Free Money Finance

Full-Service vs. Discount Brokers

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

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

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

Here's their description of discount brokers:

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

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

The Five Signs of Bad Financial Advice

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

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

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

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

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

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

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

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

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

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

Well said!

How to Make Your Child a Millionaire

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

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

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

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

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

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

Newborn

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

Age 5

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

Age 10

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

Age 15

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A few thoughts here:

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

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

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

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

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

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

• Create a simple, diversified asset allocation plan.

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

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

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

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

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

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

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

He's singing my song. ;-)

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

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

Keeping your portfolio simple can save time and money.

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

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

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

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

How to Pay Yourself First

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

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

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

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

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

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

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

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

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

Five Keys to Investing Success, Key #5: Diversify

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

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

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

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

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

• How to Find Money to Invest

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

• Take These Steps before You Start Investing

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

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

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

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

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

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

• Take These Steps before You Start Investing

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

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

• How to Find Money to Invest

The Two Benefits of Diversification

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

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

• Diversification helps increase your return at the same time.

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

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

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

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

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

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

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

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

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

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

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

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

• How to Find Money to Invest

• Take These Steps before You Start Investing

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

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

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

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

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

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

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

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

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

Minimize Taxes to Maximize Your Investment Return

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

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

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

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

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

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

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

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

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

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

More Quotes about the Effectiveness of Index Funds

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

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

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

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

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

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

For more thoughts on investing, see these links:

• Best of Free Money Finance: Investment Posts

• Take These Steps before You Start Investing

• Costs Matter If You Want to Maximize Investment Returns

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

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

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

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

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

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

• Getting Rich is Simpler than You Think

• Start on Your First $1 Million at Age 16

• The Power of Compound Interest

• Key #2: Set Exciting Goals

Quotes about the Effectiveness of Index Funds

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

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

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

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

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

For more thoughts on investing, see these links:

• Best of Free Money Finance: Investment Posts

• Take These Steps before You Start Investing

• Costs Matter If You Want to Maximize Investment Returns

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

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

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

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

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

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

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

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

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

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

How Much of Your Salary You Need to Save

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

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

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

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

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

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

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

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

Why Indexing is So Effective

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

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

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

For more thoughts on investing, see these links:

• Best of Free Money Finance: Investment Posts

• Take These Steps before You Start Investing

• Costs Matter If You Want to Maximize Investment Returns

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

What's Going on with DIS?

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

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

No, the news is bad:

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

No, the news is mixed:

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

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

A couple thoughts on it:

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

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

How Investing is Different from Most of Life

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Two Most Important Things Any Investor Can Do

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

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

See why I love this book? ;-)

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

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

How Much to Invest in Stocks

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

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

A few thoughts from me:

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

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

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

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

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

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

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

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

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

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

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

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

How to Find Money to Invest

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

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

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

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

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

3. Go to the Right Garage Sales

4. 20 Ways to Save Money on Your Car

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

6. Free Money Finance Guide to Making More Money

Bond Basics

Here's a piece courtesy of Marotta Asset Management on the basics of investing in bonds:

Bonds are boring. But smart investors use them for diversification. Understanding some basics will help you evaluate the risks and rewards of owning bonds in your portfolio.

What is a Bond?

A bond is essentially an "IOU." You become a bondholder when you lend money to the government, a corporation, or a municipality. In exchange for your money, the bond issuer promises to pay interest periodically and repay principal equal to the bond's face value at the end of a specific time period.

Consider a company that needs to build a new facility costing $2 million. The company decides to borrow the money to fund construction by issuing 2,000 bonds for $1,000 each to investors. In this case, $1,000 represents the "face value" of each bond. Prior to issuing the bonds, the company takes into account market factors and establishes an annual interest rate, or "coupon," that it will pay on each bond to entice investors to purchase them. The company also determines the bond's "maturity," the date when it will repay the face value to the bondholders. So, if the company decides to issue 5-year bonds paying a 6% coupon, then each holder of a bond can expect to receive $60 per year in interest income ($1,000 face value x 6% coupon rate) plus the $1,000 face value at the end of five years.

The Bond Market

When an entity such as a corporation issues bonds to raise money, it does so through an initial offering in the primary market. Most bond buyers at the primary offering are large institutional investors such as broker-dealers and mutual funds. After the initial offering, bonds trade freely between investors in the secondary market much like stocks do. As an individual investor, you are usually buying your bonds in the secondary market from another investor who wishes to sell before maturity. A bond's price in the secondary market fluctuates daily around its face value to reflect changes in market interest rates.

Consider a bond from our example above. At the initial offering, its face value is $1,000. If you missed out on the initial offering and want to buy this bond in the secondary market, you may be able buy it for its $1,000 face value. More likely, you will be buying it at either a "discount" to face value or at a "premium" to face value depending on whether market interest rates have gone up, down, or stayed the same since the initial offering.

For example, the same $1,000 face value bond could now be valued at $900 (at a $100 discount) or valued at $1,100 (at a $100 premium) in response to interest rate changes. However, regardless of its current price, the bond still pays $60 in annual interest. The fact that you can buy a bond in the secondary market at a price different from its stated face value is one of the main sources of confusion about bonds.

Bond Prices and Interest Rates

Bond prices fluctuate daily in response to both changes in market interest rates and the credit quality of the underlying issuer. As a bondholder, the most important concept to be aware of is that the price of a bond has an inverse relationship to changes in the market interest rates. If market interest rates rise, then the price of an existing bond will likely fall because it pays a lower rate than you can earn by buying a new bond in the market.

Let's say your $1,000 bond paying 6% matures in 5 years. One year after you buy it market interest rates rise to 7%. Your bond is now worth $966. Why? If you now want to sell your bond in the market, the price must fall to a point where another investor can earn 7% by buying it and holding it to maturity in 4 years.

Conversely, if market interest rates fall, then the price of an existing bond will likely rise because it pays a higher rate than you can earn by buying a new bond in the market. Using the example above, if market interest rates fall to 5% one year later, your bond is now worth $1,035. You can sell it for a capital gain or keep it and earn 6% until maturity.

Changes in interest rates do not affect the prices of all bonds equally. The longer it takes for a bond to mature the more sensitive the bond price is to interest rate changes. The longer your interest rate is locked the better or worse it is when interest rates change. Therefore the price of a 20-year bond moves up and down more than a 2-year bond when rates change. If you plan to hold your bond to maturity, these changes are on paper only and represent the value of your bond in relation to the new bonds you could invest in.

Bond Risks & Returns

Bonds are not risk free. When you loan your money you have three risks. First, your purchasing power could be lost through inflation by the time your bond matures and you get your money back. Second, your bond could be worth less than your purchase price if you need to sell your bond before maturity and interest rates have risen. And third, the bond issuer could default, stop paying interest and fail to return your investment. Each of these risks can be reduced through diversification just as diversifying your stock investments reduces risk. Diversification of don investments is done by purchasing bonds with different maturities, credit qualities, industries and countries.

Bonds are like the iron rods put in the bottom of sailing ships. They don't make the ship go faster, but they do keep the ship from capsizing in stormy weather. Bonds can keep a portfolio afloat in stormy markets, and can actually boost return in volatile markets.

All About the P/E Ratio

Here's a piece courtesy of Marotta Asset Management that details everything you need to know about the P/E ratio:

Stock brokers and investors often look at certain fundamental information about a stock when determining if that stock is a good stock to purchase. One of those fundamental indicators is the "P/E ratio" of a stock. While we favor low P/E stocks, often called value stocks, buying a stock simply because it has a low P/E is like assuming a car is fast because it has racing stripes and a number on the side.

The P/E ratio is the ratio of a company’s share price (P) to its earnings per share (E). The most common way of computing this number is by taking the current share price and dividing by the earnings per share from the last 12 months. This is known as the trailing P/E because it uses the actual historical information from the last four quarters. For example, recently General Electric (GE) was trading at 34.44 and had earnings per share (EPS) the previous year of 1.61 for a P/E ratio of 21.4.

Now, imagine a company—we’ll call it "Old-Fashioned" — whose stock is trading at $40 and has trailing earnings of $4 a share. This company’s P/E ratio is relatively low at 10. Assuming that the company’s earnings did not change, it could afford to pay a dividend of $4 a year per share. Even if the stock’s share price did not appreciate, shareholders would receive 10% of their investment back every year in dividends. In ten years they would be repaid their original investment and still own their shares of stock.

In very simplistic terms, a stock’s P/E ratio is a measure of how long it would take at the current level of earnings to be repaid for your investment. Said another way, the P/E ratio tells you how many dollars you have to invest to receive $1 in earnings.

Imagine another company—we’ll call this one "New-Fangled" — whose stock is trading at $40 and has trailing earnings of only $1 per share. This company’s P/E ratio is relatively high at 40. Assuming the company’s earnings did not change, it would take 40 years for the earnings to justify the stock’s purchase price.

Let’s assume that New-Fangled’s sales are projected to double each year for the next ten years. Although last year’s earnings were only $1 a share, next year they are projected to be $2 a share. The leading or projected P/E, which uses the estimated earnings expected over the next four quarters, would be 20. And if the doubling of earnings each year actually happens, the stock’s purchase price would be more than compensated in five years.

In fact, even if New-Fangled’s earnings only double for the next two years and then stop, it will end up with a P/E ratio just as good as Old-Fashioned’s P/E ratio.

While both stocks are trading at $40 per share, Old-Fashioned is assuming flat or declining sales while New-Fangled is assuming a measure of growth in company earnings. Given everything that is known about these two companies, the market has priced each stock appropriately.

However, if Old-Fashioned maintains its market share, or if it doesn’t decline as much as was expected, the stock price could go up with the realization that earnings won’t be declining. On the other hand, if New-Fangled reports earning growth of 30% when the markets were counting on 50%, the stock price could plummet.

Each stock ends up trading at where the markets find equilibrium. Investors are willing to pay more for the earnings from companies with better growth prospects. That’s why investors may be willing to pay $40 for every $1 of earnings that a growing company generates.

P/E is a better indicator than stock price of how cheap or expensive a company’s stock actually is. Stocks with high P/E ratios are expensive, even if their share prices are low. A stock’s share price changes with splits and reverse splits, but these do not change a stock’s P/E ratio. The P/E ratio is a better indicator for the cost of buying an earnings stream.

Stocks with a rising P/E ratio could be considered more or less speculative depending on your perspective. Stocks with a constant low P/E ratio have no prospects for growth and are risky because they are unlikely to improve their earnings per share. Stocks with a high P/E ratio, on the other hand, are considered by investors to have good prospects for growth. They are risky because there is a chance they won’t deliver the growth of earning that investors are counting on and then their share price will plummet.

Since a company’s prospects for growth affect the multiple of earnings that investors are willing to pay for a stock, some industries have lower average P/E ratios. The growth of gas utility companies is very limited; hence the average P/E ratio of that industry is currently 9.8. Internet Information Providers, on the other hand, have an average P/E ratio of 54.

This explains why companies like Google (GOOG) and Yahoo (YHOO) have P/E ratios of 59 and 30 respectively.

On July 19th, Yahoo’s stock price fell 21.8% in a single day even after announcing solid second quarter results that met analyst estimates.

The drop caused a corresponding drop of Yahoo’s P/E ratio as investors lowered the expectation that Yahoo will be able to keep its market share. Yahoo still has a larger share of the Internet audience but Google is gaining ground.

Yahoo makes more money than Google in visual advertising, but search advertising has become the larger market. Investors are betting on Google. Currently Google gets 49% of the Internet search engine traffic verses Yahoo’s 24%. That’s why the value of Google’s stock is about $124 billion, over three times Yahoo’s value of $35 billion.

On the other end of the spectrum, Exxon Mobil (XOM) had a P/E ratio of 10. Chevron (CVX) had a P/E ratio of 8. Conocophillips (COP) had a P/E ratio of 5. Although the oil and gas industry has had phenomenal profits in the past year investors don’t think they will last. The markets have discounted the value of these past profits and are pricing these companies as though they expect their earnings to shrink.

While we recommend over-weighting stocks with low P/E ratios, your portfolio should include a broad spectrum of stocks, including a generous helping of growth-oriented stocks. Balancing your portfolio can be a simple and straightforward process, if you have the tools and experience. On your own, it may be as difficult as using a hammer to adjust your car’s timing belt.

Take These Steps before You Start Investing

Here are three great tips from the wonderful book The Bogleheads' Guide to Investing (I LOVED the book -- see my rating for details) on the steps you should take before investing:

1. Graduate from the paycheck mentality to the net worth mentality.

2. Pay off credit card and high-interest debts.

3. Establish an emergency fund.

See why I love this book? ;-)

Here are my comments on each of the above:

1. I look at this issue as making two key points. First, you need to spend less than you earn. Second, you must realize that wealth is what you save, not what you spend. This starts with knowing, measuring and tracking your net worth. Want some tips of how to do this? See How to Compute Your Net Worth and Check Your Financial Progress.

2. Paying off credit cards and other high-interest debts is money in the bank. It's like earning a 20% investment return -- which is pretty good, after all.

3. If you don't have an emergency fund, you'll need to charge/borrow when financial emergencies arise (which they always do), which puts you back into a hole. If you don't have one, you need to get an emergency fund now.

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

On my post titled Become a Millionaire by Trading Sparingly and Investing for the Long Haul. I had a couple of good comments worth sharing with all of you. The first reinforced the idea that it's wise to trade sparingly and invest for the long haul:

That makes perfect sense; I think the people who call their brokers each morning to find out how London did are either afraid of the internet or have so much money that they're investing all over the globe that they need to call their broker to find out what's going on. In which case they're probably good friends with their broker.

Over time I've come to realize that the long haul is what's important.

Yep, me too. I focus on good, simple, easy-to-manage investments. That's why I like index funds.

The second person validates the suggestions through practical experience. Here's his comment:

I use to do a lot of trading. I was even into options trading, selling covered calls, and a lot of day trading. You can win big and then you get really confident and you start to trade bigger positions of stock and then you get a major down day or down week. So the ups are great and the downs can be really bad. I also ran out of time, my job has become more and more demanding and I travel about 25% of the time. Therefore, you end up not having enough time to watch the investments. I have since switched to using a financial planner. I figure if I would have earned 5 to 6% on my investments over the last 5 years I would have been way ahead. Instead I am still writing off my capital loses from times when I made large bets and things went wrong.

I must admit that I learned through the school of hard knocks myself -- though not to this extent. I traded stocks regularly for years, thinking I always knew better than anyone else how a company was going to perform. Needless to say, I lost a fair amount of money. But I then discovered index funds, dollar-coat averaging, and automating my investments and it's been all good since then.

Free Morningstar Stock Research

I received this email last night and thought you all would be interested:

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If you're interested in getting some good, free research on stocks, visit their site in the next couple of days. It's hard to beat Morningstar when it comes to stock research.

What Is A Contrarian Investor?, Part 2

Here's a piece courtesy of Marotta Asset Management on what it means to be a contrarian investor. This article is written by David John Marotta, President of Marotta Asset Management:

Much of my financial instincts were developed watching my parents manage money on a daily basis. Even now, one of the highest compliments that I can be paid is for someone to say, "The apple didn’t fall far from the tree." Last week my father authored specific examples of contrarian investing. This week I’d like to show how contrarian investing is at work when you regularly rebalance your portfolio.

A contrarian is an investor who buys a category when most others are selling and sells when others are buying. A contrarian doesn’t chase what is hot, but is often buying a category that has recently underperformed.

Major news sources move markets just by the tone of optimism or pessimism they adopt. The financial news is often focused on daily price movements and like all sports trivia, it tends to emphasize winning or losing streaks.

Stock prices can move on very low volume if the volume is all in one direction. Even if the vast majority of those who hold stocks are continuing to hold them, if even a few investors are motivated to buy or sell the price moves significantly.

In the long term, the markets are brilliant at setting appropriate stock prices. In the short term, though, they have the IQ of a gnat. There is so much opportunity in the markets that even conservative investors get swayed by the siren songs of greed or fear. The strait between Sylla and Charybdis are a narrow path safely navigated only if you have a nymph like Thetis to guide you.

In the financial world your Thetis is a long term investment strategy and discipline that purposefully avoids moving in one direction. Not following the crowd is the definition of being a contrarian. And the cornerstone of being a contrarian is rebalancing your portfolio regularly.

Imagine you have a $100,000 portfolio consisting of two different categories called A and B. Your wise financial advisor suggests diversifying your portfolio by investing half in each category. At the end of the first year, Category A has earned 30 percent and Category B has just broken even. You now have $115,000: $65,000 in Category A and $50,000 in Category B.

You are happy with your investment in Category A, but you still aren’t sure about Category B. All the financial news is about Category A’s stellar returns, how the industry is booming, and how Category A’s products are essential to life on this planet. The news is also about the slump in Category B. No one is buying their products. They are laying off employees, firing CEOs, and facing a wall of pending indictments and lawsuits.

To make matters worse, your neighbor to the right works in Category A and his 30 percent investment returns is all he can talk about. Your brother-in-law is dumping all of his investments in Category B and adding to his investment in Category A. So, you call your financial advisor and ask if you should make some adjustments in your asset allocation as well.

"Yes," answers your financial advisor, "You should sell $7,500 of Category A and invest that in Category B." You are stunned. Your first thought is that your investment advisor is so stubbornly enamored by Category B that he won’t admit his mistake and insists on pouring more of your investment gains down the drain.

While you are not convinced by this ‘asset allocation’ strategy you decide to give it another try. So you sell some of Category A and buy more Category B. Now you have $57,500 invested in each.

Fortunes change. The layoffs and new leadership in Category B return profitability and the industry begins to recover. Stock prices, which were beaten down because of losses rebound from their lows, and Category B gains 30 percent the second year.

Meanwhile, Category A’s growth falters. Stock prices had been driven up from new investments and were now pricing the company for 30 percent annual growth. When the industry of Category A only experiences 15 percent growth, the stock prices falter and appreciation ceases. Despite 15 percent growth, current stock valuations are barely justified and drift sideways for a 0 percent gain for the year.

Your brother-in-law and your neighbor to the right are tight-lipped.

Your neighbor to the left, however, is ecstatic. He works for a company in category B. Not only is his company doing better, his investment made a 30 percent return this past year!

You are happy, but not ecstatic. You’ve never gotten a 30 percent return. You return to your investment advisor and ask him, "If you knew that Category B was going to do well, why didn’t we put all the money in that category?"

"I didn’t know Category B would do well," your advisor admits. "But when a good category falls out of favor with investors, rebalancing your portfolio is automatically a contrarian investment. Your portfolio returned 15 percent the first year and 15 percent the second year. Unlike your neighbors, the second year’s gains compounded with the first year's gains to produce a total gain of 32.5 percent"

You are stunned. The simple contrarian act of pulling money out of the investment which was the darling of the industry and investing it in the dogs of the industry boosted your two-year returns by 2.5 percent. Not only did your investments do better than your neighbors’, but you avoided the feast or famine volatility inherent in their approach.

As a financial advisor I can often foresee which category will perform the best over the next year by which category new clients are the most reluctant to invest in. It is tough being a contrarian, but investing in beaten down categories is too important for your investment returns to let emotions get in the way.
--------------------------------------------------------------------------------
As you might imagine, I'm not really in agreement with the thought that financial advisors are "in the know" and the rest of us aren't when it comes to investing, but I do agree with his philosophy as it relates to contrarian investing.

What Is A Contrarian Investor?

Here's a piece courtesy of Marotta Asset Management on what it means to be a contrarian investor. This article is written by George Marotta, the founder, senior advisor and a portfolio manager with Marotta Asset Management, Inc. and a Research Fellow at the Hoover Institution, Stanford University in northern California:

A contrarian is one who takes a side different from the masses. When everyone is going in one direction, a contrarian chooses to go in the other direction. I confess. I am a contrarian. In investment terms, it is difficult to be a contrarian. Here are some examples.

In the spring of 2000, most investors were buying the Standard and Poor’s 500 stock index fund. This index fund had been outperforming most mutual funds that were run by trained and highly-paid portfolio managers. The success of this fund kept attracting more and more money from investors during the five-year period running up to 2000. This fund was and still is a capitalization-weighted fund. In other words, the majority of dollars coming into this fund went into the biggest companies in the index such as Microsoft, Cisco, etc. And guess what? When the bubble finally burst in 2000, that fund and those stocks took the biggest dive. Since then, the small and mid-cap stocks (non-500 stocks) have been outperforming the big boys. In 2000, contrary to "the crowd," I was not investing in that index or in tech stocks.

After the market peak in 2000, the NASDAQ Index declined more than any other stock index, falling from over 5,000 to below 1,700 in 2003. Tech stocks that had been stratospheric became very, very cheap. For example, during that correction period, I bought Yahoo for $4.50 a share (it had been as high as $120 and is now $25). I also bought Corning Glass Works for $2.50 (it had been $110 in 2000 and is now $19). And Williams Companies was almost bankrupt because it got caught up in the fiber-optic craze and overextended itself with capital spending. The stock had been $45 in 2000, and I bought it for $2.30 in 2002 (and it is now $22).

Let’s scroll ahead to today. What are the masses buying? Oil stocks, of course, because the price of oil has been going up steadily from $20 a barrel in 2002 to about $75 today. So everyone is thinking that investing in oil is a great buy– a sure winner. However, nothing goes in one direction forever.

So, how can one benefit if the price of oil goes down? The answer is: invest in things that use and depend on oil. I have been taking profits and trimming my positions in oil stocks and have started to invest in airlines and automobile companies. I know that I am sometimes early in my buys, but time will tell. These are speculative investments suitable only for a portion of someone’s portfolio if they have a high risk tolerance.

Investors always talk about their winners, as I have just done. After 9/11, I made a "contrary" purchase of stock in several cruise companies that looked very cheap. Two purchases turned out to be great bargains, but one—Classic American Voyages— promptly got a lot cheaper because the company went bankrupt a short time after my purchase.

Looking at foreign stocks, the markets that are doing the best today are the former communist countries. Communism made these countries so backward that a little entrepreneurial spirit is fueling extremely fast development. The end of communism is even benefiting some states that were socialistic, with a lot of central government control and high tariffs. Those countries are doing well as they reduce government control. I am investing heavily in "emerging-market" countries.

Just think, if you can look ahead to the next country that will shed communism for free markets, you could make a mint. Think in terms of Cuba and North Korea. As soon as Cuba abandons communism, rush in and buy real estate. That tropical paradise is going to bloom and boom when Castro’s dictatorship comes to an end.

If you look at the Korean peninsula at night from a satellite, you can clearly see where the 38th parallel (the division between North and South) is located. You can see light shining at night in the south while it is pitch black in the north. Someday, the north and the south will be one country again. How could one benefit from that? I say, invest in the Korean Electric Company located in South Korea. They know how to produce light and make a profit. And, they will sometime (soon, I hope) bring light to the north.

The iShares Morgan Stanley Capital International Emerging Markets Index (EEM) is a good way of investing in international markets. And the Korean Electric Power Corporation happens to be the eighth largest holding, accounting for nearly 2 percent of the market cap of the iShares MSCI Emerging Markets Index (EEM).

Let’s see... what else has been going up for a long time? Oh, yes, real estate! It looks like it is beginning to level off and decline a little. Let’s hope that the decline is gradual because it has been fueling the US economy for the past five years as the stock market has been correcting. Be a contrarian. If you are heavily invested in real estate, congratulations as you have made a bundle. But, if you are a real contrarian, you will begin to lock in those high prices. Remember this cliché, but truism, "Nothing goes in one direction forever."

It’s tough being a contrary investor. It means buying at a time of maximum pessimism and selling at a time of maximum optimism. It is a lonely position, but it is exciting….and sometimes profitable (more than not, I hope). A savvy Rothschild banker once gave this "contrary" advice: Buy when there is blood on the street and sell on the sound of the trumpet.
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A couple thoughts on this from me:

1. I consider myself a contrarian investor, though much of what I have invested is in index funds (not the most contrary investment option.) But I don't listen to the crowd much and like to move against the flow, so that's why I consider myself a contrarian.

2. It's really, really, really hard to be a tried and true contrarian. To buy when the market is falling like a rock is a difficult thing to say the least. I remember the first few days after 9/11 when the market opened and fell rapidly. I bought and bought and bought. It all turned around rather quickly, but it was nerve-racking to say the least -- to put money into the market and watching it become worth less almost immediately. Now it's a bit easier for me as I have everything automated, so investments happen every month automatically, no matter what the market is doing.

Socially Responsible Investing

Here's a piece courtesy of Marotta Asset Management about socially responsible investing. I don't agree with their take on the S&P 500's worth as an investment vehicle (as you know, I like index funds, and the S&P 500 has been a good part of my index investing plan), but I do agree with their thoughts on socially responsible investing (which may surprise some readers.) I'll comment more on this at the end. For now, here's their article:

The oldest socially responsible index is called the Domini Social 400. The index screens stocks it considers inappropriate out of the S&P 500 and then adds favored companies from the Russell 1000. Using the S&P 500 Index or a similar derivative as the backbone of your investment portfolio is a risky strategy that increases the danger of you failing to meet your financial goals.

Socially responsible investing based on deleting stocks from the S&P 500 only amplifies the inherent weaknesses of the S&P 500 as an investment index. Many of the stocks that are deleted from the S&P 500 are value stocks and not growth stocks. As a result, the Domini Social Equity fund (DSEFX) is overweighted towards more expensive (high P/E) growth stocks and has a portfolio beta slightly greater than 1.00. Volatility is greater than that of the S&P 500, which can increase your portfolio risk.

If the S&P were a financial advisor it would say, "Let’s buy mostly large cap growth stocks in the industry that did well last year with a high price per earnings ratio." This advice results in a very aggressive and very volatile portfolio that does better at the end of a bull market than at the beginning. And it will do very poorly at preserving capital during a prolonged bear market - exactly what happened over the last six years.

During the last half of the 1990’s, socially responsible investing could claim its returns beat the S&P 500, but the cause was better attributed to increased risk than to social consciousness. In 2000, when growth fell out of favor and value came back into favor, the Domini Social Equity fund started underperforming the S&P 500 significantly and still has not recovered.

The weaker returns can be attributed in part to the screens eliminating more value stocks. Another drag on returns is the fact that socially responsible investment products typically have higher expense ratios. The Domini Social Equity Fund, for example, has an expense ratio of 1.13% and a 12b-1 fee of 0.25% for a total expense ratio of 1.38%. By comparison, iShares S&P 500 Index Fund (IVV) has an expense ratio of 0.09% and the Vanguard 500 Index Fund (VIIIX) has an expense ratio of just 0.18%.

Often, socially responsible funds fail to meet our investment criteria which include several different factors in addition to expense ratio. In only four of the last twelve quarters has Domini Social Equity scored in the top quartile of large blend funds, and in six quarters they scored in the third quartile according to the Center for Fiduciary Study’s ranking. Its three year average score is 40 on a scale of 0 (perfect) to 100 (worst).

One of the problems with socially responsible funds is that they are not always a financially responsible way to best ensure that you reach your goals. Socially responsible funds rarely use the criteria that an informed investor would use. Most avoid "sin" stocks such as gaming, liquor and cigarettes. Few people dislike cigarettes as much as I do, having lost close family members to cigarette-related illnesses, but even these simple screens are suspect.

Altria Group (MO), formerly Philip Morris, changed its name and its business structure when it purchased Kraft Foods and expanded its business to include product lines in 99% of American households. It is more harmful not to buy a company’s products than it is not to buy their stock, but it seems ludicrous to punish Altria for expanding its business model to include healthier products.

On the other end of the spectrum, last year, Pax World fund (PAXWX) sold its entire position of 375,000 shares of Starbucks Coffee (SBUX) worth $23.4 million just because Starbucks entered into a deal to sell a coffee-based alcoholic beverage. There are much worse sins than putting a little whiskey in your coffee.

If you put so many constraints on your portfolio that you cannot meet your financial responsibilities, then you have taken the speck out of your brother’s eye but failed to notice the log in your own eye. It is impossible to create as well diversified a portfolio using funds that claim to be socially responsible as it is to use the full spectrum of investment options.

While the number of fund’s claiming to be socially responsible has grown, the contradictory natures of their screens have also become apparent. Some funds will only invest in company who support homosexual marriages while other funds shun those exact same companies.

One fund refuses to buy any companies involved in the extraction of natural resources, which has been a top-performing sector over the last few years. Energy, mining, and lumber companies are eliminated entirely in this particular fund’s screens. Even the process of putting together the fund’s annual report would be impossible with that screen. From the electricity for the fund’s computers to the staples that hold the recycled paper pages together, the fund is willing to buy the products of the companies whose stock it refuses to buy.

Nearly every company has positive and negative aspects. Take, for example, Southern Peru Copper Corporation (PCU). Many mining companies are excluded on environmental issues alone. Southern Copper has been working at modernizing its smelting process in order to satisfy the company’s environmental agreement with the Peruvian government. Should an advisor shun investing in those electronic companies that purchase from the most inexpensive source of copper, often the company with the worst environmental process?

Because of its extremely high conductivity, sixty percent of copper is used in electrical and electronic goods. Even if an investor decided not to invest in Southern Peru Copper Corporation, it is unlikely that an advisor or client would go as far as boycotting purchasing the electronics that cause the demand for copper in the first place.

Seeking to use your investment selection in order to be socially responsible is misguided. Though it may assuage a guilty conscience, it is an ineffective tool for corporate change. While it gives the appearance of taking a stand for certain values, it dodges the difficult issues that shareholders bear.

The importance of handling your finances as a responsible steward is usually not best served by utilizing funds claiming social responsibility. While there are companies whose business may best be avoided, delegating that selection criterion to a fund’s screening process is like use a blunt instrument to do brain surgery. Better is having a financial advisor who gets to know you personally and manages your finances according to your specific values.
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There are (generally) two schools of thought when it comes to socially responsible investing:

1. You should not invest in companies who "do harm" (whatever your definition of "harm" is -- it may include beer, cigarette, non-green, non-benefits for same sex partners, etc. -- the definitions vary from person to person.) By not investing in them, you are not supporting them (not giving them your money.)

2. Unless you have really, really, really big bucks, any investment you make in a stock is going to have virtually zero impact on a company (for instance, if you buy 100 shares of Altria, that purchase doesn't impact the company in any meaningful way.) As such, you should invest in whatever companies you like regardless of what they do, then use your profits (which have been maximized using this approach) from investing to give to causes you support that "do good." (Again, however you define "good.")

I use a modified approach, but I'm more on the side of #2 than #1. I don't invest in certain companies that are questionable ethically in my mind (and whose products I would never use), but it's more because they aren't good investments rather than they make "bad" products. Those companies are going to exist and do business whether or not I invest in them, and if they were good investments, I'd put money into them, make a good amount, then use part of the proceeds to help out causes I believe in. I'd see it as "turning bad money into good money."

So, what do you think about this issue?

The Best Investing Book of All Time

Here's the next item I wanted to cover from Kiplinger's "The Best List" (November issue.) Today, we're highlighting the best investing book of all time:

The Best Investing Book of All Time: The Intelligent Investor

Before Benjamin Graham, stock investing was about as scientific as astrology. Graham, who died in 1976, pioneered security analysis and propounded the notion that a stock's price should have some connection to the underlying company's actual worth. He condensed his vast knowledge into The Intelligent Investor, a book first published in 1949. Among his timeless suggestions: Seek to buy a stock at a price that is well below the company's intrinsic value. The Intelligent Investor dispenses timeless advice for less than $20. Now that's a good value.

I haven't read the book for quite some time, but I do remember it being "good." However, I'd say that The Bogleheads' Guide to Investing is more where I'm at in my investing style and I'd rate it just as good as this "classic."

Then again, it's hard to argue with the teacher/book that gave us Warren Buffett.

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

What I Invest In

On Tuesday I had a comment from my friend at FiveCentNickel to my post titled The Best Stock to Put Away and Forget. He asked:

What's the balance between individual stocks and mutual funds in your portfolio? I know that you're a huge fan of Vanguard index funds, but you also seem to own a number of individual stocks, as well. Maybe this would be a good topic for a forthcoming post...

It is a good topic for a post! And since I've thought about doing this for some time, his question is just what it took to get me to do so. So here goes:

• My portfolio is located within several accounts -- retirement accounts (401k at work, past 401ks that have been rolled over into IRAs, SEP IRA) and taxable accounts (with Vanguard, E*Trade, and Ameritrade.) In addition to these, I have investments in real estate through an LLC and, of course, in my own home.

• From these funds, I try to make my overall portfolio hit the asset allocation I want, so any one account is not the proper asset allocation -- but they are in total.

• Currently, I'm about 90% in stocks and 10% in bonds. I have a long-term investment time horizon (20+ years) and am a rather aggressive investor anyway, so this split makes sense. I am NOT recommending it for you. (you have to decide on that yourself)

• There are three pots I put my money into -- index funds, mutual funds, and individual stocks. Roughly, the split breaks down as follows: index funds (65%), non-index mutual funds (20%), and individual stocks (15%).

• Index funds are the staple of my investing strategy and are growing as a percentage of the total since I dollar-cost average into them every 30 days. For why I invest so much in them, see Why I Like Index Funds (Updated).

• I use non-index mutual funds to 1) add more international exposure to my portfolio 2) invest in bonds 3) give me a bit more growth/value stocks than my index funds do and 4) take part in a few investment strategies I find interesting/potentially fruitful. I'm aware that international funds, bonds, and growth/value stocks can be purchased through index funds too, and I'm actually moving more of this money into them. I'm just spacing it out a bit since many of these funds are older and have grown quite a bit -- so selling them gives me a big capital gains hit.

• As for individual stocks I own and why, that's for another post (or series of posts). But to see some of them, check out Update on My Three CEOs and The Best Stock to Put Away and Forget. And, for my overall thoughts on investing, check out Best of Free Money Finance: Investment Posts.

The Best Forum to Chat with Other Investors

Here's the next item I wanted to cover from Kiplinger's "The Best List" (November issue.) Today, we're highlighting the best forum to chat with other investors:

The Best Forum to Chat with Other Investors: ClearStation.com

Stock message boards are essentially online hangouts where users hash over their favorite -- and not-so-favorite -- stocks. Postings can be insightful, but they can also be freewheeling and frivolous. ClearStation.com, run by E*Trade Financial, lets you search for posts by ticker symbol. A rating is assigned to the author of each post, based on what other users think of the author's picks and comments.

I'm not a big message board user -- especially when it comes to investing -- so I don't really have a comment on this one other than the fact that it's owned by E*Trade doesn't make me want to run and check it out. But I'm sure some of you out there use it (or have in the past) -- what do you think?

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

The Best Online Investing Site

Here's the next item I wanted to cover from Kiplinger's "The Best List" (November issue.) Today, we're highlighting the best online investing site:

The Best Online Investing Site: Yahoo Finance

Many have tried, but none has been able to match the depth and utility of Yahoo's investing portal. Type in a ticker symbol and you are instantly linked to virtually every public piece of information available about a particular stock. In fact, the strength of the web site is its clean design and smart linking, which allow you to find what you need without getting lost -- or suffering intrusive ads.

I LOVE Yahoo Finance! If you haven't noticed, I get tons of post ideas from them (their columnists are excellent) and I track my personal investments using My Yahoo. If you haven't checked out what they have to offer, you are missing out. Stop by and check out all the resources there for yourself. You'll be glad you did.

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

Using the Eighty/Twenty Rule for Asset Allocation

Here's a piece courtesy of Marotta Asset Management on how to use the 80/20 rule to set your investment asset allocation:

In 1906, Italian economist Vilfredo Pareto created a mathematical formula to describe the unequal distribution of wealth in his country, observing that twenty percent of the people owned eighty percent of the wealth. The 80/20 rule has been recognized by many as a universal principle of life. Its application even wins a place in the logic of asset allocation.

Consider, for example, the mix between stocks and bonds. On average stocks are more volatile but they also have a higher average return. However, there are times when stocks have done poorly. Some people’s investments have still not recovered from the drop in technology stocks from 4-6 years ago. So if you believe in diversification, what is the best mix of stocks and bonds? For the assumptions behind the math to follow I will use US large cap stocks (the S&P 500) and an average bond portfolio (the Lehman Brothers Aggregate Bond Portfolio).

First, let me be quick to say that diversifying solely between the S&P 500 and the Lehman Aggregate Bond Index is a very bad idea. I've written previously that the S&P 500 is a poor investments choice, and in recent years anywhere other than the S&P 500 has beaten the S&P 500 Index. Additionally, there are many alternative investments with higher returns than these two indexes where a portion of our assets should be allocated. Finally, US stocks and bonds are only two of the six asset categories where we recommend investing.

Nevertheless, these two investments provide a good example and paradigm of the rule of thumb that should be used in asset allocation choices between qualified investments.

Consider an asset allocation continuum ranging from 0% Stocks (S&P 500) and 100% Bonds (Lehman Aggregate Index) through 100% Stocks and 0% Bonds. Each asset allocation is rebalanced annually. How would each of these portfolios have done over the past several years in the markets?

A portfolio’s performance is measured two ways: first, the average return it delivers, and second, the average portfolio volatility. Average return is computed by measuring what guaranteed return would have produced the same amount of money had it been compounded each year. Portfolio volatility is measured by measuring the annual standard deviation. We might expect a relatively straight line. The greater the amount of stocks in the portfolio the greater the risk (standard deviation) and the greater the return.

This is not the case.

The curve includes risk and return characteristics that are not on the efficient portfolio horizon.

The efficient frontier was first defined by Harry Markowitz in his Nobel Prize winning work on portfolio theory. An optimal portfolio is the highest returning portfolio for any expected volatility or conversely the portfolio with the lowest volatility for any given return. Only these optimal portfolios are on the efficient frontier. For any portfolio that is not optimal, a portfolio can get a greater or equal return for the same or less volatility.

Notice in our risk return example, the portfolio of 100% stock did not provide the best return, though it did provide the highest volatility. The highest return was with more than 10% bonds. With 20% bond, the return was still higher than an all stock portfolio, but the reduction of volatility was significant.

Similarly, the portfolio of 100% bonds did not provide the least volatility. The lowest volatility was with more than 10% stock. With 20% stocks the volatility was still lower than an all bond portfolio but the return was much higher.

Given the constraint of only these two investment choices, the efficient frontier would be between 10% stocks and 90% stocks. These are the asset allocation mixes which have the lowest volatility and the highest return. Between these extremes, the sweet spot for investing and balancing risk and return is between 20%/80% and 80%/20%.

During a bull market, investors are quick to forget that the markets also go down. Adding bonds to an all-stock portfolio can increase as well as stabilize returns. And some investors that are seeking stability forget that adding small amounts of more volatile investments can actually reduce volatility. Adding stocks to an all-bond portfolio can stabilize as well as increase returns.

Asset allocation becomes even more complex as additional investment choices are added to the mix. Some investment choices add neither lower risk nor higher return to a portfolio. These investment choices are best eliminated from your portfolio. Other choices may be able to reduce risk and increase return by inclusion in your asset allocation.

Turbulent years are coming as certain as they have come in the past. The 80/20 equation of life is the result of personal choices. The financial successful save consistently, diversity wisely and spend frugally.
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For more on investing, see Best of Free Money Finance: Investment Posts.

The Best Investing Strategy

Here's the next item I wanted to cover from Kiplinger's "The Best List" (November issue.) Today, we're highlighting the best investing strategy:

The Best Investing Strategy: Dollar-Cost Averaging

Instead of investing a lump sum all at once, you divide the pot into equal amounts and invest each sliver periodically -- say once a quarter. The conventional argument for averaging is that it allows you to buy more shares when prices are down. But averaging's main advantage is psychological: It forces you to invest when prices are down, which you might not otherwise do, and prevents you from investing too much when prices are high and euphoria is dictating investment decisions.

I dollar-cost average every single month. My 401k money buys new Fidelity funds every month while my Vanguard accounts get money transferred from checking and into selected funds (mostly index funds.) I've done this for years, and since it's automatic, I don't really think much about it. I just "set it and forget it." ;-)

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

The Best Stock to Put Away and Forget

Here's the next item I wanted to cover from Kiplinger's "The Best List" (November issue.) Today, we're highlighting the best stock to put away and forget:

The Best Stock to Put Away and Forget: Johnson & Johnson

How about this for a model of consistency: Johnson & Johnson has raised its dividend 44 consecutive years. J&J sits on three sturdy legs: pharmaceuticals, medical devices and branded consumer products, such as Band-Aid and Tylenol. Rain or shine, J&J can peddle its products.

I have owned JNJ stock for years now and I agree 100% with what Kiplinger's says here. My only regret: I wish I would have bought more of this stock and less of MCI WorldCom several years back. ;-)

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

Costs Matter If You Want to Maximize Investment Returns

Today is my day to host AllFinancialMatters' Bogleheads October project where a different personal finance blog reviews a chapter of The Bogleheads' Guide to Investing every day. Today I'll be summarizing and commenting on Chapter 9 - "Costs Matter."

I'll start in the reverse order of how I usually do a review -- with my comments on this chapter. I was one of the first to sign up for this writing project and as such, I got my pick of the chapters. Since I'm a big believer in keeping costs low (for my thoughts on the issue, see How High Mutual Fund Fees Can Cost You Millions (Another Reason You Should Love Index Funds)), this chapter was a natural fit. And as I expected, I absolutely loved this chapter (as well as the entire book -- I'll be reviewing it in total at the start of November.) It fits my personal thoughts on the issue of investing and costs exactly. In fact, if I could write a book on investing, this would be it. And if I wrote a chapter on costs and investing, chapter 9 of The Bogleheads' Guide to Investing would be it!

The chapter title highlights a quote from Jack Bogle, the founder of Vanguard:

The shortest route to top quartile performance is to be in the bottom quartile of expenses.

Then, the chapter begins with a paragraph that summarizes the pages to follow:

We are accustomed to believing that the more we pay for something, the more we receive. Sorry; this is not how it works when buying mutual funds. Every dollar we pay in commissions, fees, expenses, and so on is one dollar less that we receive from our investment. For this reason, it's critical that we keep our investment costs as low as possible.

Look at it this way, would you rather have an investment that returns 12% but has expenses of 2% or one that returns 11% but has expenses of 0.5%? It may not seem like that big of a difference, but that extra 0.5%, when compounded throughout the years, can make a big difference in your total return. But that's making an assumption -- that mutual funds with higher expenses ratios perform better. This isn't always (or even usually) true. So which would you rather have -- an investment with a 12% return and 2% expenses or one with a 12% return and 0.5% expenses? But I'm getting ahead of myself. We'll talk more about this later.

The chapter continues by telling just how much of investors returns are eaten up by fees every year -- about $300 billion. Yes, that's billion with a "b." Yikes! If we could save just a portion of that as investors, imagine how much more money would be in our pockets (instead of the pockets of advisors, brokers, large investment companies, and the like.)

Don't think that there are really that many costs associated with mutual funds? Think again. Here's the list (covered in detail in this chapter) of potential costs associated with mutual funds as listed in The Bogleheads' Guide to Investing:

• Sales charges on purchases (load funds)
• Deferred sales charges (load funds)
• Purchase fees
• Exchange fees
• Account fees
• Redemption fees
• Management fees
• 12b-1 fees
• Other operating expenses
• Hidden transaction costs
• Brokerage commissions
• Soft-dollar arrangements
• Spread costs
• Market impact costs
• Turnover
• Wrap fees

These are just costs associated with buying, holding and selling mutual funds. This chapter doesn't even cover another huge expense -- taxes (that's for the next two chapters).

So, how much do average fees cut into your return? Here's a list of the average equity mutual fund and what percentage of assets each of these fees takes out of the investment:

• Advisory fees 1.1%
• Other operating expenses 0.5%
• Total expense ratio 1.6%

• Transaction costs 0.7%
• Opportunity cost 0.4%
• Sales charges 0.6%

• Total Annual Cost 3.3%

How bad is this 3.3%? It's HUGE! The book gives an example of a guy who saves $3,500 annually in a Roth IRA from 25 to age 65. If his investments return 10.4%, he ends up with $1,727,501. If his investments return 7.1% (10.4% less the 3.3% costs), he ends up with $716,916 -- almost 60% less!

The book goes on to site studies that have shown how low costs equate to solid returns:

• The Financial Research Corporation found that the expense ratio is the only reliable predictor of future mutual fund performance.

• Standard and Poor's reported that in eight out of nine categories, lower-cost funds beat higher-cost funds during 1-year, 3-year, 5-year, and 10-year periods.

So, what should we do? Here's what the book suggests:

Knowing the tremendous advantage of keeping costs low, we need to put this knowledge to good use. Whenever possible, we will use index funds with their low cost and low turnover. ETFs and low cost, low-turnover, managed funds may also be considered.

Now you can see why I like this chapter so much. And it's another good reason why I like index funds. ;-)

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

Here's a piece courtesy of Marotta Asset Management that details why asset allocation is important for any investment portfolio. In addition, it provides some insights on market timing, and how improbable it is for you to outperform an on-going investment by regularly trying to time the market:

Market timing is the attempt to switch a significant portion of your assets between different types of investments in an effort to maximize profits. If this is your investment strategy, good luck, because you’ll need it.

Academics such as Burton Malkiel, author of "A Random Walk Down Wall Street," believe it is impossible to time the market. But, active traders and the get-rich-quick disagree. They claim to have seen it work in practice.

Mathematics and game theory can help us determine if market timing is a good strategy. Too many investment decisions are made as a result of emotional considerations. Usually those emotions are greed, fear, or pride. Emotions can dim the vision of even seasoned investors, fooling them into thinking their personal experience represents the set of all possible outcomes. We can illustrate the problems of market timing by looking at a simple game.

Consider the following game. You start with $1,000 and play for ten turns. Each turn you can invest your money in Investment A or Investment B. There are only two possible outcomes each turn. The first possible outcome is that Investment A appreciates 30% and with Investment B you just get your money back. The other possible outcome is the exact opposite: Investment B appreciates 30% and Investment A just returns your money.

If you invest half of your money in Investment A and half in Investment B, you are guaranteed to earn 15% each turn. After ten turns your $1,000 will have appreciated to $4,046. I’m going to call this the 50-50 asset allocation model.

Now, imagine that you decide to take a chance and each turn try to pick the investment that will earn 30%. I’ll call this the lottery method. Since you can't lose money, and your average return is still 15%, you think on average you won't do much worse than the 50-50 asset allocation. You couldn't be more wrong.

Assuming that your choice is just a coin toss — and you don't have foreknowledge of which investment is going to do well — the odds are you will do worse.

Let's just take a look at the first two turns. With the 50-50 asset allocation model, your $1,000 grows to $1,150 and then to $1,322.50. The 15% gain on the first turn is compounded with another 15% gain on the second turn for a total compounded return of over 32%.

If, on the other hand, you try to guess the best category there are only four possibilities, and three of them are worse than the 50-50 asset allocation model. If you are wrong twice, you will end up with your original $1,000. If you are right and then wrong, or wrong and then right, you will earn 30% and end up with $1,300, falling $22.50 below the returns of the 50-50 asset allocation model!

Only if you are right on each of your two tries will you beat the returns of asset allocation. Your $1,000 from the first correct guess will appreciate to $1,300 and on the second guess to $1,690. Only in this case would your 30% compounding return beat the average return of the 50-50 asset allocation model.

For those of you trying desperately to remember your high school math, this is a case where the mean (average) return is higher than the median (middle or typical) return. On average you earn the same, but typically you fall below the consistent asset allocation model’s return.

Now imagine expanding this difference between mean and median for ten turns. In our 50-50 asset allocation model with consistent 15% returns, your $1,000 will grow to $4,046. If, instead, you use the lottery method, you will do better than the 50-50 asset allocation model less than 38% of the time.

While your average return with the lottery method is still $4,046, it is buoyed up by the extremely rare case when you guess right ten times in a row and end up with $13,786. If you are that rare individual, you will likely consider yourself brilliant and mistakenly believe that market timing works. You may even start an investment newsletter called "The Lucky Penny" and try to teach others your selection method.

The median or typical return of the lottery method, however, is only $3,713 representing only a 14.02% compounded return. Over half the returns of the lottery method fall within the standard deviation in the range of $2,856 to $4,827 (11.06% to 17.05%).

Remember, in our game the diversified 50-50 asset allocation model offers a safe 15% return. With those returns, is it really wise to press for the 17.05% return with the lottery method? It seems counter-productive to risk an extra 2.05% gain against a 3.94% loss, but that is what trying to time the market does on average in this case. Asset allocation produces not only more consistent returns, but better returns.

You have to pick the winning investment consistently in order for the lottery method to do better than the asset allocation model. Our game did not include the very real possibility of losing money. If the parameters of the game are changed to include the possibility of losing money, the 50-50 asset allocation does even better.

Losses are harder to recover from. In fact, losses hurt you more than wins help you. If you lose 50% of your capital one turn you must gain more than 100% to make up for what you could have had due to the power of compound interest.

In the real world, 50-50 asset allocation isn't the same thing as a risk-free return, but it does offer a smoother ride than trying to pick this month's winning category. Math can explain a lot; a few gray hairs help too.

Great Financial Podcasts from Vanguard

For those of you who would rather listen to good financial advice rather than read it, Vanguard now has a series of podcasts titled Plain Talk on Investing. They are a bit simplistic (made more for people new to personal finances), but they do offer some great reminders as well for those of us who know a bit.

In particular, the podcasts on "How Index Funds Can Work for You" and "Why Investment Costs Matter" are especially good. They give several reasons why index funds are good investments for most people. Check them out for yourself or recommend them to a friend who's looking for solid tips on managing investments.

When ETFs Make Sense

Here's a short piece from Kiplinger's that gives some advice on when ETFs make sense for investors:

ETFs are the right choice if you make only one or two trades a year, invest a big chunk of cash and hold on for a long time. Although ETFs typically have lower expenses than index funds, you have to pay a commission when you buy or sell them, so you want to minimize trading costs.

Buying ETFs doesn't make sense if you invest a small amount every month or every quarter. If you invest less than $30,000 a year in three or four installments, it could take years to benefit from the lower expenses of ETFs, says Vanguard's Noel Archard. In that case, it's better to stick with index funds. Expenses will be slightly higher, but you'll avoid commissions.

There it is -- short and simple. And because I am a regular investor (I dollar cost average monthly), index funds are a better choice for me.

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

Keeping Expense Ratios Low

Here's another great post on keeping investing expense ratios low courtesy of Marotta Asset Management:

Rocks and sand are the composites of a good portfolio. Good portfolios have low expense ratios and minimal trading costs. Trading costs are the costs of buying a security. Depending on the brokerage house, the cost of a trade averages between $10 and $20. Expense ratios are the percentage of assets used to run a mutual fund, the overhead. We use a technique that keeps each of them as low as possible.

Keeping expenses low keeps returns high. As an example, consider the difference between investing in a typical foreign mutual fund with an expense ratio of about 1.35% verses an exchange traded fund (ETF) with an expense ratios are about .35%. The 1% spread in expenses does not mean one should not own foreign stock mutual funds, but it does mean you or your advisor should have a good knowledge of the global markets before diversifying your portfolio to include them. The advantage of the mutual fund is that they have no transaction fee to buy or sell them. This allows you to rebalance your portfolio as market conditions change without incurring a fee to do so.

Unlike a mutual fund that that is only traded at the next close of market price, ETFs are sold throughout the day on the stock exchange exactly like a stock. And also like a stock, they have a brokerage charge to buy or sell them, typically in the $10 to $20 range at a discount broker.

For small investment amounts the transaction charge would represent too large a percentage of the investment. As a general rule, the transaction cost to purchase an investment should not exceed 1% of the amount being invested. We would consider paying more than $10 to purchase $1,000 worth of a security too much.

When your investment amounts get over a few thousand dollars, expense ratios become more important than trading costs. We use a simple technique to keep total expenses low without losing the flexibility to diversify and need to rebalance periodically that we call "Rocks and sand."

The "Rocks and Sand" technique comes from the following analogy: Imaging you have several buckets that represent different asset classes you want to invest in. (We use 6.) Purchasing large rocks costs money (transaction cost), but they have a lower expense ratio after you have purchased them. Since rocks cost money to be broken up, they aren’t as cost efficient when you need to move funds from one bucket to another. Buckets can be filled in with sand with a higher expense ratio, but it doesn’t cost any money to move sand from one bucket to another.

The transaction cost of building a portfolio of ETF "Rocks" is more than compensated by the fact that ETFs have lower expense ratios. IShares MSCI EAFE (EFA) is the most popular ETF for foreign stock investing. Its expense ratio is only 0.35%, an entire percentage less than the typical foreign stock funds. Lower expense ratios are saved every year, while transaction costs are only incurred in the year the investment is purchased or sold.

Therefore, $100,000 invested in a foreign ETF with a lower expense ratio will grow to $336,083 at 12% over ten years verses only $304,415 if invested in a typical foreign stock mutual fund with a higher expense ratio. The additional $31,668 represents a 10.4% higher gain as a result of the compounded difference from the reduced expense ratio.

To reap the benefits of monthly additional investments and lower expense ratios, we use a combination of ETFs and no-transaction fee mutual funds. We invest large amounts in ETF shares that provide the rough asset allocation "Rocks" we are seeking to save on expense costs. These positions aren’t bought and sold to take advantage of lower expense ratios without incurring transaction costs. Smaller monthly amounts are invested in no-transaction fee no-load mutual funds on a regular basis, like “sand” filling in around the "Rocks". These funds have slightly higher expense ratios, but the amounts are small compared to ETFs, so the overall portfolio expenses remain small.

Then, when a significant amount of "sand" dollars collect in the mutual fund of one asset class, that fund is sold and a lower expenses ratio ETF "Rock" is purchased in its place. Conversely, if an asset class needs to be reduced, some of the ETF is sold and the smaller portion of the proceeds is reinvested in a similar mutual fund.

The lowest cost method for keeping an asset allocation model balanced is to buy mostly rocks for each of the buckets of a diversified portfolio, and then add the sand of a no-transaction-fee mutual fund into the bucket that needs rebalancing. Whenever too much sand has accumulated in one of our 6 buckets, we sell the sand and replace it with another rock. If the weight of the rock(s) in one bucket gets to be too much, we sell a piece of rock and replace it with some sand which can be easily moved into one of the other buckets.

This "Rocks and sand" technique can enhance your portfolio returns by as much as a full percent each year. This is especially true for portfolios between $500,000 and one million dollars. There are even more powerful techniques that can be used for amounts in excess of one million dollars. For large accounts, engaging a Fee-Only financial planner often pays for itself in lower expense ratios alone.

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I am always amazed when I see examples of what a significant difference is made in a portfolio's total dollar return by such a small difference in an expense ratio. But a "simple" one percent can have a HUGE difference. This is yet another reason I like index funds.

For more thoughts on this same issue, see How High Mutual Fund Fees Can Cost You Millions (Another Reason You Should Love Index Funds).

Update on My Three CEOs

In Investment Thoughts: Investing in Great Management and Strong Results for Disney (DIS) I detailed my thoughts on one way I select stocks to invest in -- find driven, smart CEOs and buy their stocks. Since this method has worked well for me several times in the past, I pick up a stock here and there when I feel like they have a really great CEO who's going to make things happen.

I currently have three stocks I bought for this reason and I thought I'd detail how they are doing so far. Here goes:

• Disney (DIS) -- Up 20.0% since purchase (bought at $25.04 per share, trading at $30.06 as of this writing.) Not bad for a stock I bought only seven months ago. And the Steve Jobs effect I wrote about hasn't even kicked in yet. Hopefully, there's a lot of upside for the House of Mouse.

• Home Depot (HD) -- Down 13.1% since purchase (bought at $42.11 per share, trading at $36.58 as of this writing.) The declining housing market isn't helping things out any, there's stiff competition from Lowe's, Nardelli hasn't been able to right the ship fully, and Tony Stewart is out of the Chase for the NASCAR Nextel Cup Championship. Man, nothing's going right for HD.

• J.P. Morgan Chase (JPM) -- Up 2.8% since purchase (bought at $45.33 per share, trading at $46.58 as of this writing.) Still lots of work to be done at this bank, but I'm still bullish on Dimon. If anyone can make this company a big winner, he's the one!

So, for now my track record is "ok" at best. I have one winner, one loser and one even so far. But I'm not in these stocks for a month or two. I think it will be a few years before the real impact of these CEOs hits the companies (at least for DIS and JPM, Nardelli has been at HD for a bit -- what's taking so long?) and I'm willing to wait.

BTW, I know Steve Jobs is not the CEO at Disney, but he's on the board, is the largest shareholder, and I know he'll have an impact. Besides, Iger seems to be doing a good job by himself anyway.

Advantages and Disadvantages of Exchange Traded Funds (ETFs)

Here's a good informational piece on the advantages and disadvantages of exchange traded funds (ETFs) courtesy of Marotta Asset Management:

There has been nothing new in finance in the last fifty years – except exchange-traded funds. Exchange Traded Funds, or ETFs, combine many of the best characteristics of stocks and mutual funds.

ETFs are index funds that trade on a stock exchange. Like a mutual fund, they represent a collection of stocks, but unlike a mutual fund, they trade throughout the day like a stock. This is similar to a closed-end fund, but unlike a closed-end fund, ETFs do not have a limited number of shares and they trade very close to their underlying net asset value.

The first, and still one of the most popular is SPY, representing the Standard & Poor's 500 Index, which began trading in 1993. It is called a "spider" based on the first initial of its official name: S&Ps Depositary Receipts.

"Authorized participants," usually between 20 and 30 large brokerage houses, "make" markets in ETFs. Arbitrage trades by these participants narrow the gap between ETF market prices and the net asset values of the indexed shares. Financial companies hold shares of the stocks in the index in a "trust." One such bank is the State Street Bank & Trust Co. of Boston, which holds the Spiders’ shares. About 80% of the volume of trading in ETFs is generated by a small percentage of shareholders, including the arbitrageurs.

The market price of shares in the ETF indexes are recalculated every 15 seconds. The actual trades on the secondary markets are posted on the ticker tape.

Advantages

One major advantage of ETFs is their very low cost of operation, frequently half the annual expense of an index mutual fund, and considerably less than a "managed" fund. For example, the annual expense ratio for a foreign equity fund averages 1.92%. This is the highest for any category of fund. An index mutual fund will average 1.06%. But an ETF fund will range from .35 to .99 percent.

ETFs can be traded like stocks. They can be bought and sold any time during market hours. They can be margined. They can be sold short. They can be bought on limit price orders. Some have options based on their price.

ETFs are also very tax efficient. They seek to minimize capital gains by exchanging those stock that are being sold out of the index for those funds that are being added to the index. Because buying and selling in the fund is done by means of like-kind exchanges, it is not a taxable event.

Many mutual funds have $2,500 minimum for purchases, but investors can buy a single share of an ETF. Mutual funds must hold cash for redemptions, but ETFs hold little or no cash and therefore better match the performance of the index better. ETFs also have less paperwork than mutual funds, and do not charge 12b-1 advertising fees, as do many mutual funds.

Disadvantages

ETFs have a few minor disadvantages. Unlike open-ended mutual funds, ETFs cannot reinvest dividends. Dividends are paid out to owners of shares at the end of each quarter. This has a slightly adverse effect on performance and is called "dividend drag."

Also, ETFs are capitalization weighted, similar to the indexes on which they are based. This shows up particularly in sector ETFs where one company might loom very large in relation to the index, such as Amgen does in the Biotech ETF, and the stock Ericsson in the Sweden ETF.

Purchasing ETFs incurs a brokerage commission just as a stock does. For small amounts where the brokerage charges would be a significant percentage of the investment, it would be better to use a no-load, no-transaction-fee mutual fund.

Prices of ETF trades are based on market forces, so a buyer might buy at a slight premium or discount. This difference between the price of an ETF and the price of the underlying net asset value is usually very small. When it drifts, arbitrageurs will step in and make a profit bringing the price back to net asset value.

Making the Most of Your Investment Portfolio -- Keep Costs Low and Diversify

We all know that expenses can limit your investment returns significantly and that ditching expensive funds can save you serious dough as a result. Here's a piece courtesy of Marotta Asset Management that highlights these points as well as talks about the benefits of diversification:

There is an art to selecting the right investment vehicles for individual portfolios. A good investment advisor will tailor the investments to the specific characteristics of the investor’s situation.

Investment needs can be divided into nine different categories that apply to everyone. First, there are three different types of accounts: Taxable, Retirement, and Roth. Then within these categories, investment vehicles should differ for small, medium and large sized accounts. Tax bracket, stage of life, cash flow requirements and other variables are also incorporated into the final comprehensive financial plan.

There are five factors that should be considered when matching an investment vehicle to a given account. Three will be covered today. Next week the other two will be reviewed along with some specific advice on how to apply the insights from these 3 articles.

Expense ratios

Insurance investment products and mutual funds sold by commission are loaded with expenses. Lower cost alternatives can nearly always be found.

No-load mutual funds may offer the efficiency of not having to compensate a salesman, but all funds incur some expenses to manage the assets they have. The expense ratio for no-load mutual funds averages about 1.2%. Sometimes there is an additional 12b-1 fee (for marketing the fund) of 0.25%. The fees for foreign or speculative mutual funds may be higher.

Exchange traded funds and some Vanguard funds have low expense ratios around 0.2% to 0.4%. Individual stocks and individual bonds have no expenses to hold them.

Keeping expenses low helps keep your return high. Everything else being equal, you should seek the investment vehicle with the lowest expenses. But the expense ratio is only one of four factors to consider.

Transaction Costs

There are transaction costs for many investments. With mutual funds, these transaction costs show up in their expense ratios. For individual stocks there is a brokerage fee to buy and sell each stock, typically under $15 for discount brokers, and more for “full service” brokers. Buying individual bonds is more complex and is mostly paid for in the spread between the price you can buy a bond and the price you can sell a bond. Individual bonds are sold is large denominations (e.g. $25,000), and transaction costs can be $100 or more.

Because of transaction costs, for very small investment amounts it is better to pay a higher expense ratio if you can avoid paying transaction costs. Paying a $15 brokerage fee on a $100 investment immediately loses 15% of your investment. Our rule of thumb is pay 1% or less of an investment’s value for the transaction to purchase it. So for very small investments, we would use no-load and no-transaction fee mutual funds instead of individual stocks or exchange-traded funds. Avoiding the transaction costs more than makes up for the slightly higher expense ratios.

Diversification

Diversifying your investment over many different types of stocks is an important way to decrease risk without sacrificing return. For accounts with small amounts, no-load and no-transaction fee mutual funds offer the best method of getting a diversified portfolio. As the amount of the investment gets larger, investment vehicles with lower expense ratios can be used. For medium sized accounts, we recommend exchange-traded funds. For large amounts, there are enough assets to warrant individual stocks. And for very large amount individual bonds can be used.

Diversification of your portfolio is critical. That means that diversification is more important than small differences between expense ratios. Diversification using individual stocks should be reserved for larger portfolios. Whatever your portfolio size, we recommend keeping your exposure to any one stock under 5% of your total. On a million dollar portfolio, that means the amount invested in any one stock should be under $50,000. That level of investment will only purchase 20 individual stocks. Smaller amounts such as $10,000 would increase the diversification to 100 individual stocks, but also increase the transaction costs required to purchase them five-fold.

Exchange-traded funds offer a nice compromise for medium sized portfolios. Exchange traded funds are collections of stocks like mutual funds, but they have very low expense ratios. A single exchange traded fund represents a large collection of stocks, but can be purchased with a single transaction.

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One comment: These factors are why I use index funds as my preferred investment vehicle.

How Much to Invest in Your Company's Stock

I've written before about the need to limit the amount of your own company's stock you have in your 401k, so consider this post part of a regular reminder. There are really two major concerns associated with buying too much stock of a company you work for. The first is simple diversification. You don't want ANY stock to be a large, dominant part of your investment portfolio. The second is that you already have a lot of financial interests tied up in the company (your job) -- how much more do you really need/want? As I said in the last post on this subject:

Buying your employer's stock, after all, amounts to placing two big economic bets on one company. If your firm suffers an Enron-type collapse - or even a less dramatic downturn - you could lose your job and a big portion of your retirement savings.

This article from USA Today gives advice on how much to invest in your company's stock and starts by reinforcing this latter point:

But you've already got plenty invested in your company, even if you don't own a single share. Your day-to-day financial security depends on your company paycheck. If you have a pension, then part of your retirement is already tied up in your company. "You have so much on the line just by working at the place," says Chuck Carlson, CEO of Horizon Investment Services, a Hammond, Ind., investment company.

Then, USA Today offers some solid thoughts on how much you should invest in company stock:

All of which brings us to the first rule of investing in your company stock: Don't invest more than 10% of your 401(k) assets in it. Most mutual fund managers won't put more than 5% of their assets in one stock. A 10% position is a huge bet.

If you read the piece, they say don't invest 10% unless you've got a really, really, really great reason to do so.  5% is good enough.

What would constitute a  really, really, really great reason? They offer a couple ideas:

• You should pay attention when an insider digs into his or her own wallet to buy shares. After all, insiders already receive gobs of stock, either by exercising options or outright grants. To buy additional shares on the open market, they need to be powerfully convinced of the stock's prospects.

• As an employee, you may have a good handle on how the company is doing, what its growth prospects are and whether Wall Street is treating the stock fairly. You may, for example, be faster than an analyst at a brokerage house to recognize when products are flying off the shelves. But you have to temper your own insights with some emotional control — and some research. Start with the emotional side. "You could have a great boss, but that doesn't make the stock a great investment," says Ray Ferrara, a financial planner in Clearwater, Fla.

My company is privately held, so I don't really have to deal with this concern -- but I have had in my lifetime. My second employer made its 401k match in company stock and also offered a discounted stock purchase plan (which I took advantage of). In addition, I was awarded shares of the company on a regular basis. I must admit, I was over-weighted in their stock for a few years (that was back in my pre-personal finance days). They did fine during that time though, and I cashed out when I moved on.

How High Mutual Fund Fees Can Cost You Millions (Another Reason You Should Love Index Funds)

As many of you know, I'm a fan of index fund investing. One of the reasons I like index funds is that they have a great track record of good, solid investment returns. Much of these great results are driven by the fact that index funds have very low expenses. And, as we know, low costs mean higher returns (also see Expenses, Taxes and Size Matter in Choosing Bond Funds (And Stocks too!) and The Advantages of Index Funds for more information.)

I found an example of how much expenses can impact your investment returns and it's pretty significant. Check out this paragraph:

If Vanguard’s 0.18% fee is low and the category average is 1.27% you can bet that some funds are as far above the average as Vanguard is below the average. A fund with an expense ratio as high as 2.36% will cost $11.2 million dollars more over 50 years than the Vanguard fund. Instead of a $16.8 million dollar portfolio with a low fee structure, your investment will only grow to $5.6 million dollars because of the higher fund fees. Add a sales load on the front and you will be left with $5.1 million dollars. The $11.7 million that was lost to fees and forgone earnings are hidden expenses that are usually not perceptible as they are happening, but extrapolated over time they are huge.

They certainly are huge! And while most of you reading this post aren't investing in funds with a 2.36% expense ratio (at least I hope you aren't), you may have total investment expenses that average 2.36% (for instance, you use a planner who charges 1% of assets and he buys a fund for you with an expense ratio of 1.36%). Or even if your total expenses are "only" the average 1.27% -- that's still a large number compared to many other alternatives and you could be losing millions throughout your investing career.

Of course, you want to maximize total return, so an investment with a 2% expense ratio that has a return of 15% is better than an investment with a 0.2% expense ratio and a 10% return. The problem is, it's hard to find a mutual fund investment that consistently earns a high enough return to justify a big expense ratio.

Or think of it this way -- one investment starts out with 1% less in built-in costs than another. The one with higher expenses is at a disadvantage from the get-go -- you're down 1% before you even get out of the gate.

It's figures like these that keep me investing in index funds.