overall market goes up. The key to managing market risk is researching the investments you buy and sticking to your plan as long as those investments are still fundamentally sound.

• Equity risk. Many investors are afraid of losing money on a bad investment, which is called equity risk. True, companies can go under, taking your investment with them. But equity risk is easy to manage by diversifying your portfolio, that is, by buying several different investments to dilute the effect of one underachiever.

• Holding period risk. This is the risk that you have to sell an investment when its price has fallen. It's a good idea to keep some money in short-term investments so you don't have to sell long-term investments when their values are down.

• Reinvestment risk. When you invest in bonds, bills, or even certificates of deposit and hold them until they mature, you face reinvestment risk, the risk that interest rates are lower when your fixed-income investment matures and that you have to reinvest your money in a new investment with a lower interest rate. Unfortunately, reinvestment risk is a fact of life with any kind of fixed-income investment you hold to maturity.

• Interest rate risk. If you buy a bond and sell it before it matures, you face interest rate risk, the risk that the bond price drops because interest rates rise.

• Currency risk. If you invest in foreign stocks or bonds, currency risk comes into play. If the dollar falls compared to your investment's currency, your investment loses value. Currency exchange rates work in your favor when the dollar is strong compared to other currencies.

Tip: When your portfolio grows large enough or you're well ahead of your plan, you may yearn to gamble on higher-risk investments, such as micro-company stocks or high-yield bonds. As a rule of thumb, the average investor shouldn't invest more than 10% in high-risk investments.

Talking about Deflation

The following is a guest post from Squirrelers. It's a bit heavy on the economics side of personal finance, but I know many of you like to discuss those sort of topics, so I'm going with it. For those of you who prefer only true personal finance posts, stay tuned -- a new one will be up shortly, as usual. ;-)

Many of us who take an interest in personal finance understand the concept of “a dollar today is worth more than a dollar tomorrow.” We realize that the present value of money today exceeds the present value of the same amount of money at some point in the future. This is due to inflation, which erodes the purchasing power of money over time. Looking at it another way, if you buy a cup of coffee for a dollar today, it might cost you more next year – say, $1.05.

Lately, the financial news has brought us discussion of a completely different concept: deflation.

When you first think about it, deflation sounds like a good concept, in that it’s the opposite of inflation. A dollar tomorrow will be worth more than a dollar today, even if stuffed under the mattress. Pretty good deal, eh?

No. In reality, deflation is not good for the economy, and the effects can wreak havoc with the ordinary investor’s portfolio.

Downward-trending prices may seem great initially, but this leads to pressure on businesses. The response is often a reduction in workforce, which in turn causes a reduction in demand as incomes drop. That’s not good for stocks. Thus, the spiral begins.

Governments may try to lower interest rates to stimulate spending and counteract these deflationary effects. Looking at our current interest rates, they are at remarkable lows compared to long-term averages. The issue is that there is only so far these cuts can go.

Japan saw remarkably low interest rates for years, as it has been in a longer-term deflationary cycle. That country was rocked by a sharp decline in real estate prices about 20 years ago. Does that part sound somewhat familiar to those of us here in the U.S?

Now, I can’t predict whether or not this will be long-term economic cycle we are in. Who knows, we could very well be headed for an inflationary period after a few years. 

Regardless, I suspect that while extended deflation may not by any means be a sure thing, it’s certainly a real possibility at this point.

In light of this, it’s interesting to consider what would be a good hedge vs. deflation. Some people are proponents of gold as a hedge; I had a recent discussion with a friend who suggested gold. This same friend correctly called the real estate collapse, despite many people – including me – thinking he was way off base. I’ll give him credit – he was right. The thinking is that if the money supply increases, inflation could be around the corner. In that case, gold would be a hedge.

That said, my take is that thinking purely about deflation, the following are good defenses:

1. Cash. 

2. Short-term Government Bonds

My questions are as follows:

1. Do you think we are beginning a period of deflation that is at least short-term, if not greater – or are these fears unfounded?

2. If deflation takes hold of the economy, how would you reallocate your investments? Would you hedge with cash/short-term government debt, gold, or other vehicles?

Deciding When to Sell a Mutual Fund

The following is an excerpt from Personal Investing: The Missing Manual.

If a fund is performing badly, investors are prone to making one of two mistakes. Some sell in a panic, while others hold onto the fund hoping it will turn things around. Most funds give a few warning signs before they crash. If you learn to spot those warnings, you can review a fund that looks like it might be headed for trouble, make an educated decision about selling, and possibly sell before the fund hits the skids. Here are fund red flags to watch for:

• Departing manager. If you own an actively managed fund, the fund manager delivers the fund performance. If the longtime manager is leaving, but co-managers or the management team is staying in place, don't sell just yet. If brand-new managers are coming in, check out their track record to see if their experience is on par with the old manager's reputation. If it isn't, consider replacing the fund.

• Proposed fund merger. Fund companies get rid of their dogs by merging those funds into other funds. If you learn that your fund is merging with another, evaluate the new fund as you would a brand-new fund purchase to make sure it's right for you.

• Changing investment strategy. Review your funds' investment objectives and the securities in their portfolios. If you notice that a fund has started to invest differently by, for example, buying large-cap stocks instead of mid-cap stocks, you may want to replace the fund with one that fits your financial plan.

• Big increase in assets. Really successful funds rake in oodles of new money. That's not necessarily good for future performance, because the fund managers may have a hard time investing all that cash. Small and mid-cap stock funds are especially vulnerable, because it's hard to find enough suitable investments to deliver the same kinds of returns they've produced in the past. If the fund management closes the fund to new investors, don't sell. They're watching out for your best interests by keeping the fund at a manageable size. If the fund continues to accept new investments, watch the fund's performance closely, and get out if it starts to falter.

• Bad long-term performance. Don't sell a fund because of poor performance for a short period like 3, 6, or 12 months. The fund may do better in up markets or down markets, or may have gotten temporarily derailed. But if performance falls behind the comparable market index and the competition year after year, look for a replacement.

• New or higher fees. Higher fees take money away from your investment returns, so they're never good. But, if the amount's small (less than 0.1%) and the fund is doing well, it's usually worth staying put. If a fund makes large increases in fees or increases its fees regularly, start looking for a new one.

• Turmoil. If a fund family is bought or sold or a star manager leaves (taking staff with him), that chaos can distract fund managers from their jobs and drag returns down.

• Rising turnover rate. If the turnover rate increases and stays at higher levels, your expenses and tax bill are likely to climb as well.

Tip: Never trade in a fund based on a hot tip you heard around the water cooler at work, at the gym, or from your landscaper. Don't automatically replace funds just because your broker gives you a suggestion. Always do your homework first.

Even if red flags aren't waving, you may decide to sell for other reasons:

• You need the money. Selling a fund because you need the money for something is perfectly OK. That's why you invest in the first place.

• Balance your portfolio. When you review your portfolio and find that your asset allocation is slightly out of balance, you should sell fund shares in the areas that are over-allocated and buy more in the areas that are under-allocated.

• Changing goals. If your life changes, so will your goals. If your child earns a big honking scholarship, you can look at reinvesting the college savings you've amassed into something else.

• Sleep. If you're losing sleep over your investments' performance, it's time to make some changes. Ratchet down the risk until you sleep comfortably at night.

• Taxes. If you sell a fund that generates capital gains, you may decide to sell a fund with losses to offset the gains.

Tip: You can find out how much you'll pay in taxes and fees when you sell by running your fund numbers through AOL's Wallet Pop "Should I sell my funds now and invest the money elsewhere?" calculator (http://tinyurl.com/yl8bn7s).

Making the Most of Tax-Advantaged Accounts

The following is an excerpt from Personal Investing: The Missing Manual.

Tax-advantaged accounts come with a variety of features, but the most common characteristic is delaying the time when you have to pay taxes. Tax-deferred means your money can grow unfettered by taxes, which come due only when you withdraw from the account. You can reinvest the full amount of interest, dividends, and capital gains you earn to compound for years without a dollar going to taxes. Only when you withdraw money during retirement do you pay taxes; at that time, your tax rate might be lower.

Chapters Chapter 10, Chapter 11, and Chapter 12 give you the full rundown on different types of tax-advantaged accounts, but here's a quick introduction:

• 401(k) and 403(b). These tax-deferred accounts (Section 10.2.1) have become the mainstay for employer-sponsored retirement savings, with the majority of employers choosing to offer them over traditional pension plans. You contribute a percentage of your paycheck before paying taxes on it, so your tax savings reduce how much you pay out of pocket for your contribution. For example, if you're in the 25% tax bracket and contribute $10,000 to your 401(k) or 403(b), you save $2,500 in taxes, so your net out of pocket is only $7,500.

In 2010, the maximum annual contribution is $16,500. (If you're over 50, you can add a catch-up contribution of up to $5,500.) You must start withdrawing from your account when you're 70 ½.

Tip: If your company matches a portion of what you contribute, that match is like an immediate 100% return on the portion the company matches. It's unlikely you'll find a return that good elsewhere, so if you can't afford to contribute the maximum amount to your 401(k), at the least, contribute enough to get the full company match.

• Traditional IRA. Anyone with earned income (salary, wages, tips, bonuses, and so on) can contribute to a traditional IRA, another tax-deferred account option. If you've contributed the maximum to your 401(k) or 403(b), a traditional IRA is one way to get more money into retirement savings. In 2010, you can contribute up to $5,000 (plus an additional $1,000 catch-up contribution if you're over 50). Your contributions might be tax-deductible depending on your income. For example, if you're single and your adjusted gross income is less than $56,000, your entire contribution is tax deductible.

You must be younger than 70 ½ and have earned income to contribute to a traditional IRA. As with 401(k) plans, you must start withdrawing when you reach age 70 ½.

Note: If you switch jobs and don't want to keep your retirement funds in your employer-sponsored retirement plan, you can move your money into a rollover IRA to continue the tax deferral.

• Roth IRA. Similar to traditional IRAs, 401(k)s, and 403(b)s, you don't pay taxes on interest, dividends, and capital gains in a Roth IRA (Section 10.2.2.2). What gets everyone's attention is that you withdraw from these accounts tax-free after the age of 59 ½. The catch is that contributions to a Roth IRA aren't tax deductible. That is, you pay taxes on the money before you contribute to the account. With some income limitations, Roths have the same contribution and catch-up limits as traditional IRAs.

Roth IRAs have other features that make them attractive for saving for your later retirement years. You can continue to contribute after you reach 70 ½, and there's no mandatory annual distribution at any time. Because you contribute after-tax money, you can withdraw your contributions at any time without paying taxes or penalties.

Note: Because you contribute after-tax, you can withdraw your contributions without paying taxes or penalties. Before you can withdraw earnings tax-free, you must be 59 ½ and have converted or contributed to the Roth at least 5 years earlier.

• Roth conversion. If you convert a traditional or rollover IRA to a Roth IRA, you have to pay taxes on the tax-deferred contributions you made to the original account. Section 10.2.3 helps you decide whether a conversion makes sense for you.

• Inherited IRA. A beneficiary of an IRA can transfer the money into an inherited IRA to keep the tax-deferral going until the IRS requires distribution. The tax rules for inherited IRAs make Einstein's theory of relativity look like a piece of cake, so consulting a tax advisor is a good idea if you inherit an IRA.

• SEP-IRA. For small businesses or self-employed individuals, the simplified employee pension IRA (SEP-IRA) is the easiest pension plan option. You can contribute up to 25% of your income each year (to a maximum $49,000 in 2010). You can set up a SEP-IRA for a side business even if you already have a 401(k) at your day job.

Note: See Retirement Plans for Small Businesses to learn about other retirement account options for small businesses, such as Keogh and SIMPLE plans.

• Section 529 college savings plan. Investments grow tax-deferred in these popular college savings plans. Withdrawals are tax-free as long as you use them for qualified educational expenses (Section 11.2.1). The contribution limits are high, sometimes as much as $300,000. Whoever contributes to the account is the owner, who can then name a family member as the beneficiary. That's good news for two reasons. First, colleges don't take the 529 investment into account when they calculate a student's financial aid, because the account isn't in the student's name. Second, if the current 529 beneficiary ends up getting a big scholarship, you can change the beneficiary.

• Section 529 college prepaid plan. Prepaid plans lock in future tuition costs at today's rates (Section 11.2.2). They aren't as popular as 529 savings plans, because they make it harder to roll over into another plan or switch to another beneficiary.

• Coverdell education savings account. Investments in these accounts grow tax-deferred, and withdrawals are tax-free if you use them for qualified educational expenses. The big drawback to these accounts is the $2,000 annual contribution limit, a drop in the bucket for college costs.

• Health savings account. If you have a high-deductible health insurance plan, you can set up a health savings account (HSA), described in detail on Section 12.4. In 2010, an individual can contribute up to $3,050 pre-tax with a $1,000 catch-up if you're 55 or older. Unlike with flexible spending accounts, you don't have to use the money you contribute during a specific year. You can invest the money in the same kinds of options you have with an IRA. Withdrawals for health care are tax-free.

Note: Medical savings accounts (MSA) work like health savings accounts, except that only self-employed people or employers with 50 or fewer employees qualify for them.

Kiss The Old Method of Retirement Planning and Saving Goodbye! (MAYBE)

The following is a guest post from Forex Traders.

The 2008 Global Credit Crisis has changed things. The world we live in is different. In the spring of 2008 it became apparent the economy was slowing down and the housing sector was going to lead the economy into a recession. But it definitely was not clear how bad it was about to get. During the spring of ’08, the talking heads on financial news networks, and even economists at the height of power at the Federal Reserve, were beginning to agree that America was about to hit a small economic road bump, but most of them assured the public that economic growth would rebound toward the latter part of 2008, and the economy would, of course, continue in its ascent to higher ground. Oh, how wrong we were. That small economic road bump ending up being a pothole the size of Texas. When the bottom fell out in September of 2008, the entire global financial system nearly failed. And, as a result, a “reset” button has been hit.

This “reset” button that was hit during the global economic recession of the last two years has changed the global financial landscape forever. A great shift in the balance of economic power is currently transpiring, and it will continue to transpire over the next 2 decades. In March of 2009, equity markets in the U.S. hit a low of 6,000 points. At this point, many Americans had suffered drawdowns of 30%-60% of their retirement accounts. Then, suddenly in March of 2009 the economy appeared to begin growing again. The equity markets rebounded and began rising. Unemployment slowly began to peak out and economic reports started to show improvement in the U.S. economy. So, from March to November of 2009, it looked as though the worst of our economic problems in America were now behind us, and growth was again before us. But then things got bad again. Really bad.

Currently, the Federal Reserve is once again raising the possibility of implementing further quantitative easing measures, which basically means they foresee very difficult times in the very near future for the U.S. economy. The Fed recently downgraded U.S. growth prospects for 2010, and they have communicated to the American public that they believe it may take 4-6 years to fully recover from the current recession. That means that economic growth will continue, but it will be very sluggish, unemployment will be stubbornly high, and general economic conditions will be less than optimal. So how has this changed the way Americans may have to plan for retirement?

For several generations in America, people were able to graduate from college, get a good paying job, and begin saving for retirement by investing in U.S. equity markets. Then, after 30-40 years of faithful service in the work force and careful retirement planning, a middle income American was able to retire with quite a bit of money. In fact, most Americans who held average paying jobs over the last 30 years and saved properly could have built a nest egg of $300,000 or more. Not bad. And a good paying job made it possible to save over $1 million. But the ability to grow a retirement account is dependent on the stock market increasing. What if the stock market doesn’t increase over the next 30 years as it has over the previous 30 years? That would make it very difficult to build a retirement nest egg, and this very possibility is why the old method of retirement planning may be dead.

Let’s break down the global economic recovery a bit more. Currently, the United States, England, and the EuroZone are all struggling significantly. Growth is expected to be very slow and general economic conditions in all three regions will be less than optimal for an extended period of time. So, these guys are running very slowly.

Then, you have China, India, Brazil, and other emerging market economies (China is a bit past emerging market at this point. They are a bona fide world power.) These economies are growing at blazing fast speeds. So, over the next decade, if the U.S. and Europe move forward at a very slow pace, and these emerging market economies move forward at a blistering hot pace, what’s going to happen to the economic balance of power in the world? It’s going to shift.

And this is why retirement planning may have to change. If the real growth over the next 20 years is going to be in China and India, then the average U.S. worker may have to be much more proactive about investing in those regions. In fact, only time will tell for sure, but investing in China and India may be one of the best decisions to make over the next 20 years.

So, how can the average investor position himself or herself to take advantage of this global economic power shift? It has been common practice in retirement planning over the last few decades to expose a small amount of one’s investment capital to overseas markets. One practical measure a person could take would be to sit down with a registered financial advisor and allocate a higher percentage of one’s portfolio to overseas exposure. For example, if the average aggressive model currently allocates 5% of capital to overseas markets, an investor may want to possibly increase that percentage to 10%, 15% or even 20%.

Another practical step an investor can take to take advantage of this global shift is to invest in an investment fund managed by a Commodity Trading Advisor that specializes in trading foreign markets. This type of investment vehicle can be thought of as a hedge fund for smaller investors. 

There are numerous other ways to profit from this potential shift in global economic power, but these are two very practical ways to begin investigating possible investment opportunities. Before making any major financial investments, especially with retirement capital, make sure to always consult a registered financial advisor for additional perspective and guidance.

Invest in All Six Asset Classes

The following is a guest post from Marotta Wealth Management.

Investors are challenged these days to know where to put their money. Everyone wants to know which asset class will perform the best and help them meet their retirement goals.

We use six different asset classes: three for stability and three for appreciation. In the stable asset classes, you loan a company money to be paid back at a fixed rate of interest. Examples include money market, certificates of deposit (CDs) and bonds. These asset classes are like the iron rods that support a sailing ship. They don't make the ship go faster, but they do keep it from capsizing in a storm.

Investors approaching retirement should have at least five to seven years of their safe spending rate allocated to stability. For them, replenishing their allocation to stability when stocks are appreciating helps secure future years of spending.

In the appreciation asset classes, you own a piece of a company and share in its earnings. Examples include shares of individual companies or the mutual funds or exchange-traded funds that invest in equities.

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). These decisions are the most critical in determining the overall behavior of your portfolio returns.

We divide the asset classes for stability into short money, U.S. bonds and foreign bonds.

Short money includes any fixed-income investment with a maturity date of two years or less, which includes money market accounts and many CDs. Short money investments are not paying a great rate of interest right now. But when interest rates rise, they will adjust quickly and be among the first investments to gain from the higher rates.

Many risk-averse investors put their money in a bank account or invest in CDs. But like any other investment, cash has its own set of risks. It is dangerous because the dollar can be devalued so the same number of dollars won't buy as much as they used to. There are good reasons to hold cash, but holding too much for too long makes it harder to grow your assets and can jeopardize your financial goals.

The second asset class, U.S. bonds, generally pays a higher interest rate the longer their duration and the worse their credit quality. But longer term bonds drop more in value when interest rates rise. And bonds whose credit rating drops lose value too because of the chance of default.

Putting money in stable instruments because you want to reduce risk only to invest in high-yield junk bonds is counterproductive. So is increasing the term of a bond when interest rates are very low. We recommend higher quality short- and intermediate-term bonds. Invest a portion of your assets in stable investments, and if you want a higher return, put the money into appreciating assets.

Foreign bonds are the third stable asset class. They can balance domestic currency values and interest rates with what's happening in the rest of the world. And they sometimes pay a higher interest rate. Foreign bonds also appreciate when the U.S. dollar is declining in value. Foreign bonds are subdivided into bonds in developed countries and bonds in the emerging markets. Like U.S. bonds, foreign bonds are categorized by quality and duration.

Appreciating assets are essential to your portfolio. They are the engine of your retirement savings. Even in retirement, you will need enough appreciation to keep up with inflation, pay the taxes and still have some real return left over.

We divide appreciation into U.S. stocks, foreign stocks and hard asset stocks. Most investors have primarily U.S. large-cap stocks, mimicking the S&P 500. They buy mostly large-cap growth stocks in the industry that did well last year with a high price-per-earnings (P/E) ratio. We don't recommend such portfolios.

On average, small cap outperforms large, and value outperforms growth. Although we recommend overweighting smaller companies with low P/E ratios, your portfolio should include a broad spectrum of stocks, including a generous helping of growth-oriented stocks. There may be times to overweight or underweight specific industries such as technology or health care.

The second appreciation asset class is foreign stocks. Diversification abroad can both boost returns and decrease volatility. Some people try to diversify internationally by investing in U.S. companies that gain a significant portion of their revenue from overseas. But these multinational companies still track fairly closely with other domestic companies, and they don't offer the same benefits as investing in foreign stocks.

Overweighting specific countries can be advantageous too. We use the Heritage Foundation's ratings to select countries that combine the greatest economic freedom with large investable markets. One yardstick of economic freedom favors countries with a low public debt and deficit and therefore a more stable monetary policy.

We recommend investing in the fastest growing countries. These emerging economies provide even greater diversification and returns. However, emerging markets are inherently volatile, so it is important to find the right balance and make adjustments as needed.

Finally, hard asset investments include companies that own and produce an underlying natural resource. These include oil, natural gas, precious and base metals, and resources like real estate, diamonds, coal, lumber and even water. We suggest diversifying hard asset stocks by resource type, geographic location of a company's reserves and company size.

Investing in hard asset stocks is not the same as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment in raw commodities or their volatility. But buying a gold mining company is a hard asset stock investment.

Over time, dollars lose their buying power, and the goods and services we buy cost more. Commodities generally maintain their buying power in dollar terms. But investing in hard asset stocks generally appreciates at a rate much higher than inflation.

Hard asset stocks have a distinct set of characteristics and are categorized separately. Their movement is generally less correlated with that of other asset classes. They have a unique (and positive) reaction to inflationary pressures. And at certain periods in the longer term economic cycle, including hard assets helps boost returns.

Many advisors don't have an asset class for natural resource stocks. They select one portion of the category instead, typically real estate, and make that the asset class. This can 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.

Natural resource stocks 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 designated to stocks and the amount designated to bonds.

Many U.S. investors crowd their assets into a combination of large-cap U.S. stocks and U.S. bonds. This allocation represents only one and a half of the six asset classes described here.

Asset allocation means always having something to complain about. Investors are continually looking for the safe investment. But inflation, sovereign debt, globalization and diminishing U.S. economic freedom make a clear choice difficult. Thus we advise a diversified portfolio that overweights certain subcategories.

If you have set such an asset allocation, what did poorly this past quarter may be poised to do better in the coming year. If your asset allocation is wrong, change it. But if it is right, don't abandon a brilliant allocation simply because of short-term returns.

Finally, rebalance regularly. 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.

Rules Are Essential, but They Do Not Guarantee a Win

The following is an excerpt from It's About More Than the Money: Investment Wisdom for Building a Better Life.

Have you felt let down by an economic crisis? You might if you thought you were following all the investment rules you’d been taught. You may feel disappointed, resentful, and even angry. You are in good company if you are thinking, “I followed the rules! I should have won!” After all, doing so should entitle you to a certain reward. Doesn’t following the rules protect you from losses, or at least minimize them?

Unfortunately, life doesn’t work that way, and neither does the economy. Following investment rules doesn’t necessarily mean you won’t lose sometimes. However, using the rules as a general, meaningful guideline, even if you have to be flexible at times, is wise.

To succeed as an investor, you need to move beyond the emotional frustration of “losing” by examining your process and changing your behavior. This requires a constructive, focused, and objective mindset.

First, you have to acknowledge that there are no guarantees. But there are parameters to consider, and they are based on years of experience. Think of it this way. Picture a child running across the road between two parked cars on an active street. He makes it safely to the other side. He thinks, “Why do they tell me at school not to run between two parked cars? I did it, and nothing happened.” Just because nothing happened one time doesn’t mean it’s a reasonable risk. One lucky win has nothing to do with the probability of future success. In fact, the probability of a win decreases with each risk taken because the odds will eventually catch up to you.

Yet sometimes this is how investors think. Either they have no investment rules, or they break their own rules and take on too much risk. When that rule-breaking strategy works, they do it again and again, thinking they are guaranteed phenomenal returns. Then they’re surprised when they get run over!

The same scenario can also work the opposite way. An investor follows a rule, and it doesn’t work. The investor “loses” and begins to think that following the rules doesn’t matter because the rules can’t guarantee safety. Think of a person who lives a healthy lifestyle, exercising and eating properly. She eats no fried food and avoids saturated fat. Can you guarantee that she won’t get heart disease or cancer? No, but that doesn’t mean that following the rules isn’t a good idea. Although it may seem that the rules got her nowhere, the reality is they probably gained her a great deal. Could it be that her healthy eating prevented cancer from developing at an earlier date? Might she be more likely to beat heart disease because she is in great physical condition? Could it be that her quality of life before and during an illness could be improved by her healthy habits? Just as breaking the rules doesn’t always lead to disaster, following the rules doesn’t always lead to safety. That doesn’t mean that following the rules is a bad idea.

When an economy turns south, many investors—including the ones who followed the rules—experience losses. This doesn’t mean they should conclude they had poorly designed rules or that the rules don’t work. Investment rules yield their effect over time. It’s true that over short periods of time you might feel that you lost. You lost this one. You lost that one. But in the grand scheme of things, if you follow the rules—and we’ll talk later about what those rule are—you’re more likely to be on the right path.

Although you can’t guarantee you’ll never lose, what you can do is improve the probability of winning. That is what superior athletes do. Like the professional baseball player, all any of us can do is swing at the balls being pitched to us. And, like the baseball player, when you follow the right rules, you can increase your chances of getting a hit. You may not connect with the ball every time, but if you position your stance, practice your swing, and study the craft, the probability is that you are going to hit consistently over long periods of time. What do top players do to be in their best form? They study films, including those of the competition. They practice the skills they need until they are at the level of unconscious awareness. What looks like autopilot to us, the spectators, is really the result of years of active dedication to the sport. Top athletes are lifetime students of their game, and they learn to perform under pressure that includes less than desirable ¬conditions. Will continual “perfect” practice always lead to a win? Is there a way to guarantee a connection with the ball? No. But practice greatly increases the chances of success. This reasoning applies to sports, investing, and anything else you value in your life.

Rules are guideposts that improve your probability, and that can make all the difference. What’s the range, statistically speaking, between the minor leagues and the major leagues? For the best players, it can be very small. And yet, a ball player’s life and the life of his family can be dramatically changed when he moves up to the major leagues and becomes a fixture there.

The same logic applies to the difference between mediocre and remarkable investment returns. From 1989 to early 2009, the Standard & Poor 500 stock market index return has been about 8.4% (J.P. Morgan Asset Management, Guide to the Markets, March 31, 2009). Can you guess what the average investor’s rate of return has been over that period of time? About 2%. Why? Because investors, for whatever reasons, tend to buy high and sell low instead of doing the desired opposite. In any one year, the differential may not be that large. When you add all 20 years together, the cumulative effect is substantial.

Following are several ways you can improve the probability of “winning,” which means increasing the potential for your investment performance.

Evaluate the Investment Rules You Followed

When you look back at the performance of your investments, ask yourself what rules you followed and how well they worked. Did you have the right rules? Were you following the rules that were appropriate for someone in your financial situation and at your stage of life? Did your situation change, and did that require revision to the rules?

This is how Rebecca describes her experience.

Rebecca: My husband and I were on a wonderful trip, hiking in Switzerland, when he suddenly had a heart attack and instantly died. I can’t even describe the shock and pain of this; I was numb for weeks. When I got home, among all my new obligations I had the responsibility of all our investments, and I had never done any of this before. I discovered that there was quite a bit of money in higher risk securities. I learned to use a computer and I took a course on investing. I wanted to handle things personally, and before I knew it, I was day trading! I guess because my husband was an active trader, I thought that’s what I was supposed to be doing. I was in over my head. I felt like there were no rules, or the rules that my husband had relied on previously were no longer appropriate for me, an inexperienced widow. I realized I needed an investment strategy with boundaries and an advocate to stand by me. It was a great relief when I found an advisor who was supportive and sensitive to my needs.

Examine How Well You Followed the Rules

It’s painful to lose money. It especially hurts if you felt you were following the rules. But for the higher purpose of helping you to empower yourself, you need to look at yourself honestly. Did you really follow the rules? Did you follow them as closely as you could? Did you have a realistic time frame, or did you lose patience with the process? Maybe you had rules you weren’t following at all. Maybe you were following other rules because you got distracted from the original rules you established.

Charles talks about how this happened to him.

Charles: For 20 years I have had a successful business in home security systems. I am confident and have a strong head for financial decisions. I always believed in diversification and therefore used different asset classes. This meant being invested in stocks, bonds, real estate, even art and collectibles. Each time I had a positive investment result, I added more money to that specific category because I was so pleased with how things were working out. Eventually, I had large sums deployed in more aggressive and illiquid assets, and the returns took a negative shift. I kept telling myself that these things just needed more time, but I ultimately had to acknowledge that I lost track of my own rules for managing risk. I was attracted to the high potential returns and forgot to limit the percentage of funds in each asset class.

Get Back in the Game

To paraphrase Yogi Berra, the game isn’t over until it’s over. You may have temporarily lost money, maybe even a lot of it. But as long as you’re an investor committed to your future, you still have the opportunity to participate constructively as the market recovers. You have options.

You can improve how you’re handling your investments. One of the ways you surmount a crisis is to remember that you can be a strong force in your financial recovery if you can step away for a minute to examine your game. What investments should you be in now? Are you in them? Addressing your investment strategy is one way to correct the mistakes of the past and position yourself better for the future.

You can cut your expenses. When you go through a financial crisis, suddenly you become an expert on what you must have versus what you can live without. Can you do some of the things you used to pay others to do and do those things just as well? Can you cut expenses without significantly reducing your quality of life?

You can add to your income. You may go back to work or earn some extra money by doing something for which you have unique expertise. You can sell things of value, like furniture or jewelry. You may love to have nice things, but can you live without them? Do you have any valuable objects you thought meant something to you and now you realize their intrinsic value has decreased? Perhaps now you can trade for cash and buy some time while you get stabilized.

You can prioritize your life. Maybe you lost some money in the financial markets, but did you lose in every game you were playing? Maybe you are focusing on one game that you lost, but maybe you won a lot of others. How satisfying is your family life? How rewarding are your friendships? How’s your health? To move past the anger of losing, it helps to step back and view the broad canvas of your life. Money isn’t the entire puzzle; it’s only one piece! Look again at what you thought you wanted. Ask yourself, “Is that still how I feel, or have my priorities changed?” Maybe what you thought you wanted isn’t really what you wanted, or maybe you can achieve those same things in another way.

Here is Dan’s story:

Dan: I retired with what I thought was a lot of money, and I had big plans to dabble in real estate and enjoy my avocations, which are very expensive pastimes. In this most recent crisis, my liquid assets and real estate plummeted, and my expenses went up! I was so stressed out about paying my bills that my hobbies no longer provided me with satisfaction. In fact, because of their expense, they were compounding my anxiety. I had to go back to square one and evaluate my life. I realized that my heart just wasn’t in these high-powered activities any more, and I was actually relieved when I successfully abandoned them in favor of more volunteer work and time spent with my family. This change helped me get my finances under control and simplify my life. Even though this was a difficult experience, I consider it a win.

The score is about more than what happens when you’re standing at home plate. When you’re at the plate, all you can think about is getting a hit, maybe even a home run. But there’s a bigger picture: what your fans are thinking about you, how valuable you are to your team, what kind of example you are to the sport, what kind of a student you are of the game, and how much you are enjoying winning. The end game is about so much more than that one big hit.

If you follow the right rules, you’ll ultimately be a winner. You may win in a way that is far more important than the way you used to keep score. In adverse circumstances, when it feels that you’re losing, losing, losing, you can start to feel like a loser. It’s only when you lose the little stuff that you realize you may have been winning in a big way all along. You may also discover the potential to “win” in a way you had not previously considered. Develop rules that make sense for you and follow them. Give them time to work and reevaluate them when necessary. In the long run, following the right rules will bring you closer to winning.

The Safest Way to Invest in Gold

The following is a guest post by Shaun Connell, the webmaster of Learn Mining News.

Complete financial security is impossible. No matter what happens, you can lose your shirt – no bank, no government, no portfolio is foolproof. Risk is simply a part of financial life.

But even though risk is inherent, that doesn’t mean you can learn actionable steps to mitigating your financial or investing risk. In this post, we’ll be discussing on specific method of minimizing your investing risk – learning the safest way to invest in gold.

Gold Speculation is Risky

All speculation is risky. There’s a lot of debate about what “speculation” even means, but a general consensus is this: speculation is when you only profit after you sell your assets. In other words, speculation is all investing where your investment doesn’t earn an income. Flipping real estate, buying gold when it’s cheap to sell when it’s expensive, buying and selling baseball cares – these are all speculations.

An income-earning investment is obviously quite a bit different. It’s when the asset you’ve invested in provides an actual income, such as with dividend stocks, purchasing a small business, bonds, etc. These are all income-earning investments.

Gold speculation, and all speculation in general, is risky because if the price of your investment goes down, you can lose money. If you buy gold at 1200 per oz and it drops to 300 per oz, you’ll probably not make any money for decades – if at all. So, rather than getting a steady 10% return, you could get less than 1%, or if you sell before the value increases, you could lose most of your investment.

Speculation is something even big financial institutions are cautious with – a fairly novice investor has no business making big speculations. I don’t speculate with my finances at all, and prefer to put my money into income-producing investments exclusively.

But what does this have to do with investing in gold? Because the best gold investment isn’t necessarily physical bullion – but mining stocks.

How to Invest in Gold With Less Risk

Gold mining stocks are a safer way to indirectly invest in gold than physical gold bullion. The reasoning is as follows:

• Less Volatile. Stocks in general swing less than the price of gold, especially the bigger stocks. There are exceptions, of course, but mining stocks is simply less volatile. That means there’s less of a chance you’ll lose your investment in a price swing.

 

• More Secure. It’s hard to steal a gold mine. It’s a lot easier to steal a couple of ounces of gold. By having your money in gold mining stocks, you’re less likely to get robbed and lose your investment to a thug.

 

 

• Gives Income. In my opinion, this is easily the best justification for investing in mining stocks and not metal bullion – stocks can provide a steady dividend income. By providing you with a dividend income, you can go ahead and just play it safe and never sell at all. This gets rid of most speculative risk on the part of your investment.

 

Conclusions

Of course, just because gold mining stocks are less risky than gold bullion doesn’t mean you should necessarily forego investing in physical assets at all. There are still reasons to own the physical product – hedging against a worst-case economic scenario, investing “off the grid”, etc.

In the end, speculation is risky, dividend investing is often less so, and mining stocks are one of the best ways to invest in gold with less risk.

Questions for you to consider:

• Do you think gold is going to go up over the next year?

 

• Do you think gold is going to go up over the next 20 years?

 

 

• Do you have any other strategies you use to cut back on risk?

 

Just Say ”No” to TIPS

The following is a guest post by MasterPo from The Po File.

With concerns over national debt levels and the Federal Reserve printing money like confetti inflation worries abound (and not without good reason!). Traditionally physical ownership of precious metals, most notably gold, has been the main way to protect assets against inflation risk.  However, today TIPS are being pushed as a “safe” (or “safer”?) way to get protection. The popularity of TIPS as mushroomed, fueled by both these concerns and eager financial gurus touting them as the best thing since beer in a can.

TIPS – Treasury Inflation-Protected Securities – for those who have yet not heard of them are U.S. Federal Treasury bonds that contain an inflation adjustment component to the interest calculation. They have a fixed coupon rate plus an inflation adjustment add-on to the principle amount. The purpose is to add (or decrease) the inflation adjustment to the principle amount (face value) rate annually. This results in increased (or decreased) semi-annual interest payments a s interest is computed on the adjusted principle amount, and, at maturity you receive the great of the face value of the bond or the adjusted principle.

Sounds like a sweet deal!

But all that glitters isn’t gold. The U.S. Treasury isn’t offering TIPS (and I-Bonds) out of the sheer grace of their over-paid Federal hearts.

TIPS, gold and inflation all have an intertwined history.

The double-digit inflation of the early 80’s saw investors and individuals flock to gold as a protection. They sold securities – most notably fixed income Treasury bonds – to raise the cash to buy gold. New cash was also put into gold instead of Treasuries. The result was obvious to happen: Gold reached then-record highs and the U.S. Treasury had a liquidity problem.

If the government printed more money that added to inflation. If they didn’t interest rates would have to rise to lure back investors to buy Treasury bonds. In the end a combination of approached worked to lower inflation and bring back Treasury investors. But the government learned a lesson.

Enter TIPS.

TIPS has the affect of essentially monetizing inflation. Rather than holding a real, physical, tangible and historically valuable item like gold as a protection against inflation and the unknown, now you can own paper as your protection. Oh joy! And now the Treasury can attract and keep more investors instead of loosing them to gold (which is why in the current economy, while gold is at record highs, it has been a slower climb and not as high on an inflation-adjusted basis as the high of the 80’s).

The promise of one paper to protect you against loss of another paper. Seems rock solid to MasterPo!

But there are a few annoying things still nagging at MasterPo.

First, there’s the whole sovereign debt issue (a la Greece). The U.S. may be bigger but at $13.7 TRILLION in national debt (as of writing this) don’t think it can’t happen here.

Second, there’s the politics. The Obama White House announced there was no inflation in 2009. Phuleeze! And it’s been leaked they plan to say there will be no inflation in 2010 and 2011. How wonderful they can predict that!

But let’s go with Fantasy Land for this example. No inflation in 2009, 2010, or 2011 according to the White House.

So explain to an old MasterPo: If the White House says there’s no inflation how can the Treasury give an inflation adjustment to TIPS?!

Third, gold has real value worldwide. Unless something civilization shaking happens on a global scale there will always be an eager market for gold (and if something like that does happen cashing in your gold will probably be the least of your worries!). Can’t say the same for sovereign paper.

If all works out fine and dandy TIPS as concept is great.

But TIPS are only paper. And what looks good on paper doesn’t always play out the same in the real world.

Nations come and go but gold survives.

The Seven Pillars of Financial Success, Pillar 5: Invest to Make Your Money Grow

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

The Bible discusses the keys to personal finance success quite plainly. If you read the book of Proverbs in particular, you'll see that the path to financial success isn't that difficult or extensive. In fact, the wisdom to be prosperous can be found in a few simple steps.

Over the next few weeks, I'll be sharing what I consider to be the seven pillars of financial success from the Bible.  I picked up on the number seven from Proverbs 9:1 where it says:

Wisdom has built her house; she has hewn out its seven pillars.

Today we'll be discussing Pillar #5: Invest to Make Your Money Grow.

The Bible says a lot about making your money grow over time, being diligent in managing your money/finances, and applying wisdom to money management. But the verse I like best about investing is from Proverbs 13:11 where the Bible says:

Dishonest money dwindles away, but he who gathers money little by little makes it grow.

I love the idea of making money grow "little by little." For me, it's a perfect picture of what it takes to be successful: saving money (last week's pillar) from your surplus (the first week's pillar) and then investing it to make it grow bit by bit over time. This strategy is successful because taking advantage of time is the best way to maximize your investments. If you invest early and invest (save) often, your money will accumulate and grow over time -- slowly at first and then more rapidly as it gains momentum -- until you become a wealthy individual.

Saving alone won't get your there -- you need to invest your money to make it grow/compound. I think of it this way: Savings provides the fuel, investing lights the spark! ;-)

Do you agree or disagree?

Come back next week as I discuss Pillar #6!

Avoid the "Ring-of-Fire" Countries

The following is a guest post from Marotta Wealth Management.

A few months ago Bill Gross, co-founder of PIMCO and the country's most prominent bond expert, wrote a provocative monthly newsletter. He evaluated countries based on their total public sector debt as a percentage of gross domestic product (GDP) as well as their annual deficit, which is making matters worse. Gross singled out those countries heaping significant deficits on their mountain of debt and called them "The Ring of Fire."

The eight countries he identified were Japan, Italy, Greece, France, the United States, the United Kingdom, Ireland and Spain. The International Monetary Fund (IMF) cautioned that rising government debt has replaced financial industry stress as the biggest threat to the global economy. Gross warned his readers to watch "the U.S. with its large deficits and exploding entitlements." We recommend that you reduce your investments in these countries.

Our own government spending spree was not necessary. A Heritage Foundation study concluded that the stimulus money spent by countries had a negative short-term correlation with that country's GDP. In other words, stimulus money may even have had a slight negative short-term effect as well as a stronger negative longer term effect.

The IMF study agreed, stating, "Longer-run solvency concerns could translate into short-term strains in funding markets as investors require higher yields to compensate for future risks." In other words, we've taken short-term financial illiquidity and turned it into a long-term government deficit, which in turn raises the cost of short-term liquidity.

If you've lost your job or are struggling to live within your budget, running up your credit card never helps. It may make you feel better momentarily, but it doesn't even really help your situation in the short term. Spending beyond your means only makes matters worse. And government spending is making everyone miserable.

A small amount of government spending is necessary for infrastructure, which appears to boost economic activity. Successfully funding the rule of law provides the economic freedom necessary for economic activity. The optimum amount of spending appears to be relatively small, perhaps about 18% of GDP.

In every economic analysis, greater government spending is associated with weaker economic growth. The Keynesian views of economic stimulus have been largely discredited, although its ideas continue to be misused politically to support massive government-spending programs.

Government intervention continues to do more harm than good. This past year it took a common recession and prolonged it into a more permanent malaise. GDP growth, which has historically averaged 6.5%, is liable to slow to a more European rate of 3 to 4%. Official unemployment numbers will lower but only as people drop out and are no longer counted. Real unemployment is likely to remain high for some time.

Lest you think these policies don't affect you, they do. Part of Greece's austerity measures include raising the retirement age 14 years. Lower U.S. stock returns could have the same impact on your ability to leave the workplace. For each 1% less in return over your working career, you will have to retire seven years later to achieve the same retirement lifestyle.

Countries obligated to impose austerity measures illustrate the natural consequences of spending money you don't have while taxing and regulating wealth creation. Politicians take the credit for enacting feel-good programs they can't pay for, and then they scapegoat private enterprise to cover their misguided thinking.

Reduce your investment in these countries. Put your money where the entrepreneurial spirit is rewarded and the welfare state is discouraged, not the other way around. We suggest lightening up on foreign investments that primarily just follow the MSCI EAFE index.

EAFE stands for Europe, Australasia and the Far East. It represents all the developed countries outside of the United States and Canada. This includes large investments in all seven of the non-U.S. ring-of-fire countries. The EAFE consists of 22% Japan, 21% United Kingdom, 10% France, 4% Spain, 3% Italy and 1% Ireland and Greece. In total, 61% of the EAFE index is invested in ring-of-fire countries.

But before you stop investing in foreign stocks altogether, remember that 100% of domestic stocks are invested in the eighth ring-of-fire country, the United States. And we need our own austerity measures. The total compensation package for federal workers in the United States is $108,476--a full 55% higher than workers in private industry whose total compensation amounts to only $69,928. Going forward may be one of the times when a strong tilt toward specific foreign countries may provide superior long-term returns.

Gross advises seeking return where "national debt levels are low, where reserves are high, and where trade surpluses promise to generate additional reserves for years to come." This suggests investing more in emerging markets such as Chile, China, India and Brazil.

It also includes emphasizing countries with economic freedom such as Hong Kong, Singapore, Australia, Switzerland and Canada. Or mostly free countries with lower debt such as Denmark, The Netherlands, Finland, Sweden, Austria, Germany or even Norway. These countries should outperform their debt-laden counterparts.

As Gross ended his newsletter, "Beware the ring of fire!"

Stop-Loss Orders Can Lose Money Quickly

The following is a guest post from Marotta Wealth Management.

After investors and their advisors experienced the precipitous market drop during the fall of 2008, many people searched for ways to protect their assets. After a year-long review of possible ideas, I decided to stay the course and not change our investment strategy. Every technique I reviewed would have put such a drag on portfolios as to erase gains over the last 10 years.

Although the S&P 500 had a flat or down decade, even my simple gone-fishing portfolio had satisfying gains over that same time period. I write every year or so about how this diversified portfolio is doing. Although they aren't even the best funds to select today, they remain popular funds with low expense ratios.

The portfolio consists of 20% Vanguard Total Bond Index (VBMFX), 21% Vanguard 500 Index (VFINX), 10% Vanguard Small Cap Index (NAESX), 21% Vanguard Total International Stock (VGTSX), 10% Vanguard Emerging Market Index (VEIEX) and the final 18% in T. Rowe Price New Era Fund (PRNEX).

Through the end of April 2010, that portfolio has a 6.05% 10-year annual return versus 0.19% for the S&P 500 alone. Over 10 years, that's the difference between being up 79.93% and down 1.88%. Diversification over the last decade boosted returns significantly. It doesn't always safeguard you from market losses, but as I said, anything you do to protect yourself from losses can weigh down portfolio returns significantly.

My favorite quote last year was from former Fed chairman Paul Volcker: "You can't hedge the world." If you try too hard to avoid volatility, you will probably just dampen your returns and may still experience some other unexpected event (the so-called black swan), like the defaulting of municipal bonds you thought were secured.

One strategy we rejected as a hedge against a precipitous market drop is a technique called a stop-loss order. After purchasing a stock or exchange-traded fund (ETF), an investor can place an additional order with instructions on when to stop holding the security and sell it. Stop orders are triggered when the security reaches a specific price.

Sell limit orders are placed above the current market and execute when the security reaches that prices.. Sell stop orders are placed below the current market with the objective of limiting losses if the market value drops.

We recommend avoiding these types of orders for downside protection. Getting out of the markets at a 15% loss doesn't help you know when to get back in. Most investors who get out remain there until the markets rise well above the triggering values. Getting out is also the exact opposite of rebalancing. When the market drops, rebalancing your portfolio would mean selling bonds and investing more in the markets, not getting out of the market.

We think these are good reasons to avoid stop-loss orders, but many others disagreed. Thousands of investment advisors recommended this technique to their clients. Now it looks like this advice may have been the cause of the market plummet.

For example, take Vanguard Value ETF (VTV), which was trading at around $50 per share on May 6. Investors or advisors who wanted to protect their investment from a catastrophic drop in the markets may have wanted to sell if the markets dropped by 15%. This would mean placing a stop-loss order that would be triggered at $42.50.

Just because a market move sets off a stop-loss order doesn't mean the investor will get the trigger price. The trigger submits the sell order as a market order, meaning it gets whatever the next market price is. Under normal conditions this might mean the stock would be sold at most for a nickel below the trigger price (i.e., $42.45).

Unfortunately, May 6 wasn't normal conditions.

Possibly some large sale of Procter & Gamble caused a drop in the Dow. That may have triggered some automatic stop-loss orders in Dow index funds, which may then have caused other Dow stocks to drop in value.

The drop in Dow stocks could easily have triggered additional stop-loss orders. Each sell pushed stock values lower, triggering more stop-loss orders set at even lower levels. This cascade of stop-loss orders caused the May 6 free fall.

But it gets worse. The stock exchange has speed bumps in place to slow the market when it appears to be moving too fast. These curbs limited transactions from market makers at exactly the time when higher liquidity was needed. A market maker is a firm that stands ready to buy or sell a particular stock on a regular and continuous basis at a publicly quoted price. Market makers move that price gradually, which keeps the market orderly.

Without market makers, when there are more sellers than buyers, a stock has no price. Some of these market orders got picked up by exchanges linked to the New York Stock Exchange. Others got picked up by stub orders for a penny a share.

Between 2:40 pm and 3:00 pm, at some points no one knew what certain stocks or ETFs were worth. Consequently, the value of many ETFs hit virtual zero. Stop-loss orders for VTV set at $42.50 got executed for $0.10 a share. Then after every stop-loss order was finally triggered, the plunge came to a halt.

After the last of the stop-loss orders was cleared for pennies a share, the automatic selling stopped. At that point many institutional investors or their automated systems stepped in to bargain hunt and pick up shares for fractions of what they were worth. The market quickly rebounded, recovering most of its value in the next 20 minutes.

You can see this effect on Google finance, where it looks like the stock price for VTV bounces off zero that day at 2:52 pm. These trades were not an isolated event. Many stocks sold for just a penny per share. These trades show a market in free fall with a snowball of cascading stop orders and no market makers stepping in to set a reasonable price.

The statistics are already being cleaned up to erase this trading anomaly. Some sites still show the year low of these ETFs as $0.10 or even $0.00. But other sites now have the edited low of VTV as $18.58 or $19.32 that day.

After the close of trading on May 6 and numerous investor and advisor inquiries, the NASDAQ mandated canceling these clearly erroneous trades. But they insisted these were legitimate market orders executed in a reasonable manner and were not aberrations or mistakes in the system. In other words, you have been warned that the events of May 6 were a natural consequence of using stop-loss orders during a market free fall.

Thus the stop-loss order technique failed at the very moment it was supposed to save the average investor. It tried to sell in a free-falling market and only succeeded in dumping valuable stocks on a dime and for a dime. Even after adjustment, some investors lost 63% on a day where the stock market only closed down 3.62%. I doubt investors or financial advisors will be advocating the widespread use of stop-loss orders again in the near future.

But if they do, I suggest putting in a series of limit orders to buy stocks or ETFs at half their current value. If investors ever want to dump their shares for half their value, I'm more than willing to buy at that price.

Be a contrarian. Buy when people are selling. Especially when they have automated their panic with stop-loss orders.

Now's Still the Time to Buy a House

The following is a guest post from Marotta Wealth Management. To note, this piece is a bit centered on a specific area of the country, so the findings/recommendations might not be the same for your area. That said, real estate is still at very low relative prices in much of the country.

Between 2005 and 2009 I annoyed local realtors by claiming that real estate values were headed lower. Then in a column in July 2009, I said it was the time to buy a house. And now in the spring of 2010, it is still the time to buy a house.

Early in 2005 my father George Marotta and I explained the coming subprime debacle and predicted "the bubble, if it is a bubble, could pop as late as 2006 or 2007." Our projection was accurate. Real estate continued to rise that year. But it was relatively flat in 2006, underperforming the markets that appreciated over 15%.

Two years later, I wrote, "Many homeowners with adjustable rate mortgages have seen their monthly payments increase 50%, due to the higher rates. With the sudden jump in monthly mortgage payments, many are finding they can no longer afford to stay in their homes. The rate of late payments and foreclosures has continued to rise, leaving many lenders on the brink of bankruptcy themselves."

Again, the prediction was accurate. In 2007 the Cohen & Steers Realty Majors Index turned negative, losing 18.03%. Residential real estate did even worse. Apartments suffered one of the largest declines, down 25.4%. In February 2008 in my column "For Now, Avoid Real Estate Investment Trusts," I warned again to stay out.

It wasn't until well after the financial implosion that I suggested to readers it was the time to buy a house. I said, "Nathan Rothschild offered the contrarian advice to 'Buy when there's blood in the streets and sell to the sound of trumpets.' It is time to consider buying residential real estate. The bottom is forming, although it may continue to do so through early 2011."

I believe that advice will also prove accurate. Comparing last month's statistics from the Charlottesville Area Association of Realtors, the median home price has dropped from $247,000 last July to $238,000, but the rate of decline has slowed. The average days on the market have risen from 125 to 153. And although the number of active listings is still high at 3,312, the number of houses actually selling has started to pick up.

Home prices are well below 2005 averages, and time on the market is well above the healthy market average of 90 days. Sellers have been slow to realize that their home isn't necessarily worth the appraised value or what they paid for it or even what they owe. Houses are simply worth whatever the market will bear, which is a lot less than it was at the peak of the market three years ago. National trends have followed a similar cycle.

Half the advisors at our firm have purchased real estate in the last year, and I'm personally still looking for investment opportunities. It isn't too late because the recession has been prolonged and the recovery delayed.

Investment real estate isn't for everyone. You shouldn't have more than a third of your net worth bound up in real estate. For many families the home they live in provides them with more than enough real estate exposure.

Also, you don't need to buy and manage individual properties to get an exposure to real estate. Publicly priced and traded real estate investment trusts (REITs) offer an easy way to get in and out of real estate for the average investor. In a favorable climate, up to 8% of your portfolio might be invested in REITs this way.

We got out of REITs entirely and are only looking to get back in recently. My father would always say, "Make half a mistake," which suggests putting perhaps 4% of your portfolio back in REITs now and waiting until early 2011 for the other half.

If you are looking for an easy recommendation for an investment vehicle, try the Vanguard REIT exchange-traded fund (symbol is VNQ). The expense ratio is only 0.15%, and the yield is 7.8%. This is by far the simplest way to take advantage of this trend.

Specific individual real estate holdings offer investors the opportunity to leverage their investments by holding a mortgage on the property. Lending requirements are very tight right now, so for investors who can still get credit, there is real opportunity.

Investors could invest $1 million in appreciating securities, or they could invest $700,000 in appreciating securities and put $300,000 down on a $1 million commercial real estate holding. Assuming normal conditions, the second arrangement will produce a better return. The danger is that you do not want to be highly leveraged in a falling real estate market. Borrowing the money you are investing amplifies the gains, but it also amplifies the losses.

I've heard a number of bleak predictions for the housing market recently. Everyone is expecting real estate to underperform the stock market for many years going forward. Maybe they are right.

With the $8,000 first-time homebuyer tax credit expiring, demand may shrink. Starting your search now may be the perfect time. And there will be another opportunity at the end of the summer when buyers shrink even further. But maybe they are wrong. By this time next year, I expect the markets to turn positive. And I think it is time to make half a mistake and invest a little back into real estate.

It was only a few years ago that everyone was boasting about how real estate was appreciating by 1% every month. They made us feel like fools to be out of the market. With only a handful of listings out there, we were told that even if a glut of houses came on the market it would take years to satisfy the demand. But markets can turn quickly. Now we are contrarians again, looking at the trends and trying to gauge if there will be a second precipitous drop before the bottom. I don't think so. I think that we are near the bottom and brighter days lie ahead.

In the meantime, there's still blood in the street. Don't miss this opportunity to look for a great real estate deal.

The Eight Money Ratios, Part 3

The book Your Money Ratios: 8 Simple Tools for Financial Security lists eight money ratios that are designed to help us all determine where we stand financially. They're so good that the Wall Street Journal called them "some of the best tools we have seen for gauging where you stand." So I thought I'd list each of them as well as tell you where I stand on each measure. This is part three of the series and covers ratios #5 and #6. (FYI, here are #1 and #2 and here are #3 and #4).

The Investment Ratio

I've posted on this ratio previously and it generated quite a bit of discussion. But before we get to that, let's review the guidelines the author gives for this ratio. Here's how he says investors should allocate their assets between stocks and bonds at various ages:

Here is the Investment Ratio (for various ages):

• 25 years old -- 50% in stocks, 50% in bonds
• 30 years old -- 50% in stocks, 50% in bonds
• 35 years old -- 50% in stocks, 50% in bonds
• 40 years old -- 50% in stocks, 50% in bonds
• 45 years old -- 50% in stocks, 50% in bonds
• 50 years old -- 50% in stocks, 50% in bonds
• 55 years old -- 50% in stocks, 50% in bonds
• 60 years old -- 40% in stocks, 60% in bonds
• 65 years old -- 40% in stocks, 60% in bonds

The general backlash from the previous post was that these ratios are waaaaaay too conservative. Here's a general sense -- not his exact words, but a summary of what he covers over several pages -- of the reasons the author provides these guidelines:

• The greatest risk an investor faces when investing is losing a good part of his investment.

• Bonds are designed to protect you on the downside -- to minimize your losses in case the market goes bad.

• Hence you need to have a good amount of bonds to keep your portfolio safe and protected from market drops.

Again, that's my short summary of what he gets at.

Personally, I don't buy it and I'm willing to take on more risk in hopes for a better return (BTW, there's a risk of being left behind in a bull market, and bonds can certainly be a drag on returns during those times.) I'm about 75% in stocks (domestic and international stock index funds) and the rest in bonds or cash.

The Disability Insurance Ratio

The sixth ratio is the disability insurance ratio and is designed to make sure you have the proper amount of disability insurance for your income at various ages. Here are the ratios he recommends:

• Age 25 to 55: A disability policy that replaces 60% of your income
• Age 60: A disability policy that replaces 40% of your income
• Age 65: No disability policy needed

I'm all set here. Several years ago I bought a disability policy that replaces 60% of my income. It's pricey ($3k per year) but it protects my #1 financial asset, which is pretty valuable after all, so I think it's worth it.

So what do you think of these ratios -- good or not so good? And where do you stand compared to them?

Should You "Sell in May and Stay Away"?

The following is a guest post from Marotta Wealth Management.

The old stock market adage "Sell in May and stay away" suggests you can avoid risk and increase return by getting out of the markets during the summer.

This advice appears this time of year whenever the markets have appreciated over the previous six months. Sometimes it's right, adding anecdotal evidence that you ignore the advice only at the risk of your equity.

But it's a slippery claim to evaluate and consequently a difficult trend to capitalize on. Let's begin by pinning down the exact days you would exit and then reenter the market.

The saying originated in Britain as "Sell in May and go away, stay away till St. Leger Day." The final horse race of the British equivalent of the Triple Crown takes place on St. Leger Day, in the second week of September. In the United States, September and October historically are considered dangerous months to invest. In addition, St. Leger Day is unknown here. So the date of reentering the markets has been pushed to the end of October, causing the rule to also be known as the "Halloween indicator."

Buying in mid-September or at the end of October is a significant choice. Since 1950, September has been the only month averaging a negative return. The S&P 500 has appreciated an average of 0.97% each month. But the September average is -0.37%, due to severe losses in 1974 and 2002.

October, contrary to popular opinion, is a typical month with an average return of +0.82%, despite the 21.5% loss in 1987 (Black Friday) and the 16.8% loss in 2008. Prior to two years ago, the average for October was 1.17, well above the 0.97% monthly average.

Mark Twain commented wryly on October, saying, "This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February."

For the purposes of our analysis, I will use October 31, Halloween, as the day we would buy back into the markets.

The date to sell stocks is equally challenging. The traditional wisdom suggests selling May 1. But since 1950, May has performed well with an average return of 0.80%.

The problem with the data is what time period you use to back-test it. My data are from 1950 through the end of last month. But when the saying first circulated, May was flat. Since 1987, however, May has done phenomenally well, averaging 2.11%. May's recent streak of luck has raised its average substantially.

Yale Hirsch popularized this approach of investing in his "Stock Trader's Almanac" starting in 1986. He found that investing in November through April produced better returns than May through October.

Mark Vakkur refined Hirsch's approach to cherry-pick the best months. He suggested alternating between being fully invested, half invested, and out of the markets entirely depending on the month. September has the worst returns, but February has the second worst.

Historical patterns can be correlated to an infinite number of future predictions. Others would suggest that price per earnings ratios or the yield spread between long- and short-term bonds are a better indicator of stock returns. To suggest that each month is a reliable indicator of future results requires more than past statistical anomalies. Even if those statistics are taken from 60 years, they still represent a limited data sample.

I tried a simple thought experiment taking 720 imaginary pennies and flipping groups of 60 in 12 different categories, each labeled with a different month. In total I flipped 40 more tails than heads. But one month alone contributed 24 of the extra tails. Flipping 42 tails and only 18 heads in one month certainly seems meaningful. Simulating penny flips with a spreadsheet, I repeated the experiment multiple times. Each time at least one random month produced an anomalous result.

Here's another saying I like better: "Stocks go up and stocks go down." The markets are inherently volatile. Sometimes most of the tails can land in one month over a 60-year sample.

Seasonal investing hit the height of its support in Sven Bouman and Ben Jacobsen's 2002 study. The drop in the markets that summer heavily contributed to the trend. Between 1950 and 2002, returns for November through March averaged 9.06% versus only 3.18% between May and October.

Since 2002, however, the trend has been much more muted. The recent difference between these numbers is statistically small for the wide range of returns.

In 2009 May through October went against the trend and was up 20.10%. But in 2008 that same time period was down 25.84%. The past five months, November through March, are following the trend and up 13.87. But a year ago, November through April was down 8.53%.

Even in the last two years, this volatility can be made to fit the trend. Adding the two years together, November through April was more up, and May through October was more down. Although the markets have gone nowhere, blindly following the strategy would have produced a 5.74% gain.

As this column has repeatedly advised, rebalancing and diversification are clearly a better long-term approach.

Larry Swedroe of Bogleheads.org, an indexing discussion site, did an analysis starting in 1926 that switched to U.S. Treasuries every May 1 and moved back into the S&P 500 on November 1. The strategy produced an annualized return of 8.3% versus 10.25% for just holding the S&P 500.

By cherry-picking the right years, he found periods when the strategy might outperform a buy-and-hold strategy. This held true specifically for 1987 through 2002, the very period in which the saying received national attention.

Given the volatility of the markets and the strength of seasonal psychology, there may be a period of months when markets will perform better. But that doesn't mean Treasuries can outperform May through October.

My own study shows that since 1950, May through October has contributed a 3.16% return; November through April has contributed 8.44% for an annual return of 11.60%. If you sell in May, you have to be able to get a six-month Treasury return better than 3.16%. Considering trading costs and capital gains taxes, that's difficult.

If a seasonal ebb and flow to market returns really exists, it may be as simple as observing when cash is tight and not flowing into the markets. In February bills from the holidays arrive, and many people are gathering cash to pay their taxes. Summer vacations strap many families, resulting in high expenses in September. Only after bills are paid can money flow back into the markets.

In contrast, December sees large profit-sharing bonuses put into the markets, and pension funds are often invested in January. In the early spring, people are funding their retirement accounts.

These are just speculations. It could just as easily be the amount of sun in the Northern Hemisphere affecting people's emotions. Or it could just be that a lot of random tails fell in the September portion of the carpet.

Thus we provide a thoughtful compromise between jumping in and out of the markets and ignoring the seasonal effect entirely. If the markets are up, as they are now, and we are approaching the summer months, it is a good time to take some profits off the table. I'd like to replace the adage with the following advice: "Rebalance in May and call it a day."

Appreciating Assets Part 2: Other Investments

The following is a guest post from Marotta Wealth Management.

Your top-level asset allocation determines both the ultimate return you will receive and the volatility you will experience. Your investments should be working for you, appreciating more than inflation to become an engine of growth that pays you money and provides some measure of financial freedom. A combination of stocks and bonds with low expense ratios and a tilt toward stocks provides the best tuned engine of growth.

Stocks average 6.5% over inflation. Bonds average 3% over inflation. Thus after 25 years, $100,000 invested in stocks will have a buying power of $483,000. And $100,000 invested in bonds will have a buying power of $209,000.

Many other assets fare worse than these two categories. Understanding the average appreciation of these assets can help you model retirement projections and decide to invest or not.

Commercial real estate barely appreciates at the rate of inflation. Actually, it depreciates against inflation by about 1% a year. Fortunately, it should produce enough income to overcome this depreciation and produce a real return of about 4.9% over inflation. We invest in Real Estate Investment Trusts (REITs) that are publicly priced and traded as equities on the stock exchanges.

Handling a private commercial real estate requires more work. If private commercial real estate isn't generating a lot more income than it costs to maintain it--including depreciation--it isn't pulling its weight. Only if it can produce significant income and grow at a real return of 4.9% over inflation will a $100,000 investment in real estate grow to $331,000 after 25 years.

Similar equations can be used for residential real estate. On average it produces slightly less income, giving a real return of 4.1% and growing to have a buying power of $273,000. Obviously all real estate is subject to the increasing desirability of the area where it is located. Some excellent school districts have experienced appreciation significantly greater than inflation. But many rural communities have barely kept up.

A few years ago real estate was the darling that appreciated at over 1% a month. Now in parts of Michigan, Florida and California, those same homes are going for 20 cents on the dollar in foreclosure sales.

Remember that the house you are living in is an expense, not an investment. An investment pays you money. Although the principal portion of your mortgage payment is forced savings that will nearly keep up with inflation, it doesn't grow and work for you. Because you are occupying the house, you forgo the rental income that would provide the real return above inflation.

Gold is even worse than real estate. There is never any possible income from gold, so it just holds its value. And gold can be extremely volatile, losing 69% of its value in a 21-year decline from $850 an ounce in 1980 to $260 an ounce in 2001.

At least gold holds its value. Cash loses its buying power by the rate of inflation. After 25 years, although you might still have $100,000 in cash, it will only have the buying power of about $32,000. An inflation rate of 4.5% is devastating over the long term.

Fixed annuities act like cash. They lose their buying power quickly over time. Even if you could get an immediate annuity paying 7% at age 65, it would still be a bad deal. Seven percent sounds good only because you fail to take into account the immediate loss of 100% of your principal. If you die any time during the first 14 years, your return would be zero. You would only have received your own money back.

Assuming you live an average lifespan, your return would be 3.06%, not even keeping up with inflation. And even if you and your spouse both lived to be 100, your annual return would only reach 6.35% or a 1.85% real return, which is worse than an all-bond portfolio.

Immediate annuities initially seem like sufficient spending money, but that's only because they are front-loaded with buying power. If you want to maintain a certain standard of living, you should save some of the initial payout to supplement purchasing power at the end.

Even if you could purchase a $100,000 fixed annuity paying 7%, or $7,000 a year, you should only spend half of that amount. You would need to save the other half to supplement your spending later when you need more money to keep the same lifestyle.

Social Security is a little like a fixed annuity. Because it is indexed to the government's official inflation numbers, it doesn't keep up with real inflation. As a result, Social Security has a real return of about -2%

At this rate, over 25 years your Social Security payments will drop to about 60% of their initial purchasing power. Consequently, at the full retirement age of 66, we recommend only spending 84% of your Social Security income on your standard of living. Save the other 16% and invest it in equities to supplement your lifestyle later when the buying power of your Social Security payment dwindles because of inflation.

No one should count on Social Security. Had the money we've paid into Social Security been saved and invested in almost anything, every senior would be retiring as a multimillionaire. Until our Social Security system is privatized--like the one in Chile--it is not an investment you own. It is completely subject to the political risk of the next stroke of the pen. Inevitably Social Security benefits will be means tested so that people with more than a certain amount of assets, say a half million dollars, will no longer receive benefits.

We pencil Social Security payments into retirement equations tentatively and then see where we are without considering them. The younger the client, the less chance of collecting even the smallest fraction of what was contributed.

Many other expensive items should not be considered an investment. Just because it costs a lot doesn't mean it is an investment. For example, art is not an investment. Neither is furniture or a new roof. Neither is installing solar or geothermal. It may save you money, but that doesn't make it an investment. If it saves you money, you should be able to reduce your standard of living accordingly and put more money into your real investments. If that is the case, I would call putting more money into your real investments the "savings" and not consider the energy efficiency an investment.

If you can't put more money into your savings, then your purchase simply allowed you to increase your spending someplace else and was neither an investment nor did it save you any money. This principle should be applied toward anything that salespeople are apt to call an "investment," such as energy-efficient cars or time-share rental property.

Just calling something an investment doesn't make it so. Investments should appreciate at a rate that grows faster than inflation and gains purchasing power. And spending your money on non-investments can jeopardize a plan to reach your goals of financial freedom. Investments should work for you, paying you money that you can spend or reinvest elsewhere.

The Pros and Cons of Annuities

Here's a list of the pros and cons of annuities. It begins with the pros:

1. Flexibility and investment choices
2. Tax deferral for your investment gains
3. Income for life
4. Asset protection
5. Potential protection from market losses.

And now the cons:

1. Irreversible consequences.
2. Locked up until 59 ½.
3. Poor tax planning.
4. Insurance company financial health.
5. Inability to screen for your moral and social preferences.
6. Surrender charges
7. Up-front commissions.
8. Annual fees, administrative charges, mortality expenses, and other charges

The article then gets to the heart of why annuities are often a bad deal for investors:

With so many layers of fees, how will you make money? I have seen investors who have been in annuities for 10 years or more make very little money because of these high fees. It will affect your investment performance. These charges are often buried into the cost of your annuity. Reading a prospectus is often eye-opening!

Of course, new products are always coming on the market and low-cost companies are starting to come out with their own annuity products, so as costs drop, those objections may go away (or will at least be minimized.) That said, you'll still need to weight the pros and cons carefully since locking into an annuity is often a decision that's difficult, if not impossible, to un-do.

Personally, I haven't thought a lot about annuities since I don't have the need for extra income at this point in my life. In addition, I'm guessing that rates of return are pretty low these days. Will I ever consider annuities? Sure, but not until retirement (or close to it.)

Has anyone out there invested in annuities? Why or why not?

By the way, if you want to know more on this subject, check out these posts:

• Why Annuities Are a Bad Idea 
• The Psychology of Why People (Used to) Hate Annuities 
• All About Annuities

An Investing Reminder: Time is Your Biggest Ally

While reading a piece on maximizing your 401k, I ran into this quote:

"The biggest influential factor is definitely when you start saving," says Josh McWhorter, president of Black Oak Asset Management in Cartersville, Ga.

Money you save in your 20s and 30s has decades of compounding ahead of it.

For example, a worker who saves $5,000 each year between ages 25 and 65 and earns 5% interest would have $634,199 in retirement. An employee who saved the same amount annually but didn't start until age 35 would have just $348,804.

Seeing this simply reminded me that maximizing the amount of time you invest is best way to maximize your investment return (something I detailed last spring.)

It wouldn't seem this way if you looked at all the financial press and TV. They are all focused on how to get the best investment return. Sure, it's better to have a 10% return than a 9% one, but you'll get better results if you simply focus on saving now and saving as much as you can. And fortunately, those two things are within your control -- earning a better return isn't.

Most of my investing strategy has been focused on socking away as much as possible as soon as possible. I've created a big gap between what I earn and what I spend so I have a decent amount to set aside each month. It gets automatically put into index funds without any action required on my part. I simply focus on keeping the fire stoked -- putting as much away as possible. After that, I let the index funds do their work and add what they can, but I'm not spending, nor am I willing (or able?) to spend, hours and hours each week to identify, buy, and manage investments that MAY earn me slightly more than what I already have. I'm focusing on what I think are the keys to investing success -- saving early and saving often!

The Investment Ratio

The following is an excerpt from Your Money Ratios: 8 Simple Tools for Financial Security.

It’s a hard time to be an investor. Markets are volatile and panic is in the air. Many people are questioning the conventional wisdom that buying and holding sound investments is the most reliable way to build long- term wealth. But is it? Or has the wisdom of 100 years been turned upside down by the events of the past few years? Let’s start by asking our Unifying Question:

“Will investing help move me from being a laborer to a capitalist?”

Probably. That’s because investing is a double- edged sword. If done prudently, it can help increase your capital and move you from laborer to capitalist. But if done foolishly, it can reduce your capital and move you the other way. My Investment Ratio represents the prudent and time- tested approach to building capital over the long term. I will fi rst cover the ratio and how it is designed to help you build and protect your capital. Then in the next chapter, I will get into a more detailed discussion about the fi nancial markets and investing to help put the Investment Ratio in perspective.

The Investment Ratio

There are two basic types of investments you can own: stocks and bonds. With stocks, you own a small part of a publicly owned company. With bonds, you are lending money to others with the promise that they will pay you back. Thus you can be an owner, a lender, or a little of both. One of the key questions in developing your investment strategy is, “What mix of stocks and bonds should I have?” Stocks carry greater risk and therefore offer greater potential returns; bonds are more conservative and therefore safer, but over time, your returns will typically be lower than with stocks.

The Investment Ratio sets forth the fundamental split between stocks and bonds that you should consider at different stages of your financial life cycle. This allocation will determine the vast majority of the risk you are taking and the potential return of your portfolio. It is the most important thing to get right when it comes to investing, and it is where most people make their biggest mistakes. Some investors make the error of being too aggressive and lose more of their capital than they thought possible. Meanwhile, other investors
are too conservative, which reduces the likelihood that they will reach their long- term capital appreciation goals. The ratio helps you curb both of those costly tendencies.

The ratio is simple to use. Just find your age, and then the corresponding allocation to stocks and bonds. For instance, a 45- year- old should consider an allocation that is approximately 50% stocks and 50% bonds. Later we will discuss why I believe this approach, which may seem conservative to some, is actually quite prudent, even if you are young.

Here is the Investment Ratio (for various ages):

• 25 years old -- 50% in stocks, 50% in bonds
• 30 years old -- 50% in stocks, 50% in bonds
• 35 years old -- 50% in stocks, 50% in bonds
• 40 years old -- 50% in stocks, 50% in bonds
• 45 years old -- 50% in stocks, 50% in bonds
• 50 years old -- 50% in stocks, 50% in bonds
• 55 years old -- 50% in stocks, 50% in bonds
• 60 years old -- 40% in stocks, 60% in bonds
• 65 years old -- 40% in stocks, 60% in bonds

It is important to note that this ratio is for general education purposes and is not an individual investment recommendation. Because investment decisions must be based on your particular circumstances, I recommend that you work with a qualified financial advisor to determine how to invest your savings. The Investment Ratio provides you with a framework for understanding risk and return that will help you work with an advisor and make more informed investment decisions. You may ultimately decide that you would like to follow the ratio, but this decision should only be arrived at after you have considered your individual circumstances and objectives.

Appreciating Assets Part 1: Stocks and Bonds

The following is a guest post from Marotta Wealth Management. 

All assets are not equal. Some investments appreciate better on average than others. If you have $100,000 saved toward your retirement, how you invest it can make a difference in the likelihood and standard of living of your retirement.

Let's look at various investments over a 25-year time horizon. That span of time could be before retirement, say from age 40 to 65. Or it could be your retirement years from age 65 to 90.

We begin with equities, shares of stock in companies that earn a profit and grow their business. Equities could be individual stocks, stock mutual funds or exchange-traded funds (ETFs). On average, equity investments appreciate at a rate of 6.5% over inflation.

In the United States, inflation has been higher since 1970. It has also been officially underreported since 1996 when the government changed the way it calculates the Consumer Price Index (CPI). This lowered the official inflation figures by about 2% a year. But for the purposes of this article, I assume inflation is a constant 4.5%.

The stock market averages between 10% and 12% a year. But the annual return almost never falls in that range. Just look at the returns of the prior five years: 4.9%, 15.8%, 5.5%, -37.0%, and 26.5%. None of these fell even close to the 10% to 12% average.

This return comes partly from a 4.5% annual inflation and partly from a 6.5% real return over inflation. Add those two components together, and you get an average 11% return. When inflation runs higher than 4.5%, you may get a higher return, but you won't get increased purchasing power. In fact, all you will get is taxed on the larger capital gains caused by inflation.

The appreciation of equities produces an engine of growth. Over our 25-year period at 11% growth, our $100,000 initial investment grows to over $1.3 million. At this rate of return, our investment doubles every six years.

Two important reminders: First, equity markets don't provide a smooth return. Pick any 10 years over a century, and 6% of the time you will find returns that are zero or have losses in the S&P 500. Diversification helps, but the equity markets are inherently volatile, especially in the short term.

Second, the $1.3 million you end up with only has the buying power of about $483,000. Inflation eats the other $875,000. You also have to pay capital gains on the entire $1.2 million growth. With Congress raising the capital gains tax from 15% to 20% or even 25% because health care reform has passed, it hardly seems worth all the risk. But as we will see, the alternatives are worse. Economically, the capital gains tax should be zero. It would certainly produce more jobs than taxing business to pay for extending subsidies of people not working and calling it a jobs bill.

When planning with clients, I've found it much better to factor out inflation and not use inflated numbers. It is difficult to hear $1.3 million and mentally translate into the equivalent in today's dollars. So let's use a 6.5% real return and compare against our $100,000 growing into $483,000 over 25 years.

Some equities, although more volatile, can boost returns even higher. Mid-cap and small-cap stocks average higher returns. So do value stocks and emerging market stocks. If small-cap value stocks averaged 8.5% over inflation, your initial $100,000 would grow to a buying power of $769,000. And history suggests the small-cap value growth rate is even higher.

Equities are the engine of your retirement savings. Most of your savings should be invested to take advantage of this appreciation. Even in retirement, you need enough appreciation to keep up with inflation, pay the taxes and still have some real return left over.

The second largest portion of a good investment plan should be in stable assets such as fixed income. Fixed-income investments are most commonly bonds: individual bonds, bond mutual funds or bond ETFs. A stock means you own a piece of the company. A bond means you have loaned the company money, and it has promised to pay you back with interest. If the company goes bankrupt, you may not get your money back. And if the company does incredibly well, you will not have a share in that good fortune. The most you will get is what you put in plus the agreed-on interest.

Fixed-income investments are much more stable than equity investments. On average, however, they only earn about 3% over inflation. With inflation at 4.5%, fixed-income investments should be paying about 7.5% on average. With the Federal Reserve holding interest rates low, fixed-income investments currently are earning below their historical averages.

Your $100,000 investment earning a 3% real return would grow to a buying power of just $209,000 over 25 years. Again, although you might have $609,000, you would only have the buying power of $209,000. And you would have had to pay ordinary income taxes on the $400,000 of interest that just kept up with inflation.

But you should not tie a large portion of your assets up in fixed-income investments over 25 years. We recommend only having the next five to seven years of safe spending rates in fixed income were you to retire today.

At age 65, this strategy would allocate about 25% to stable fixed income and the remaining 75% of investable assets to appreciating equity investments. This is a higher equity allocation than many agents would suggest. They will earn their fee just as well off a bond fund as an equity fund. And they have found that investors don't notice the high fees as much if they have a lot in stability.

They might allocate 40% or 50% to fixed income instead of just 25%. But this reduces your return. Stocks average 6.5% over inflation. Bonds average 3% over inflation. Any mix between the two provides a blended return. So a 50-50 allocation has a 4.75% average return. And a 75-25 portfolio averages a 5.625% return.

Your average real return is this percentage minus the expense ratio charged by your investments. With low expense ratio investments from Vanguard or iShares, your expense ratio should be around 0.4%. Typical mutual fund selections have average expense ratios of 1% or more. The average 401(k) plan has even higher expense ratios.

So a 50-50 allocation from an agent selling funds with an average expense ratio of 1.2% produces an expected real return of only 3.55%. But a 75-25 allocation with an average expense ratio of 0.4% produces an expected real return of 5.62%. In our 25-year case study, your $100,000 portfolio only grows to have the buying power of $239,000 in the conservative portfolio with higher fees. And in the other case, it grows to $392,000. Those who combine playing it safe but suffering higher expense ratios retire on average with a lifestyle of only 61% as much.

The top-level asset allocation decision determines both the ultimate return you will receive and the volatility you will experience. Your investments should be working for you. They should appreciate more than inflation in order to be an engine of growth that pays you money and provides some measure of financial freedom. A combination of stocks and bonds with low expense ratios and a tilt toward stocks provides the best tuned engine of growth.

Anyone Use a Rewards Checking Account?

In case you haven't noticed, cash investments earn about nothing these days. As such, many people are looking for ways to make the best return possible on their cash and wondering what they can do to earn more than a paltry 0.5% or so. Well, enter rewards checking.

MSNBC details some rewards checking offers by regional and local banks. Of course the specifics vary from bank to bank, but you can earn up to 5% (yes, 5%!) on your money. How? Here's an example of the things you'd have to do in order to participate in one rewards checking plan:

• Make 10 to 12 debit card transactions a month.
• Accept electronic rather than paper statements.
• Set up direct deposit or at least one monthly automatic payment.
• Log on your account online.

If I could find one in my area, I'd be all over it! We already do the last three (I'd just have to change my direct deposit account) and I could easily make 10 to 12 transactions per month on a debit card (I'd keep them in the lower-price level so as not to impact my credit card rewards.) I'm going to have to start looking around -- 5% is nothing to sneeze at.

Or maybe it doesn't have to be in our area. Here are two lists of rewards checking accounts -- many of them offering accounts nationwide.

Anyone have one of these accounts? What do you have to do each month? How much do you earn?

Undercover at Free Financial Seminars

Kiplinger recently sent a writer to various "free" financial seminars to learn how to be a stock trader. He went to seminars hosted by three big trading-education outfits -- Online Trading Academy, BetterTrades, and Profit Strategies. The summary of his experience:

As I completed my journey, I couldn’t help but wonder why those who possess the magic formulas for successful trading would give away their secrets -- even if they did earn $4,000 or so per customer. After all, if you can earn 80% a year, why would you run the risk of seeing the effectiveness of your strategy diminish as more and more people started using it (a common occurrence in investing)? That aside, what’s clear is that if you decide to learn how to trade from any of these companies, you will need to have faith that your instructors know what they are doing and that you can convert their knowledge into winning moves. The odds will be against you.

Ha! My thoughts exactly!

He also commented on another company related to the three above:

In December 2009, Investools paid $3 million to settle an SEC complaint that two of its salesmen misrepresented themselves at seminars as expert traders.

Kinda reminded me of my experience with Investools over three years ago.

Finally, the author lists several reasons why it's hard to trade and come out ahead. They are:

• High costs
• Too much time
• Potential losses
• Tough competition

Exactly. Just another set of reasons why I'm sticking with index funds.

For those of you interested, last year I posted a book excerpt discussing "free" seminars. You might enjoy it.

Anyone out there been to any sort of free financial seminar lately?

Investment Costs Everywhere - Another Point for Index Funds

Here's a piece from MSN Money that asks if your retirement fund is leaking. Why would it be leaking? Because investing costs are eating away at it. Consider this:

In selecting mutual funds, most investors know to check the expense ratio, the standard measure of how much it costs to own a fund. U.S.-stock funds pay an average of 1.31% of assets each year to the portfolio manager and for other operating expenses, according to the fund experts at Morningstar.

But that's not the real bottom line. There are other costs, not reported in the expense ratio, related to the buying and selling of securities in the portfolio, and those expenses can make a fund two or three times as costly as advertised.

A study updated last year of thousands of U.S.-stock funds put the average trading costs at 1.44% of total assets, with an average of 0.14% in the bottom quintile and 2.96% in the top. Expenses are one of the most important things investors can look at, says study co-author Richard Evans, an assistant professor of finance at the University of Virginia's Darden School. "We find that our estimates of trading costs" are an important predictor of performance. While "some trading actually adds value," Evans says, high trading costs overall tend to have a negative impact on performance. On average, $1 in trading costs decreased net assets by 46 cents in this study.

What exactly are these costs? There are four main components: brokerage commissions, bid-ask spreads, opportunity costs and market-impact costs.

It certainly is hard to overcome a big cost disadvantage when investing. That 1% (or more) difference between the average actively managed fund and a decent index fund is HUGE -- especially when you're investing over several decades.

The cost advantage of index funds is one reason I like them so much. The index funds I use as my primary investments have expense ratios of 0.07%, 0.10%, and 0.27%. The Fidelity index fund I have my 401k invested in has an expense ratio of 0.07%. It takes a pretty good fund manager to overcome an almost 1.5% advantage that these funds have over an actively managed fund -- and that's why most don't beat index funds once expenses are accounted for. That's why I'm sticking with index funds all the way!!

Warren Buffett on the Best Investment You Can Make

The following is a guest post by Rich Avery from Life Compass Blog.

Warren Buffett, one of American’s wealthiest people, is famously followed for his investing views and strategies.  And why not?  As chairman of Berkshire Hathaway, Buffett has led his company, through acquisitions and investments, to exponential growth.  A $1,000 investment in Berkshire Hathaway in 1959 is worth $25 million today!

And yet Buffet, known as the “Oracle of Omaha,” is now talking about an investment that is even greater.  During the Q&A session at Berkshire Hathaway’s annual meeting in 2008, Buffett said:

The most important investment you can make is in yourself. Very few people get anything like their potential horsepower translated into the actual horsepower of their output in life. Potential exceeds realization for many people…The best asset is your own self. You can become to an enormous degree the person you want to be.

In an ABC news interview in July of 2009, when asked whether it is still important for families to send their children to college or higher learning, Buffett said:

Generally speaking, investing in yourself is the best thing you can do.  Anything that improves your own talents; nobody can tax it or take it away from you.  They can run up huge deficits and the dollar can become worth far less.  You can have all kinds of things happen.  But if you’ve got talent yourself, and you’ve maximized your talent, you’ve got a tremendous asset that can return ten-fold. 

He went on to say that he doesn’t mean that everyone should go to college.  And he added that learning communication skills are tremendously important for everyone.

Buffett recently appeared in an online animated series called the Secret Millionaire's Club in which he teaches kids about finance and investing.  Appearing on CNBC in July of 2009 to talk about this new venture, Buffett was asked, “What’s your hope that kids will take away from these episodes?”  His reply:

Well, one way or another you develop financial habits when you're very young.  And the habits you develop live with you for the rest of your life.  So if we can get through to some young people that it's better to be a little bit ahead of the game than behind the game, watch out for credit cards.  The most important message is that the best investment you can make is in yourself. Teaching them if something's too good to be true, it probably is, and so on.  If they learn those things the easy way through these stories early on, it may save them learning it the hard way later on.

…Like I said, the most important message you can deliver to a young person is that anything you invest in yourself, you get back ten-fold.  And nobody can tax it away, they can't steal it from you.  So we'll be trying to deliver those messages.  You have to do it with a good story.  They're not going to watch it to get a lecture.  They're going to watch it to get entertained, and in that entertainment we hope there can be a good message.

So, what are some of the best ways you can invest in yourself?

1. Create your own personal development plan.  A good one helps you define your preferred future (your dream life), clarifies your life’s purpose, evaluates your current reality in the basic areas of life (financial, family, career, health, spiritual, etc.), reveals your personal values for each life area (the beliefs that are important to you), sets well-defined goals, and creates a specific plan of action.

2. Be a lifelong learner.  Read good books and resources.  Take classes (formal or informal).  Attend webinars and listen to podcasts. But don’t stop there – you’ve got to apply what you read and hear, and take action! 

3. Surround yourself with people who will help you achieve your goals and dreams.  If you have friends or family who are downers all the time, or who don’t believe in you or your goals, get new ones.  I don’t mean that you replace your friends or family, but find some new ones to add to the mix.  We all need to have positive people in our lives.  And maybe you need a mentor or coach who can help you take action on your goals.

4. Improve your communication skills. Buffett mentioned this in one of the interviews.  Communication skills are extremely important today.  And not just in how to be a great speaker, but also a great listener.

What do you think about Buffett’s assertion that the best investment you can make is in yourself?  What do you think are some of the best ways to do that?

More Thoughts on Precious Metals

After our discussion about buying physical assets (which was quite lively and fun, BTW), I ran into this piece from Kiplinger talking about investing in precious-metals ETFs. Still, I'm not sure it's the right move. As many people pointed out, gold, silver, et al are neither stunning investments (unless you really time things right -- which is very difficult to do) nor great ways to guard against a total meltdown of the economy (one commenter noted that we need look no farther than Haiti to realize that food, water, and the like are more important than precious metals if everything goes to pot.) Besides, if you're thinking these investments may be needed in a financial emergency, isn't the way to own them physically -- so you have them on hand when the situation occurs? If everything melts down, shares in any ETF will either melt as well or certainly be hard to cash in.

But this isn't really the issue (at least I don't think it is.) For me, the reason to consider investing in precious metals is as a hedge against inflation -- especially rampant inflation. This piece from Yahoo touches on the issue of how to deal with a jump in inflation (caused by the massive deficits our country is racking up) as follows:

• Be very wary of long-term bonds.
• Make sure you are globally diversified and not entirely dependent on the U.S. economy and the dollar.
• Make the most of your tax shelters.
• Secure a cheap fixed-rate 30 year mortgage on your home while you can.
• Take a hard look at the risks in your portfolio.

Notice anything? No mention of investing in precious metals. Interesting.

I've already taken care of items #1, #3, and #4 (we don't have a mortgage), and I do have a decent chunk of my investments in international index funds. But I think I do need to re-look at my asset allocation and perhaps bump up the percentage devoted to foreign investments a little.

The issue I'm most grappling with is "take a hard look at the risks in your portfolio." This is why I'm asking questions, thinking about precious metals or perhaps even land as investments, and so on. I've ordered a few books for the library and will be learning quite a bit on the subject over the next couple months.

I'll let you know if I make any noteworthy moves...

Is It Possible to Beat the Market?

The following is a guest post from Paul Williams of Provident Planning.

The simple answer is yes - it is indeed possible to beat the market. People do it every day. I'm sure you've heard stories from friends or family members who have a market-beating stock broker or financial adviser. Maybe your uncle got a 150% return from his stock picks last year. There's no debating the fact that it is possible to beat the market.

The problem is that's the wrong question for investors to be asking. Yes, it's possible to beat the market. But the real question is this: is it possible to beat the market in the long run? When you're investing for retirement or other long-term goals it doesn't matter if you can beat the market for a day, a month, a year, or even five years. If you're going to try to beat the market, you need to be able to beat it for the entire time you'll be investing. If you aren't able to do that, you'll have wasted all the time, effort, and money you put in to trying to beat the market in the first place.

Why can I say that? Because one simple mistake can wipe away all those years of great returns and lucky stock picks.

My point is that long-term investors have to be focused on long-term results. I'm talking 20, 30, or 40 years - not 3, 5, or 10. If you're trying to beat the market, you need to know if it's possible over the long-term.

So here's my question for people who think they can beat the market. If 80% of professional mutual fund managers fail to beat their benchmarks, how do you expect to beat the market?

The pros spend every day studying their markets, screening stocks, and researching information. They have support teams and networks that you'll never be able to afford. They have inside contacts who can give them information just seconds after it has been released. Yet 80% of the pros still fail to beat their benchmarks (the market). How are you, with your limited time and resources, going to do better than they can?

It's clear that you'd be a fool to try to beat the market using your own strategy or ability to research stocks. But if you're not going to do it, you're left with two options.

1. Find someone else to do it for you.

2. Invest in a diversified portfolio of index funds.

So your first option is to find either a mutual fund manager, a stock broker or financial adviser, or an investment newsletter that will do all the work you can't do to help you beat the market. The problem is that finding someone to beat the market for you requires skill/luck on your part to identify that person in advance. Remember, you've got to find someone in that 20% group who's going to outperform the market. How are you going to do that? There is no reliable method to determine which professional is going to outperform the market.

Even after you overcome the hurdle of identifying the right person, you're still left wide open to the chance of underperformance. You're relying on humans to help you beat the market, but humans easily make mistakes. Consider Bill Miller (an often-used example) of the Legg Mason Value fund. Although he was able to beat the S&P 500 from 1991 to 2005, he lost to the market in 2006 and bombed in 2008. As of right now, the S&P 500 has outperformed the Legg Mason Value fund from 1991 to present (and the S&P 500 has handily outperformed the fund since 1986, the year the fund began). It's clear that even a pro with a good track record is susceptible to mistakes that will decimate the results of 15 years of effort.

Index funds remain the best choice for investors because of their simplicity, low-cost, and reliability. Picking a good index fund only requires you to compare a few key bits of information like the expense ratio, the underlying index, asset class, and any other costs. Because index funds don't require active trading, you get to enjoy lower costs and lower taxes - which will help improve your investment results. And finally, with index funds you know you will get results that match the index you're tracking minus your costs. You never have to worry about human mistakes erasing all the outperformance you may have received in the past.

They're not fun. They're not exciting. But index funds work and they'll give you consistent results compared to the market. I can't guarantee what the markets will do, but I can guarantee that a good index fund will match the performance of the markets very closely.

Five Things Every Investor Needs to Know

The Wall Street Journal lists five things every investor needs to know as follows:

1. A Good Run Will Not Last Forever.
2. Expense Ratios Vary Widely.
3. Other Fees Can Add Up.
4. Short-Term Gains Can Be Taxing.
5. Watch out for closet indexers -- actively managed funds that mimic an index (especially if they are charging high fees.)

True enough indeed.

As most of you know, I by-pass many (if not all) of these issues by investing in index funds. I have most of my investments in a handful of index funds designed to mimic the US stock market, the US bond market, and the international stock market. The investments are on auto-pilot with money going from my paycheck to my bank account to my investment account to a fund purchase every single month. Easy-peasy.

Now if I can keep this up for another decade, I'll be retired before I hit my mid-50's. ;-)

Anyone Buy Physical Assets?

I was at breakfast the other day when my friend (a financial advisor) said that he was buying lots of silver. He had it in both bars and coins and was getting it from a contact he had in Texas. No, he wasn't trying to sell it to me, it just came up in casual conversation. He said he was buying it as a hedge against inflation as well as in case of an economic meltdown. (FYI, he was storing it in his home.) He said he preferred silver because it had both investment value as well as utility uses (in manufacturing) and he felt it would hold its value no matter what happened with the economy.

A couple days later I talked to another friend and he noted how he was investing in commodity ETFs. I asked him about buying physical assets (gold, silver, platinum, lane, real estate, etc.) directly and holding them as a hedge versus future calamity, and his thoughts were that if the market/economy went that bad, nothing he/we could buy in physical assets would save him/us.

Currently, other than my home, all of my investments are in stocks or bonds -- no physical assets at all. I know that investments like these are often very illiquid, have a very long holding period, and are currently priced at or near all-time highs (like gold is), three big negatives IMO, but maybe I need to have some as part of my portfolio. Am I missing something?

Maybe those of you out there who are wiser can enlighten me and others about the pros and cons of investing in physical assets. A few questions:

• What's the reason/strategy for investing in them?
• How do you buy them and from whom?
• Are there alternatives (like buying stock in a gold mine versus buying gold)?
• What resources are there to learn more?
• What are you doing along this line of investing and why?

I've missed a ton of questions, I know, but these should get us started. Any advice out there?