Free Money Finance

How to Handle Six Money Dilemmas, Prepay Your Mortgage OR Invest

Money magazine lists six money dilemmas and what to do about them. Over the next few days, I'll list each dilemma, what Money suggests as the best option, my take on the issue, and additional FMF posts on the topic. Here goes:

Dilemma #4: Prepay Your Mortgage OR Invest

Money's suggestion: Investing wins.

My take: I have a mixed response on this one, but for the most part, I'm going against the flow.

I would first fully refund my retirement plans (for me it was my 401k) and THEN I would pay off debt. I know that Money recommends investing that second portion as well, but we simply wanted to be rid of the debt and owe nothing to anyone. Could we have made more money with another option. Probably. Did we rest better at night knowing we didn't owe anyone anything? Certainly. Have we done well financially as a result of our plan. Yep, our net worth has continued to grow dramatically throughout the years.

FMF posts related to this topic: Paying Off a Mortgage Versus Investing, My Formula for Buying a House

Money Math: The Rule of 72

Money magazine has five short money math tips in its January issue and I'll be sharing/commenting on them over the next few days. Here's one for today:

How many years will it take to double my money?

The math: Divide the number 72 by your annual investment return. If you're making 8%, you'll double your stake in nine years.

I sometimes use my own rule of 70, but as some readers have pointed out, that method leaves a lot to be desired -- especially in later years.

I use the rule of 72 to get a rough guess at my net worth in the future. If I think I can grow it by 8% a year, I know I'll have twice that amount in nine years (when I'm __ age), four times as much as I have now in 18 years (when I'm __ age), and eight times as much as I have now in 18 years (when I'm __ age). It gives me a feeling for how much I'll have at retirement and whether or not I'm on track.

FYI, my net worth has been growing at a bit over 16% for 15 years or so now, so I use 10% and 7 years (my rule of 70) for ease of calculation, knowing I still have plenty of room for error.

How Shrewd Investors Save on Taxes

This article is courtesy of Marotta Asset Management and discusses saving on taxes by giving appreciated stock. I do this, as I've detailed in A Great Way to Change Your Portfolio.

When you're building wealth, saving a penny on your taxes is just as important as earning a penny in the markets. You can use both investment losses and investment gains to good tax advantage.

For example, in November some U.S. stocks experienced a significant drop. Disciplined investors use these declines to save on their taxes and rebalance their portfolios.

But most people are loss averse. Selling an investment for a loss feels like failure. So they hold on and wait for it to come back up before they sell. It doesn't matter if another investment might appreciate faster and recover the loss more quickly. Their reluctance to sell is even more pronounced when the investment was purchased recently. In taxable accounts, however, investors must overcome this loss aversion and learn to realize capital losses whenever possible.

The stock market normally appreciates over 10% each year. Any investment you hold for a few years will probably have a satisfying capital gain. The only investments you are likely to be able to sell for a loss and deduct on your taxes are recent purchases. Be quick to sell your capital losses in taxable accounts and reinvest the money at a lower cost basis going forward.

The difference between what you paid for an investment and its current worth is called a "capital gain" or a "capital loss." As long as you continue to hold the investment, the gain or loss is "unrealized." Selling the investment means "realizing" the gain or loss, which you must report on your taxes.

Realized capital gains are commonly taxed at a reduced 15%. Realized losses can offset realized gains, but you are also allowed to deduct up to $3,000 of capital losses against other types of income. If you have net losses in excess of $3,000 in one year, you can carry your losses forward to future years.

Now is a good time to review your portfolio for investments you can sell for a loss. Use software to track your investments. Even a simple spreadsheet can compute the current value minus the cost basis of each investment. Consider any significant losses for tax-loss selling.

Ask yourself, "If I did not own that security now, would I buy it at current prices?" If the answer is no, sell. If the answer is yes, sell it anyway. Then wait 31 days and buy it back. That way you "realize" the loss for tax purposes and still hold the security. And you have reduced your tax liability by sharing that loss with Uncle Sam.

Another technique is to double up. First, purchase the same number of shares you currently hold in that security. Wait 31 days. Then sell the original shares for a tax loss. Waiting a month between the sale and the buyback avoids a "wash sale," which would prevent you from taking the tax loss.

Most investments (stocks, bonds, mutual funds) are subject to the same tax rules, but owning individual stocks provides additional tax-loss selling opportunities.

Compare two millionaire investors. The first buys $1 million of a mutual fund that invests in 200 different stocks. No stock represents more than $10,000 of the investment, and the amount invested in each stock is $5,000. Although the mutual fund might have a tame 10% return for the year, one of the underlying stocks in the fund might have doubled and two others lost 50% of their value during the year. But this investor only owns shares in the mutual fund, and he cannot take advantage of any tax-loss selling.

The second millionaire buys all 200 as individual stocks. Her overall portfolio also has a tame 10% annual return, but she has additional choices that help boost her earnings even higher. She can sell the two stocks that have a 50% negative return and take the loss on her taxes. By selling the stocks with losses, she realizes their loss for tax purposes. By not selling her stocks with gains, she avoids realizing those gains and therefore is not required to pay any capital gains taxes.

Selling investments with losses can reduce your taxes, but you can also save on investments that have gone up by using appreciated assets for your charitable gifting.

Many Americans donate to charities in December. No matter what worthy organizations you support, you can contribute up to 15% more if you give appreciated investments instead of cash.

For example, if you sell $1,000 worth of appreciated stock, you most often pay capital gains tax of 15%. If most of the stock's value is appreciation, the tax burden approaches $150, leaving only $850 for charitable giving.

But if you give the stock directly to the charitable organization, you can take the full $1,000 tax deduction, and the organization will not have to pay any taxes when it sells the stock. You could save up to $150 on capital gains taxes, and the gift itself reduces your taxes at your marginal rate. In total, your $1,000 gift could cost you $500 or less if you use appreciated stock!

Here's how to do it:

1. Ask your financial advisor to choose which stocks are best for charitable giving (probably those that have appreciated the most and you do not want to continue holding in your portfolio).

2. Determine the amount of each charitable contribution. To compute how many shares of stock to give to each charity, divide the current price of the stock into the amount you wish to donate. The number of shares will not work out exactly, so you may need to round up or down.

3. Call the designated charities and ask for their "stock liquidation brokerage account." Nearly every organization has one expressly for this purpose. You may like to give anonymously and without fanfare, but you only have to request this account number once.

4. Instruct your brokerage firm to transfer the correct number of shares from your account into the charity's stock liquidation account. You can fax this request directly and then send the original by mail.

5. Save these letters and account numbers for next year's charitable giving.

6. Report the gifts to your tax accountant. Stock gifting is deductible at the fair market value, that is, the amount the stock was worth at the close of the day it was transferred. The stock may change value after you have transferred the stock but before the charitable organization sells it. These changes do not affect your tax deduction, but it may mean the charity reports a different amount than you must declare on your tax return.

Giving appreciated stock is a great way both to reduce your taxes and to give more generously to worthy charities.

Cash Has Been the Riskiest Investment

Here's a post courtesy of Marotta Asset Management.

If you think hiding money under your mattress is a risk-free way of building wealth, think again. Cash, it turns out, has been the riskiest investment since 2002. Many investors try to avoid risk by putting their money in a bank account or investing in CDs. But like any other investment, cash is subject to its own set of risks.

Cash is dangerous because the dollar can be devalued. When our currency decreases in value, we experience inflation and the purchasing power of the dollars we hold is compromised. Having the same amount of dollars doesn't do you any good if your dollars won't buy as much as they used to.

Since the beginning of 2002, the U.S. dollar has lost much of its purchasing power. From 2002-2007, the U.S. Dollar Index has dropped over 36% from 120 to 76.5. During that same period, the dollar has dropped over 39% against the Euro going from $0.88 to a Euro to $1.45. And the dollar has dropped over 64% against gold going from $280 to an ounce of gold to $795.

Money market's real risk is the dropping value of the dollar, not exposure to subprime lending. Cash in money market has lost over 40% of its buying power since 2002. And the US Dollar has dropped 10% just this year alone.

Interestingly enough, the consumer price index (CPI) over this same period has only registered a 15% drop in the dollar's purchasing power. While 15% is still significant, many economists believe that the federal government has been under reporting CPI since they changed the rules for computing it in 1996.

Purposefully under reporting CPI allows the government to cut the impact of cost of living increases in social programs and helps curb runaway government entitlement programs. Started under the Clinton administration and continued under Bush, these changes have rendered the official CPI numbers less meaningful.

Current CPI calculations have changed inflation numbers through tricks such as "substitutionary adjustments", "component removal" and "hedonic deprecators". This creative accounting rivals anything done by Enron. These changes were made specifically during a political debate over cutting back cost of living increases to Social security and other federal benefits. The changes have saved the Government tens of billions of dollars a year at the expense of benefit recipients whose benefits buy them much less now than they did a decade ago.

Any attentive consumer knows that cumulative price inflation since 2002 has been closer to 50% than 15%. This corresponds to the CPI being understated by about 5% a year. One study suggested that the CPI index has been understated by about 7% per year. No matter the exact amount, your bank deposits and money market funds have been the riskiest investments and have lost significant buying power to inflation. The danger of the U.S. dollar continuing to decline is aggravated if you try to be "safe" and over-expose your investments to cash and money market.

Just this year the dollar has continued its decline. Since the beginning of 2007, the U.S. Dollar Index has dropped 9% from 84.2 to 76.5. The dollar has dropped over 10% against the Euro going from $1.30 to a Euro to $1.45. And the dollar has dropped over 21% against gold going from $625 to an ounce of gold to $795.

Over half of your portfolio should be protected against the risk of a falling dollar. You can protect your portfolio against a falling dollar with investments in foreign bonds, foreign stocks, and hard asset stocks. Hard asset stocks are one of the best ways to protect yourself. As an asset class, they have also provided one of the best returns since 2002.

Hard asset investments include companies that own and produce an underlying natural resource. Examples of these natural resource stocks include companies that produce oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel, and other resources such as diamonds, coal, lumber, and even water.

Keep in mind that investing in hard asset stocks is not the same thing as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities or their volatility. Commodities, as an asset class, generally maintain their buying power in dollar terms. Stocks, as an asset class, generally appreciate over inflation after dividends are factored in. For that reason, it may be to your benefit to invest in hard assets stocks which have an underlying commodity.

One index that tracks hard assets is the Goldman Sachs Natural Resources Index. This index is comprised of 70% energy and 11% materials. As of the end of October 2007, this index is up 34.00% year-to-date. Its three-year annualized return is 30.69% and its five-year annualized return is 30.43%.

And please don't be fooled into thinking that cash in your mattress is a safe investment.

Costs Can Cripple Your Investment Returns

Almost everyone who reads Free Money Finance knows that I invest primarily in index funds. Yes, I have some stock and actively managed mutual funds (bought a long time ago -- I'm trying to weed them out without paying a ton in capital gains taxes), but almost all of my new investment money is going into index funds and has been for quite some time.

A key reason I like index funds is because their net return is better than most other alternatives. While the gross return of an index fund may actually be lower than other fund options, the net return of index funds are generally higher because the expenses associated with index funds are lower.

For example, let's say you have a stock index fund that earns 10.5% per year and has expenses of 0.2%. Your gross return is 10.5%, but what you take to the bank (so to speak) is 10.3% (10.5% - 0.2%). On the other hand, you may also own an actively managed mutual fund that returns 11.0%, but costs you 1.0%. In this case, your gross return is 11.0% but you end up earning a net return of only 10.0% (11.0% - 1.0%). So when all fees are taken out, the index fund delivers a better overall return.

Now some reading this might suggest that an extra return of 0.3% isn't really worth that much. But it is. For example, let's say you invest $5,000 a year for 30 years. Over this period of time and with this level of investment, the difference is almost $50,000. And that's with such a small amount of spread between the net returns. Now if the spread is more, obviously the difference goes up significantly.

Here's an example from Vanguard that illustrates this principle as well as details some of the costs you might face when investing in mutual funds. Expense ratios, sales charges, 12b-1 fees, trading costs. All of these can add up to significant amounts that hamper the performance of your investments. Index funds tend to minimize these fees, thus giving them an advantage in delivering an overall better return.

In conclusion, I wanted to share this from the Vanguard article. It recommends that investors look for funds with:

• Expense ratios of 0.50% or less.
• Turnover ratios of less than 50%.
• No sales charges.

For related posts, see these:

• Index Funds Continue to Be Great Investments

• Index Funds Save on Taxes

• The Top S&P 500 Index Funds -- I Own Them All (Almost)

Is Prosper.com a Good Way to Earn Money?

I've always wondered about Prosper.com -- the site that connects borrowers and lenders -- and whether or not it was s good investment. For instance, if people were earning 15% on their money by lending it to others, maybe I would want to get in on the action with part of my portfolio.

MSNBC recently did a piece on Prosper and included was how much the lenders make. The details:

Each Prosper borrower is assigned a grade based on their credit score to help lenders evaluate their risk and the site verifies borrowers’ identities. The average rate of return for lenders is 9.28 percent, with lower-grade loans earning 10.45 percent, according to Prosper.

Prosper makes its money by charging a 1 percent or 2 percent closing fee, based on the borrower’s credit grade, and lenders pay an annual loan servicing fee of 0.5 percent to 1 percent. It also collects fees for late payments on behalf of lenders and reports to credit bureaus. After 30 days, a collections agency is assigned to delinquent loans.

Ok, so what's not clear here is whether or not the fees are deducted from the earnings in the numbers above (I'm assuming the 1-2% closing fee is paid for the borrower.) In the best case-scenario, lenders are earning 9.28% to 10.45% -- in the worst case (if the annual fees get deducted from these numbers) the results are about 1% lower.

Either way, it doesn't look like something I'm interested in for investment purposes. Yeah, there's the "read people's stories, get involved, and help them out" angle associated with Prosper, but I'm ignoring that. I'm looking at it as an investment and whether or not it's a good option for me. And to be a good option, I needs to beat my main investment of choice: index funds. But it doesn't. Here's why:

1. Stock index funds will average about 10% return over the long-term. That's roughly what Prosper loans earn too -- at best. It could be 1% lower. And we all know that over a couple decades, that 1% can make a really big difference in your total investment return.

2. The Prosper loans take a lot of time to select and manage -- at least more than index funds do. The latter are easy, especially when you set up your investments automatically.

3. Index funds seem less risky. It's not that stocks are without risk, but do I really want to lend money to someone who can't get a loan from a bank? Think about it -- people who do this professionally (bankers) have said this person is a bad risk. So why do I want to give them money.

I know I'll get some Prosper success stories in the comments. I'll hear how some people are making more than the numbers above, they've never had a default, and how it doesn't take much time to invest with Prosper. That's great for them. But to me, I have other options that I feel return as much or more, require less time to select and manage, and have much less risk. So why would I want to move my money from them into Prosper loans?

A Great Way to Change Your Portfolio

A few months ago, I noted that I had investments in mutual funds (that I made several years ago) that I wanted to get out of but didn't want to take the big capital gains hit that was associated with selling them. Then a reader commented that I should give the funds away instead of selling them. What a great idea! So that's what I've been doing this year -- instead of giving cash, I've been giving appreciated shares in funds I no longer want. I then take the cash I would have given and invest it in funds I do want to own (index funds.) The charity gets a donation, I get to change around my portfolio, and I avoid the capital gains taxes. (FYI, to see how this works, check out Save on Taxes and Give a Bigger Gift by Donating Securities Instead of Cash.)

I recently ran into another piece from Vanguard that listed four ways to give gifts and save on taxes at the same time. Of course, giving appreciated securities was on the list. Here's what they had to say about it:

Another way to reap tax benefits while giving is to donate appreciated securities. Donating stocks, bonds, or mutual fund shares generally lets you take a tax deduction for the full market value of the investment and avoid paying tax on capital gains. To qualify, you must have owned the security for more than a year and the deduction cannot be more than 30% of your adjusted gross income (AGI) in any given year. (If the deduction would be more than 30% of your AGI, you can spread it out for up to five years.)

Good stuff!

I'll be employing this method for the next couple years as I look to rid myself of some funds purchased a long, long time ago and consolidate more and more of my holdings into index funds.

Index Funds Continue to Be Great Investments

Here's a piece from MSN Money that talks about the fact that many investment advisors/money managers charge a fortune to handle your investments. So what's the alternative? Index funds, of course. The details:

Today's index funds make it possible to build a diversified portfolio at very low cost. With a combination of mutual funds and exchange-traded funds, you can build a portfolio for an average cost of about three-tenths of 1%. If you are approaching retirement with a portfolio of $250,000, you can save $1,750 a year over a 1% annual charge from a manager or $4,250 over a 2% annual charge.

Yep, that's one reason I love index funds -- they keep costs low, which in turn helps you earn a better return on your money.

For more on the advantages of index fund investing, see these posts:

• Facts on the Benefits of Index Investing

• Illustration of How Costs Can Greatly Hamper Your Investment Returns (And Why Index Funds Do So Well)

• Index Funds Save on Taxes

I Love Compounding

I've talked before about the power of compound interest and the power of time (which are closely related -- time is what makes compounding so powerful) and how they can make you rich rather easily (simply save, invest, and repeat for many years.) And while this next piece is really nothing new, Kiplinger's does remind us how great compounding is. Their thoughts:

Here's the gist: When you save or invest, your money earns interest, or appreciates. The next year, you earn interest on your original money and the interest from the first year. In the third year, you earn interest on your original money and the interest from the first two years. And so on. It's like a snowball -- roll it down a snowy hill and it'll build on itself to get bigger and bigger. Before you know it ... avalanche!

They then give three tips to making the most of compounding:

1. Start young.
2. Remember that a little goes a long way.
3. Leave it alone.

I've been doing this for about 15 years now and the amount I earn each year from compounding is really starting to take off. My magical date: when I earn more from the growth and compounding of my investments than I do at my job. That will be a glorious day. And while it's still a bit off, it's not so far away that I can't see it coming. I'm so excited!!!!

Did I mention that I LOVE compounding? ;-)

Paying Off a Mortgage Versus Investing

Here are some thoughts from a Yahoo Finance piece comparing paying off your mortgage versus investing instead:

As I see it, if money is even the slightest bit tight, hold onto it and pay off the mortgage month by month. There's nothing magically good about having a paid-off mortgage, but there's something seriously bad about not having ready liquid assets even if your home is paid for.

In short, unless you're sitting on surplus cash, I see no urgent reason to pay down or pay off your mortgage in a hurry.

As a "pay off your mortgage" advocate, here's my response:

1. I agree that you shouldn't put all your available cash into paying off your mortgage. You need an emergency fund and need to be saving for retirement (at least enough to get the full employer match) as well. If you can do these two things and still have cash left over, then paying off your mortgage is a viable alternative. This is the situation I was in when I paid off mine.

2. There's a big difference between theory and reality. In theory, paying a mortgage month-to-month and investing the rest is a great idea. The numbers will certainly support it as the better alternative. But how many people actually go ahead with the "plan" -- to actually save? I've seen many start to save for a few months or even a couple years, only then to decide that they "need" a big-screen TV, new boat, etc. and blow it all. So much for the "plan." Reality is different than theory -- especially in personal finances.

3. Everyone generally discounts the built-in insurance that comes with having a mortgage being paid off. For instance, two people lose their jobs. One has his home paid off and the other doesn't. Who's more worried? Yeah, if the second guy saved/invested like he should have, MAYBE he's less worried. But it's likely he hasn't exactly stuck to the plan (re-read point #2), so the guy with the home paid off is probably more secure.

4. What's the "I don't owe anything to anyone" feeling worth? Most people don't know because they owe something to someone. As a person who's had no debt for ten years now, I can tell you it is certainly a nice feeling. You hear the term "debt freedom" (or something like it) thrown around all over the place, but you don't really know that there is a true sense of freedom until you become debt free. And that's a feeling money can't buy.

5. My wife wants us to be debt free, so we are. ;-)

Index Funds Save on Taxes

I had this comment recently left on my post titled Why I Like Index Funds (Updated):

You missed just one advantage of index funds - they are tax friendly. Index funds have not only lower fees, but also save you from taxes (due to the fact that index funds hold the stock longer than the other types of mutual funds) and thus generate higher returns by allowing you to invest those saved money.

Actually, I didn't miss that point -- it was part of the post. It just wasn't broken out individually, it was noted as part of how index funds save on costs (and thus deliver a good return.) It's a good point though, and one worth being clear on.

BTW, since I wrote the post noted above, I have updated it with Why I Like Index Funds, Part 3.

Help a Reader: Stuck with a Variable Annuity

I recently received this question from a reader on my post titled Variable Annuities Are Money Traps. I told him I'd post it for all of you to answer. Here goes:

I was talked into rolling my 401(k) from a previous job into a variable annuity within an IRA. I realize this is my own fault for not doing my research before hand, but the sales pitch was too tempting (which should have been my first clue). Everything I read seems to say that this is the worst idea. I have two questions I'm looking for help on: (1) are there any cases where the variable annuity is a good choice, and (2) If not, is there any way to get out of a variable annuity in an IRA? Background if this helps, I'm 33, married, with one child. I've had the annuity for about 4 years, and it has about $50k in it. Any help would be appreciated!!!

So, what would you tell this guy to do?

Index Funds Plus a few Stocks Works for Me

Recently I received the following comment on my post titled Do You Have the Right Investments for Retirement?:

I believe that index funds serve as a good tool to use for some of a mutual fund portfolio, but I like to try to have some other funds who have consistently outperformed the overall averages as well. I know that index funds beat most mutual funds, but some funds do consistently outpace the major averages.

It's true, some funds do beat index funds, even after expenses are taken out. But how do you find these funds in advance (it's easy to find them looking back)? That's the problem, you can't.

So what should you do if you want the good performance of index funds with a bit of a "boost" to try and beat them? Here's what Money magazine suggests in addressing how many stocks you should own:

First, direct 90 percent of your U.S. equity allocation into a total stock market index fund that automatically gives you a stake in thousands of companies. That guarantees you a piece of every superstock that already exists or might emerge later - and, more important, it means you'll be adequately diversified and your investing costs will be at rock bottom.

Then pursue your search for the next Microsoft or Google by researching the daylights out of a very small number of companies and putting the remaining 10 percent of your portfolio into your one to three best ideas. This way you'll let yourself have a little fun. You will also minimize your risk and maximize your hope.

This is my current investing philosophy (I say current because I still own tons of managed mutual funds from my pre-index days that I'm trying to get out of, but managing my way through the capital gains bills.) But most of my new money is going into index funds with an occasional investment into a few hundred shares of one stock or another.

ETF 101: 5 Reasons ETFs Trump Mutual Funds

While I'm on vacation, I've asked a few good bloggers to fill in with a couple new posts each day. This one is from the ETF Expert.

I recently spoke at a seminar in New Orleans. Inevitably, the attendees wanted to know why ETFs are better than mutual funds. After all, don't all 401ks have mutual funds in them? And how come most advisors keep insisting that exchanged-traded funds are for unsuccessful market-timers?

Having spent nearly a decade discussing the virtues of ETFs, I am often troubled by these inquiries. I know that advisors resist ETFs because they're either lazy, uninformed or... worst yet... choosing to sell commission-based mutual funds. (And yes... that is why many advisors don't like to talk about no-commission ETFs. Your advisor won't make money on you!)

As for 401ks, they are mostly controlled by the biggest fund families and largest insurance companies. Since they themselves are not ETF providers, they are less likely to offer them in a plan that they are helping a company administer. (Yet, even 401ks are evolving. More 401ks have begun offering employees ETFs as an alternative within their plans each day.)

By way of review, here are 5 reasons that investors should look to exchange-traded funds for investment success, rather than traditional mutual funds:

1. ETFs Cost Less. Even though you do not receive a bill from mutual fund providers, you are charged a fee through the expense ratio. This is the primary way in which your fund family makes money. The typical mutual fund will run you 1.4%, or $1400 on every $100,000 that you invest. The average ETF has been estimated at approximately 0.36%. Even rounding up to 0.4%... $400 on every $100,000 invested is a lot less expensive than $1400.

2. ETFs Track Indexes...And Indexing Beats Actively Managed Mutual Funds. It may represent Wall Street's dirtiest secret, but fund managers do not beat pre-established indexes over significant lengths of time. Over any 10-year period studied, the overwhelming majority of actively managed mutual funds with overcompensated stock-picking gurus cannot keep up with the benchmarks (a.k.a. indexes) that they are paid to beat. When a few managers do outperform, the stock picker has often taken excessive risks in one segment of the economy (e.g., technology, energy, etc.). Yet given time, those big risks come back to bite. In short, ETFs track indexes, and indexing are your preferred road to success.

3. Pricing. Traditional mutual funds are priced at the end of the day. you have no control over the price you purchase at and, more importantly the price you may wish to sell at. In contrast, like individual stocks, ETFs makes it possible for you to choose the price point you wish to buy at. And, should you need to sell to protect your portfolio from sharp downturns, you have control over the price you wish to sell at as well.

4. Tax Efficiency. Traditional mutual funds buy and sell stocks. And many active managers have turnover rates... rates of turning over a portfolio in a year... of 100%. That's a lot of buying and selling of stock picks. The mutual fund structure. passes along capital gains form the buying and selling activity to the fund shareholder. You may not have any personal gains from being a fund shareholder, but come year-end, you are likely to experience a distribution that you must pay tax on... even when you are simply holding the fund! ETFs have next-to-no turnover because indexes rarely change. The low turnover of ETFs leads limit capital gains distributions and, due to a unique structure for ETFs, even rebalanced indexes do not necessarily have to buy and sell. In short, if you wish to keep the money you make, rather than pay taxes, ETFs win hands down!

5. Transparency. When you buy a mutual fund, what do you really know about it? You see a few stars from a rating group like Morningstar. You see a number of calendar year percentage gains. Do you really know what the fund manager invests in? You may get as description of the top 10 holdings in  a previous 3 month period, but you are essentially, guessing. In contrast, an exchange-traded fund (ETF) represents a specific index. You know exactly the stocks in that index and exactly the weight of each stock in the index. That transparency gives you the confidence to know what you are investing in...precisely.

Variable Annuities Are Money Traps

AARP recently listed several money traps people fall into. One of the traps on their list is buying variable annuities. The details:

The cardinal rule of investing is, keep things simple, and variable annuities are anything but, melding the potential for growth that comes from stock investing with the guarantee of a steady income that all annuities are supposed to provide. Mixing motives costs you. The average annual expense fee for a variable annuity is 2.39 percent of assets, compared with the average mutual fund expense fee of 1.36 percent.

Need we say more? We could, because that number doesn’t even include sales commissions or surrender charges applied if you pull your money out years later. And the fund monitor Morningstar reports that the average variable annuity underperformed the average mutual fund no matter what time span it examined—one year, three years, five years, or ten years. For the past ten years the average variable annuity invested in stocks posted an annual return of 6.72 percent, compared with the average fund return of 8.71 percent.

A few thoughts here:

1. Variable annuities are often very complicated and difficult to understand. Many make it hard to know what you're really earning. Strike one.

2. Variable annuities are expensive. 2.39% of assets is a FORTUNE -- especially when you could pay 0.20% with an index fund. Remember, costs make a tremendous impact on the performance of an investment and variable annuities simply cost too much. Strike two.

3. Variable annuities get even more expensive when you add in the extra fees noted above. As a result, they end up nearly two points below the performance of the average mutual fund. Two percentage points is a huge amount -- especially when it's compounded through the years. Strike three.

Three strikes -- they're out.

Is Your House an Investment?

My boss and I have an on-going debate. He says his home is an investment (thus he has a nice, big house as part of a golf course community) that will grow in value and provide for him in retirement. He's moved several times in his career and has always made good money on the sale of his homes. I, on the other hand, have a much-less-expensive "average" home (nice, but nothing special) and prefer to put as much as I can into the stock market. My thought is that a home is closer to a purchase than an investment and thus I want to get a good value on it and put as much money into something else that really performs.

Money magazine takes on these issues in the September issue where it asks if your house is a nest egg. In the piece, they list and refute three myths:

• Myth: My home is a sure investment
• Myth: Downsizing will leave me flush with cash
• Myth: I can always tap my equity and invest it for even better returns

And they end with this "bottom line":

Saving for retirement is still Job No. 1. Your home may provide a roof over your head in retirement, but you'll need cash if you want to eat.

I'll be sending this article to my boss. ;-)

In the magazine (not online) they also have an interesting graphic that compares 51- to 56-year-olds net worths "today" (really 2004) versus in 1992 and how the growth in that time has mostly been in home values (Money labels the graphic "House Rich, Cash Poor".) Here are the stats:

• Total net worth in 1992: $136,260
• Total net worth in 2004: $152,000
• Difference: +11.6%

• Total nonhouse wealth in 1992: $49,140
• Total nonhouse wealth in 2004: $47,500
• Difference: -3.3%

My thoughts on these:

1. So, held over long periods of time, it appears homes do grow in value, huh? Duh! Of course. Still, that fact alone doesn't mean they are a good replacement for stock investments. In fact, it can be argued that renting and investing is a better deal than buying a home.

2. I remain shocked at how little net worth people have. Now there are a few caveats to this data. It doesn't say whether it's average or median information, so we're in the dark there. Also, the information doesn't include "401k, pension income, and business wealth," all of which could be a decent amount. That said, even if these doubled the amounts above, the net worth numbers are still paltry for people in their early to mid 50's. Come on -- some of these people are 10 years from retirement age!

3. The nonhouse wealth is really distressing. These people have less than $50k liquid net worth? And it's gone DOWN in the 12 years measured? Unbelievable.

Do You Have the Right Investments for Retirement?

Here are four questions from Money magazine that will help you determine whether or not you have the right investments for retirement:

1. Do you have the right stock and bond mix?
2. Are you holding the line on fees?
3. Do you ignore hot investing trends?
4. Do you rebalance once a year?

Here's how I do on these:

1. Right now, I have 20-25 years before retirement (unless I retire early), so I'm almost totally in stocks. I think that's right for me based on the time I have left as well as my tolerance for risk (which is moderate to high.)

2. I certainly am holding fees down. That's one reason I love index funds -- low costs.

3. Index funds are the opposite of hot investing trends. ;-)

4. With my allocation so heavily weighted in stocks, there's not much rebalancing to do. But I am trying to consolidate all my investments into a handful of accounts and a handful of funds. It's taking some time as I'd accumulated several funds over the years before I got into index investing. So now I'm moving them around slowly, trying to minimize capital gains taxes. here's one way I'm going this.

For more of my thoughts on investing, see these posts:

• Illustration of How Costs Can Greatly Hamper Your Investment Returns (And Why Index Funds Do So Well)

• Investment Smackdown: Index Funds Versus Actively Managed Funds

• Key to Investing: Start Early

Timeless Money Rules: Investing, Debt, and Estate Planning

Money magazine has a series on 20 timeless money rules that's pretty interesting. Over the next few days, I'll be sharing a few of these as well as my thoughts on them. The first one for today is to invest abroad. Money's thoughts:

Most Americans have less money in foreign funds than the 15% to 25% experts recommend. But you don't have to be like most Americans.

I'm in the category of "most Americans" here but I've been working on putting more money in international index funds the past couple of years. I should be in the 15% to 25% range in a couple more years.

Money next gives some thoughts on how not to panic when the market drops:

When the Dow sheds 300 points in a day, it's natural to feel doomed. And when the market surges, it's easy to be convinced that stocks have entered "a new paradigm," to echo a bubble-era phrase. Don't delude yourself. As Sir John Templeton notes, "The four most expensive words in the English language are, `This time it's different.' "

This is why I've been going against the flow recently and why, despite the fact that the market's been rocky, I think it's a great time to invest.

Money now moves off investing and suggests people need to borrow responsibly:

Face this truth: If you let them, lenders are only too willing to advance you more than is good for your family. Mortgage banks and credit-card issuers don't care if your monthly payment makes it impossible for you to sock away money in your 401(k) or fund your kid's 529 plan.

So what should you do? Get out of consumer debt, pay off your credit cards, and save for major purchases like cars. And if you're really disciplined, work on paying off your mortgage.

Finally, for today, money suggests that you exit gracefully. In other words, they say that you need a will and an estate plan. I couldn't agree more.

For those of you who want more details on these thoughts, check out the following:

• Nine Ways to Pay Off Debt

• You Need a Will

• Why You Need Some Investments in Foreign Markets

Timeless Money Rules: More on Investing

Money magazine has a series on 20 timeless money rules that's pretty interesting. Over the next few days, I'll be sharing a few of these as well as my thoughts on them. The first one for today is to not time the market. Their thinking on this issue:

The lesson: The surest way to investing success is to buy, then stick to your guns.

This is why I buy and hold. And hold. And hold.

I've tried it the other way (early on in my investing career) and I paid for it. But experience is a great teacher and I learned at an early enough age what NOT to do. So now I add to my investments steadily every month and hold them forever.

Money's tips next discuss the fact that costs matter significantly when investing. They start with a quote from Jack Bogle:

Performance comes and goes, but costs roll on forever.

Ha! So true.

So many costs are fixed into many mutual funds -- costs that will be there no matter how the investment performs -- which in effect doom the funds to poor performance even before they get started. Here's what Money has to say:

If you choose a fund that eats up 1.5% a year in expenses over one that costs 1% (let alone the 0.2% that index funds may charge), your fund's return will have to beat the other's by half a point a year just for you to come out even. Past returns are no guarantee of the future, but today's low-cost funds are likely to stay low cost. Buying them is the only sure way of giving yourself a leg up.

Index funds. Nothing else needs to be said.

Money next advises that investors shouldn't follow the crowd. Their thoughts:

As the legendary financier Sir James Goldsmith has said, "If you see a bandwagon, it's too late."

I'm a big believer in going AGAINST the crowd. I detailed much of my rationale for this recently in Going Against the Flow.

Finally, for today, Money suggests that we buy low saying:

If a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. --Warren Buffett

Now this is easier said than done, of course. But there are times when you can see that the market's acting irrationally, and if you have some money on the sidelines, you can swoop in and buy stocks while they are on sale.

For some more thoughts on these issues, see these posts:

• Costs Matter If You Want to Maximize Investment Returns

• Minimize Taxes to Maximize Your Investment Return

• Why I Like Index Funds

Timeless Money Rules: Keys to Investing

Money magazine has a series on 20 timeless money rules that's pretty interesting. Over the next few days, I'll be sharing a few of these as well as my thoughts on them. The first one for today is to take calculated risks. Their thinking on this issue:

To earn returns high enough to build true wealth, you have to put some of your money in risky assets like stocks--the only investment to handily beat inflation over time.

I've got this one covered. As you know, I'm a big believer in long-term stock investing. I'm on the aggressive side, with about 90% of my portfolio in stocks. But I have a long time horizon (20 years or more), so I'm comfortable with such a high mix of "risky" investments.

A few tips later, Money says that a key to investing success is to diversify your investment types:

Nothing can break the law of risk and reward, but a diversified portfolio can bend it. When you spread your money properly among different asset types, a rise in some will offset a fall in others, muting your overall risk without a commensurate drop in return.

I spread my money among many different stocks -- that's a key advantage of index funds -- but not really among asset types. I do have some money in real estate (my house, of course, as well as a small amount in a real estate LLC), but little in bonds and none in commodities.

Next, Money again notes that asset allocation is key to investing success. They comment:

What really matters to your long-term returns is asset allocation--that is, how you split up your portfolio.

Since researchers dropped this bombshell 20 years ago, experts have debated the size of the asset-allocation factor. Some say it accounts for 40% of the variation in investors' returns; others (like the original researchers) say 90%. But no one refutes that it's major.

They then note how different people can have different asset allocations based on their tolerance for risk. I guess my tolerance is just high, since I'm so invested in stocks.

And we end today with Money singing the praises of index funds. They start by including a quote from Warren Buffet:

The best way to own common stocks is through an index fund.

;-)

They go on to tell why index funds are so successful and end with this:

It's hard to argue with the math, and history bears it out. Besides, if the Greatest Investor of Our Time believes that index funds are superior for most investors, shouldn't you?

I've covered all of these issues in past pieces, so they may be a bit old hat for some readers. But just in case you want more, here are some pieces to check out:

• How to Balance Risk and Return in Your Portfolio Asset Allocation

• Why You Need Some Investments in Foreign Markets

• Why I Like Index Funds

Jim Cramer Doesn't Know Stocks

Here's a piece I find interesting to say the least. It's from MSN Money and is based on a Barron's study of Jim Cramer's (the Mad Money host) stock picks. Turns out, he's not very good at picking stocks (who would have guessed?) Their summary:

Over the past two years, viewers holding Cramer's stocks would be up 12% while the Dow rose 22% and the Standard & Poor's 500 Index ($INX) gained 16%, according to a record of 1,300 of the CNBC star's "buy" recommendations compiled by YourMoneyWatch, a Web site run by a retired stock analyst and loyal Cramer-watcher.

We also looked at a database of Cramer's "Mad Money" picks maintained by his Web site, TheStreet.com. It covers only the past six months but includes an astounding 3,458 stocks -– "buys" mainly, punctuated by some "sells." These picks were flat to down in relation to the market. Count commissions and you would have been much better off in an index fund that simply tracks the market.

The piece goes on and on -- for four pages -- on the efforts the author took to try and get Cramer or CNBC to refute the fact that Cramer's picks underperform the market. Read it if you will, but the short version is that he got nowhere. They stonewalled, didn't respond, gave excuses, and so on.

A couple thoughts here:

1. Jim Cramer is an entertainer as much as he is anything else. He does well at providing a good "show" and that's on reason people like/watch him. Yeah, they think he can earn them some money too, but his flamboyant style is certainly part of his appeal.

2. Is anyone surprised any more when they find out that an "expert" isn't all they're cracked up to be? Or that a financial advisor of some sort is just as interested in making money for himself as he is at helping a viewer/client? Personally, I've lost all sense of shock on this topic.

3. Forget Cramer and his stock picks and go with index funds. Check out these recent posts for thoughts on why:

• Facts on the Benefits of Index Investing

• Illustration of How Costs Can Greatly Hamper Your Investment Returns (And Why Index Funds Do So Well)

• Warren Buffet Recommends Index Funds

The Top S&P 500 Index Funds -- I Own Them All (Almost)

Here's a piece from USA Today that lists the top three S&P 500 index funds. Their list:

• Vanguard 500 (VFINX) is the granddaddy of S&P 500 investments. It's one of the largest mutual funds in the world and it was the first index fund to track the S&P 500. It's a great option for many investors, given its low 0.18% expense ratio.

• Fidelity Spartan 500 (FSMKX) is Fidelity's answer to Vanguard's 500. While Fidelity isn't known for its index funds, Fidelity Spartan 500 is compelling since it has an expense ratio of 0.1%, which is even lower than Vanguard's.

• E*Trade S&P 500 Index (ETSPX) is offered by online discount brokerage E*Trade. The 0.09% expense ratio is a tad lower than Fidelity's, which is interesting, but probably not enough to get you to switch. But if you have an E*Trade brokerage account you may lean toward this fund because it can be bought without a commission.

I own all three of these (if you give me a "close enough" on Fidelity) as follows:

1. Most of you know that the bulk of my investments are with Vanguard. I have a taxable account with them as well as a couple IRA rollovers (one from me and one from my wife.) All of these have shares on Vanguard Index 500 in them.

2. My 401k at work is with Fidelity and I investment into funds very similar to FSMKX. I put my money into Fidelity Spartan Extended Market Index (FSEMX) and Fidelity Spartan Total Market Index (FSTMX) -- two funds that are broader than just the S7&P 500.

3. My kids have Coverdell college savings accounts with Etrade that I have invested in ETSPX. Costs are VERY low here, and the fund has done well for us over the past few years.

Facts on the Benefits of Index Investing

Here's a piece from Vanguard that offers some stats on how index investing has done versus actively managed funds:

Indexing has generally beaten many of the actively managed funds available. Over the 20 years that ended December 31, 2006, for example, the Vanguard® 500 Index Fund outperformed 80% of the actively managed large capitalization funds. [Sources: Lipper Analytical Services, Vanguard, and Standard & Poor's.]

And one of the main reasons index funds do so well:

One reason many index funds have consistently done better than most managed funds is because they typically have lower expenses. . . . It is that gap between expenses of the two types of funds that can give you the advantage from indexing. [Sources: Lipper Analytical Services, The Plexus Group, and Vanguard.]

So which would you rather have, a fund that returns 10.5% but has 1.5% in expenses or one that returns 10% and has 0.2% in expenses? (I don't know the exact numbers, but the illustration gets the point across.)

For more on this topic, check out these posts:

• Illustration of How Costs Can Greatly Hamper Your Investment Returns (And Why Index Funds Do So Well)

• Another Vote for Index Funds

• Blending Index Funds to Achieve Higher Returns

• Low Costs Usually Equal a Better Investment (And the Various Costs You Need to Look For)

Now's a GREAT Time to Invest

Here are a few more comments to the thoughts I shared yesterday on Going Against the Flow and an earlier post on Stocks "On Sale". We'll start with a piece from USA Today noting how professional investors often panic (and thus we see the market tumble) but if you're in to for the long haul, you shouldn't worry:

If you're a long-term investor, there isn't any large reason to be terrified. Before you panic, however, take a deep breath. When you sell in haste, you often repent at leisure.

There's no reason to panic is right! In fact, why sell when you can snatch up some great deals today? That's what the Motley Fool says in Why You Should Be Buying:

In fact, Miller would probably say my colleague Bill Barker understated the case when he called now the best buying opportunity in 12 years; Miller says stocks are the cheapest they've been since January 1991 (16-plus years)! That makes now, in Miller's words, "a pretty good time to be a buyer of stocks!" After all, "lower stock prices mean values are better and future rates of return are higher."

They expand on these thoughts a bit in The Best Buying Opportunity in 12 Years?:

It's also worth noting that Wharton professor, best-selling author, and leading market historian Jeremy Siegel has said that given the low trading costs and ease of diversification today, P/E levels of around 20 are probably justified for the future. If that turns out to be the case, today's levels are certainly one of the better buying opportunities you'll find.

I bought more shares in a broad-market index fund yesterday and will look at future market declines as opportunities to pick up some more shares at bargain prices.

Time Shares are a Purchase, Not an Investment

Truer words were never spoken:

Time shares are a purchase, not an investment.

A Bankrate reader recently asked about purchasing a time share for $20,000 for one week's worth of vacationing and wanted to know if this was a good investment. Here's what Bankrate said:

I don't think you should look at this purchase as an investment. Regardless of how you feel about fractional ownership or time shares, it's rare for them to perform well as investments. Take a look at the resale market for fractional ownership in your vacation spot and that should show you why these purchases aren't good investments and demonstrate a way to buy in without paying primary market prices for the weeks you want.

Don't forget to consider the maintenance fees, property taxes and other annual costs associated with this purchase. You also have to place a lot of trust in the property manager to keep up the place and protect the value of your purchase.

My advice is to be very cautious before buying.

My advice is don't buy! Unless you really, really, really love doing the same thing in the same place and you really, really, really know/trust the owners/managers of the property and you really, really, really have more money than you know what to do with, then I'd say you should pass on the time share idea.

We have friends who recently bought into the Disney time shares and seem to like them. Disney may be an exception to the rule, but even with their time share, like others, the cost is very high for what you get.

Anyone out there own a time share or know someone who does (or did?) Any stories to share? I'd love to hear if anyone bought a time share and then sold it some time later for a profit.

Stocks Still Return 10% a Year

Here's an amusing USA Today piece. It highlights the author's challenges with his readers. He argues that stocks, on average, return 10% a year. But when the markets are down, he gets letters that he's crazy -- it returns no where near 10%. And in this piece, he gets a letter asking if 10% is too low to expect. Why? Because the market had a great year the previous year. Here's his response:

The market, on average, returns 10% a year. I have no idea how much the market will return this year or next year. It's also important to point out it's uncommon for the market to return exactly 10% in any given year. That's a long-term average. For all I know, this year the market may return 20% or it might fall 20%. But if you stay invested in stocks, and own the kinds of stocks that fit your taste for risk, a 10% average annual return isn't an unreasonable assumption.

That's right -- the AVERAGE is 10%. But in a five year period, there will likely be significant swings both above and below this level. But 10% is still a reasonable number to use when estimating how your stock portfolio will perform over the long term. In the short term, it's anyone's guess what your portfolio will do.

Another good thing with 10% is that it's easy to calculate in your head -- much easier than 8% or 12%. ;-)

I look at the performance of my portfolio (of course), but a bigger issue for me is the performance of my net worth. This number factors in not only how my portfolio is doing but also how much I'm able to add to my net worth by saving from current income as well as how my home is increasing in value (or decreasing as it is in the current environment). I've averaged a bit over 16% compounded growth in net worth for the past 15 years or so -- a figure I'm pretty happy with. But, as you can imagine, as my assets get larger, it's harder and harder to maintain that level as I'm trying to grow on a bigger base. That said, I certainly would rather have smaller increases on a large number than large increases on a small number. ;-)

Stocks "On Sale"

A reader asked USA Today what it means when people say stocks are "on sale". The answer:

It's really just a general comment meaning a stock is less expensive than it used to be. It is a play on words of sorts, equating a stock price decline with a markdown on a sweater in the department store. Since the prices have been cut on both things, they're technically on sale.

As an example, let's say stock ABC is a "good" value at $50 a share. But then the market turns down, the economy stalls, investors panic -- any one of a ga-zillion bad things that can drive the market down happens -- and ABC goes down with everything else. Now let's say it's priced at $45 a share. If it was good at $50 a share, it's now even better at $45 a share (assuming nothing changed that significantly impacts the company's performance) -- a $5 "sale" that many investors will jump on.

I am a sale shopper myself when the market takes a dive. Between my emergency fund, savings for big ticket purchases (new cars, etc.), and the fact that I'm accumulating cash for a potential downpayment on a new house, I have cash on the sidelines now that I can tap into to "buy low" if (or maybe I should say "when") the market declines.

Of course, I'm buying into index funds every month already, but when there's a big sale, I like to jump in and get a bit extra. I'm a sucker for a good sale. ;-)

Everything Warren Buffett

US News and World report has a great section on Warren Buffett and his investing style. I'm going to highlight a few of their pieces and add my comments to them.

In How to Make Money The Buffett Way they ask:

What if the bottom was falling out of the stock market, and your portfolio had plunged by 10 percent in a week?

Buffett's answer:

d) Study and reconfirm your assessment of the company, then smile and buy more?

If you answered "d," you may have a future at Berkshire Hathaway, the financial juggernaut whose 76-year-old chief executive and godhead, Warren Buffett, is searching for a successor. That's because, in addition to the requisite financial smarts, you'll need the sort of temperament to do what the "Oracle of Omaha" has long done best: take advantage of the market's temporary insanity to stock up on sure things at bargain prices.

Ha! Warren and I are on the same page when it comes to this tip. ;-)

They also list the six keys to investing Buffett style including:

• Make money by not losing money.
• Don't get fooled by earnings.
• Look into the future.
• Stick with companies with wide "moats."
• When you bet, bet big.
• Don't be afraid to wait.

This is basic investing 101, really. These tips are simple to understand, but hard to implement. That's what makes Buffett so good in my opinion -- he knows these rules and consistently follows them no matter what others think, what the market is doing, etc. To me, it's his implementation that's a big part of his success.

Then again, he's brilliant too. In Built to Make Billions? they wonder if Buffett's brain is simply wired in the right way:

To be sure, Buffett possesses one of the keenest intellects in business, with a knack for crunching numbers in his head. "His neurons are really good at thinking in a purely abstract, rational way," says law professor Lawrence Cunningham, author of How to Think Like Benjamin Graham and Invest Like Warren Buffett. "It's a way of thinking in terms of calculations, of instantly recognizing if a company generates profits at a given cost over time. It's something businessmen learn to do before making a capital allocation. But for him, it's an innate apparatus."

No fair, no fair!!!! (as my 9-year-old would say.) ;-)

And if you doubt he's both brilliant and a great implementer, check out how $1,000 invested with him in 1956 would be worth almost $28 million today.

Not bad at all!

Illustration of How Costs Can Greatly Hamper Your Investment Returns (And Why Index Funds Do So Well)

As most of you know, I'm a big fan of index funds. One reason I like them so much is because their low costs help them perform better than most investments. Here's how Vanguard, the company that's probably the biggest proponent of index funds, summarizes the relationship between index funds, costs, and investment returns:

"One reason many index funds have consistently done better than most managed funds is because they typically have lower expenses," Dr. Malkiel said in a recent Vanguard.com interview. "It is that gap between expenses of the two types of funds that gives you the advantage from indexing."

In the same post that contains this comment, there is a simple illustration that shows how higher investing costs can be a drag on total returns. For many of you, it will be too simple (you'll know this already), but I thought it was a good graphic portrayal of what I discuss here quite frequently, so I wanted to highlight it.

To see the illustration, click this link, then scroll to the bottom (unless you want to read the article too) to where it says "higher expenses can be a drag." The illustration is right below an opening paragraph. Enjoy.

Where Do You keep Your Short-Term Cash?

Here's a reminder from Bankrate that you should keep any money you'll need in the next couple of years in a very liquid account like a money market. The details:

I'm with you and agree that you should be investing conservatively when you have an investment horizon of two years or less. CDs, money market accounts (MMAs) and money market mutual funds (MMMFs) are all good choices. CDs typically aren't as liquid as the other choices with penalties for early withdrawal.

We keep our short-term money in a Vanguard money market. It earns competitive rates and makes it easy to buy Vanguard funds if I decide I want to move some money from short-term savings to long-term investments.

How do you manage your short-term cash? Where do you keep it?

Warren Buffet Recommends Index Funds

Here's a piece from Bankrate detailing the Berkshire Hathaway annual meeting featuring financial thoughts from Warren Buffet. As usual, he dispensed his brand of folksy financial wisdom on a variety of subjects, but one part of the piece I wanted to highlight is what he said about index funds. His thoughts:

In response to a question about why Buffett recommends index funds to investors, he said that for "a know-nothing investor, a low-cost index fund will beat professionally managed money." He also said he had a standing offer to anyone who could name 10 hedge funds that will beat a low-cost index fund. No one has taken him up on his offer.

Asked later why he didn't take his own advice on index funds, he said he thought Berkshire could beat the S&P by a couple of percentage points, "just not a whole lot better."

Wait, did he just call me a know-nothing investor? ;-)

That's ok, I don't take offense since he's calling 8 out of 10 (or so) mutual fund managers know-nothing investors as well. That's roughly how many can't beat index funds over the long term. ;-)

For more on why I think index funds are a great investment, see Why I Like Index Funds.

Another Vote for Index Funds

In Money magazine's interview with legendary fund manager Bill Miller this month, they ask him why investors shouldn't just put their money into an index fund versus trying to find the next great mutual fund manager to invest their money. His response:

The odds of getting a manager who can outperform over 10, 15 or 20 years are about one in four. So there's a very significant case to be made for having most of your money in index funds.

The fact is, however, that index funds do not give you the results of the index. They give you the results of the index less your costs, which are small but real.

To have a prayer of outperforming, you've got to have some money in active management.

Let me translate this:

• You have a 25% chance of finding a fund manager who can beat an index fund. Looked at the other way, there's a 75% chance that an index fund will outperform any managed fund you select. Seems pretty obvious to me that index funds are the clear winners based on the numbers here.

• There are costs associated with index funds too, though they are generally low. And, as we all know, keeping costs low is a key part to making the most of your investment.

• If you think you can beat an index fund by going with an actively managed fund, you better be a praying person. ;-)

Ok, I stretched that last one a bit, but I think you get the point overall. What he's really saying is that in the vast majority of cases, an index fund is a better investment than an actively managed fund. He gives 75% to 25% advantage to index funds, but I think the advantage is bigger than that. Here's what the Motley Fool has to say on the issue of index funds outperforming actively managed funds:

Almost all actively managed equity mutual funds over time lose to the market averages. And those funds that do beat the market's return typically do so for only a very short period of time, and then quickly reverse course.

So the odds are MUCH better for us all if we stick with index funds versus actively managed stock funds.

Mr. Miller closes the interview with a comment I also want to highlight. He says:

Being willing to lower your average cost [by buying more when a stock drops] is a great strategy. But it's difficult.

See? I told you so. ;-)

Blending Index Funds to Achieve Higher Returns

The following is courtesy of Marotta Asset Management and gives their thoughts on using index funds for investing:

If you have been following my investment advice closely, you can probably guess that I don't favor stock-picking as the best way to meet your financial goals. But even if you favor index funds, as I do, that doesn't mean you have to use them exclusively.

You have probably heard the statistic that most actively managed funds fail to beat their indexes. Here's why. Most mutual funds are laden with loads, fees and expenses. It is nearly impossible to recover from the drag of high expenses. This is why most mutual funds have to be sold by mutual fund salesman. They could never compete when there are funds that are just as good with half the expenses. Most funds have no hope to beat their indexes because they are gouging their investors. But be aware, there are even index funds with high fees.

But, if most actively managed funds fail to beat their index, nearly all 100% of index funds fail to beat their index. Even if an index fund tracks their index perfectly, they too have expenses and even if their expenses are as low as 0.2% then they will still under-perform the index by 0.2%.

Even if you are a die-hard believer in the efficient market hypothesis, that doesn't mean you have to invest only in index funds. If the efficient market hypothesis is correct, then you won't do any worse (on average) with a random collection of stocks within an index than you will by holding the index. If stock picking doesn't matter, then you are free to pick any collection of stocks within the index that vaguely represents the index.

Some index funds perform poorly against the index not because they have high fees, but because they are trying to track the index too closely. When a stock is added to S&P 500, millions of dollars invested in S&P 500 Index funds must all buy that stock in order to track the index exactly. Stocks added to the S&P 500 do very poorly the year after this surge of automated buying. Funds that delay purchasing these stocks can perform better than those who purchase them immediately and pay a premium. Similarly, stocks that are being removed from the S&P 500 will out perform the index over the next year because all the index funds dumping the stock drive the price down needlessly. Delaying the sale of this stock until it has had a chance to recover produces superior returns.

In fairness, there are a few index funds which use these actively managed techniques to purposefully not track the index as closely as they could in order to try to beat their index. Vanguard 500 Index Fund (VFINX) uses some of these trading techniques and has beaten the S&P 500 Index over the past 3, 5, and 10 years. This past year, though, they under-performed the S&P 500 Index by 0.18%, which it just so happens is exactly their expense ratio.

Even if you believe in the efficient market hypothesis and investing in indexes, you have to ask the question "Which index?" Take for example the allocation you invest in foreign stocks. The EAFE Index is a cap-weighted index of a collection of countries that are in Europe, Australia, and the Far East, hence the initials EAFE. EAFE had a return of 27.00% over the year July 2006 through June 2007. The EAFE Index is split into EAFE Value and EAFE Growth. On average Value produces higher returns than growth, so you may want to buy some EAFE Value to provide this emphasis. Over the past year EAFE Value had a return of 28.65% vs. 27.00% for EAFE. EAFE Growth only returned 25.29% over this same time.

If you want to tilt your EAFE investment toward value, you would still want to invest the majority of your investments in the index and then add a portion in value specifically rather than just buying more EAFE Value than EAFE Growth.

The iShares EAFE (EFA) has an expense ratio of only 0.35%, while iShares EAFE Value (EFV) or Growth (EFG) have expense ratios of 0.40%. So you can reduce your expenses ratios by investing the bulk in iShares EAFE (EFA) and a portion in iShares EAFE Value (EFV) in order to keep expense ratios lower and still tilt toward value in order to boost your returns on average.

EAFE, however, does not include Canada. Many investors forget or don't know this, so they only invest in the United States and EAFE. A more sophisticated investor would add an appropriate share of Canada, such as iShares Canada (EWC). Canada is a good investment to include in your portfolio. Canada, not China, is America's biggest trading partner. Rich in natural resources, Canada's oil reserves are second only to Saudi Arabia's. In fact, Canada is the largest foreign supplier of energy to the US. Canada's returns over the past year were 28.3% vs. 27.00% for EAFE.

You may also want to invest in the emerging market countries. These are 26 countries of the developing nations that are not part of the EAFE Index but are part of the emerging market EMU Index. This past year the EMU Index had returns of 36.63% vs. 27.00% for EAFE. The iShares has Emerging Market Index exchange traded fund (EEM) provides an easy way to invest in this index. In addition to EAFE, EMU and Canada, those countries with the most economic freedom produce superior returns. We just finished our analysis and found this collection of a dozen countries produced an average return of 34.02% over the last year vs. 27.00% for EAFE. This technique requires another dozen country specific indexes most of which can be purchased through iShares exchange traded funds.

Just as Value indexes do better than Growth indexes, so also Small Cap indexes do better than Large Cap indexes. There currently isn't an iShares for small cap foreign, though this would also boost your returns, if it existed.

So far I have mentioned several indexes you should be investing in to provide the right mix just for your foreign investments. Even if you use all index funds, we recommend blending dozens of them in an asset allocation aimed at reducing risk and increasing returns to best meet your specific financial goals.

Rather than judging a fund solely on whether it is an index fund or not, funds should be judged by a whole set of criteria. Look for funds with low expenses, a broad collection of stocks, superior execution and low turnover.

And also, judge a fund by what index is follows most closely, does it drift outside that index, and what correlation that particular index has with other investments in your portfolio.

Building an asset allocation which is a blend of dozen indexes based on their expected risk, return, and correlation to other investments in the portfolio is what comprises the analytic analysis even for those who believe in mostly efficient markets.

Why You Need Some Investments in Foreign Markets

The following piece is courtesy of Marotta Asset Management and gives their thoughts on the need to have foreign investments as part of your portfolio:

Adding international investments to your portfolio is a good way to diversify for safety while boosting returns. On average, international stocks appreciate more than US stocks. What's more, companies located in countries with the most economic freedom typically appreciate more than the broader international average. Over the past year, countries with the most economic freedom appreciated 7% more than the international index.

The MSCI EAFE Index of international developed markets gained 27.0% (in US dollars) during the one-year period ending June 30, 2007 and has averaged 22.2% annually for the past three years. Compare that to the stock indexes of the twelve most economically free countries which gained 34.0% during the past year and returned 25.4% annually for the past three years.

For small accounts, investing in a good international mutual fund is usually sufficient foreign diversification for your investments. However, greater diversification and returns can be gained by putting some money into the "emerging markets" category. Emerging markets, as measured by the MSCI Emerging Markets Index, appreciated 36.6% (in US dollars) over the past year and has averaged 26.5% over the past three years. Although emerging markets have a higher appreciation rate, they are also inherently more volatile than the markets of more developed nations.

Returns 6/30/2006-6/30/2007

Singapore 60.7%
Germany 48.8%
Sweden 44.3%
Australia 43.6%
Netherlands 38.4%
Austria 36.4%
Belgium 33.2%
Hong Kong 29.5%
Canada 28.3%
United Kingdom 27.4%
Switzerland 22.5%
Japan 7.23%

To balance investment performance and volatility, a simple foreign asset allocation might invest two-thirds in the MSCI EAFE Index and one-third in the MSCI Emerging Markets Index. Using this technique, you would have gained 30.2% for the past year and averaged 23.7% over the past three years.

For larger accounts, a more complex asset allocation can be used for further diversification. This asset allocation strategy takes advantage of the fact that economic growth is often better in those countries with the greatest economic freedom. We use the Heritage Foundation's measurement of economic freedom to emphasize those countries that combine the greatest economic freedom with large investable markets.

Since its inception in 1994, the Heritage Foundation Index of Economic Freedom has used a systematic, empirical measurement of economic freedom in countries throughout the world. The conclusions from this study clearly demonstrate that countries with economic freedom also have higher rates of long-term economic growth. This makes the study useful for investors to use to decide which countries should be emphasized in their country-specific foreign stock allocation.

According to the Heritage Foundation's study, "Economic freedom is defined as the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, people are free to work, produce, consume, and invest in the ways they feel are most productive."

A country's economic freedom score is based on fifty measurements that fall under the following categories: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and foreign investment, banking and finance, wages and prices, property rights, regulation, and informal market activity.

A number of the countries ranked high in economic freedom have exchange-traded funds (ETF's) which track the market indexes of these countries and provide an easy, convenient, and inexpensive way to invest in each country. Exchange-traded funds combine the liquidity of individual stocks with the diversification of an index fund. The ETF's also typically have lower expense ratios than most mutual funds.

For larger accounts, we recommend investing half of the assets using the simple technique described above. As such, one-third is invested in the MSCI EAFE Index fund and one-sixth in the MSCI Emerging Markets Index fund. The other half is divided among the twelve countries with the most freedom that also have markets large enough to have a country-specific ETF.

All of the top twelve most economically free countries, except Japan, beat the United States's 20.6% return over the past year as measured by the S&P 500. In descending order, the past year's investment returns for the top twelve countries are as follows: Singapore 60.7%, Germany 48.8%, Sweden 44.3%, Australia 43.6%, the Netherlands 38.4%, Austria 36.4%, Belgium 33.2%, Hong Kong 29.5%, Canada 28.3%, the United Kingdom 27.4%, Switzerland 22.5%, and Japan 7.23%.

Over the past year, ten of these countries beat the broad MSCI EAFE Index and only two Switzerland and Japan) fell short. Of the twelve countries, Japan and Belgium were only ranked high enough by the Heritage Foundation's Freedom index this past year to warrant being added as country-specific investments. While Belgium's index had nice returns, Japan has not yet contributed as much.

Averaged together, the top twelve free countries gained 34% this past year. This is a full 7% above the MSCI EAFE Index which gained 27%. Excluding Japan, the other economically free countries beat the MSCI EAFE by a full 11%. Over the past five years, investing in countries with the most economic freedom is a strategy that has beaten the MSCI EAFE Index by an average of four or five percentage points annually.

Diversifying your foreign investments is just one important component of an optimal asset allocation.

Simple Criteria for Looking at Active Management

The following is a post from a reader who's a CFP at Hong Tran Financial:

Many people that read Free Money Finance are passive investors that use index funds for the investment management.  I thought it would be interesting to write about “the other side”, that being the active money managers.  I focused on what are some of the criteria that make a good money manager as well as a good active fund.  I hope you enjoy it!

Mutual fund money mangers are evaluated on various metrics, but the most common is performance.  Unfortunately, as the disclaimers you see on investments state, past performance is no guarantee of future performance.  So what do you look for with performance or any other measurement when trying to find a good money manger?  Here are some metrics that I hope will help you get a better grasp on this:

• Performance – Rather than use 3 or 5 year performance (what some consider “long term”), I suggest using at least a 10 performance.  The reason for this is that a typical market cycle can last up to 10 years (or occasionally longer).  Using a 5 year performance can get you the high end of the market or the low end of the market, but it may not get you both.  A great example is the technology boom of the late 1990s.  From 1995 – 1999, most equity funds did well along with the market.  This was a drastic difference the following years when the same funds showed huge losses during the technology bust.

• Assets under Management – The bigger the fund is, the harder it is for the fund to buy significant stakes in the companies it wishes to own.  For example, a fund that manages 50 billion dollars wants to have a 1% stake in the companies it owns.  This equates to a 500 million dollar investment. However, if some of the companies that it wishes to own have a market cap of 1 billion dollars, than the fund is forced to buy half of the company which would drive the stock price of that company up before the fund can acquire the 1% position for itself.  The fund would have to pay significantly more for the stock or else buy a smaller position than it wants.

• Management Tenure – Management tenure at the fund is as important as the long term performance of the fund because the money mangers are going to be the ones that dictate the investments.  If they just joined the fund recently, the past performance was not attributed to their skills, so is less indicative of what you can expect.

This is by no means a complete list of what to look for, but I hope it gives you a starting point to evaluating money managers.

The Joys and Frustrations of TD Ameritrade

As I wrote some time back, I have transferred my SEP IRA from TD Ameritrade to Vanguard because of TD Ameritrade's lack of customer service. The transfer itself has had some positive and negative impacts on my experiences with TD Ameritrade, so I thought I'd detail those for you all to see:

1. I'm actually pleasantly surprised with their site and how easy it is to navigate. I haven't been there a lot in the past, but they have a great site with tons of useful information. And best of all -- you can find what you're looking for. Not all online brokers make it easy to accomplish whatever you're trying to accomplish.

2. Their web customer service is actually GOOD (versus the phone experience I had that was bad.) When I email them, they respond within a day. Pretty good.

3. The transfer didn't go smoothly. During the process, I earn 37 cents in interest that didn't get transferred. Isn't there a way TD Ameritrade could have pro-rated this early and sent it along with the entire transfer? So I had to contact them and ask that they send the ENTIRE amount to Vanguard. Their response:

"When assets are transferred out, there is often the need for a residual sweep to bring any lingering amounts.  Your new firm will need to request this sweep."

Ugh. So I just contacted Vanguard and asked them to sweep the account. What a pain to have to do this twice!

4. I have a transfer request in to TD Ameritrade to give some stocks to a charity as part of my plan to avoid capital gains taxes while rebalancing my portfolio. I'll let you know how they do on this. I've done it twice with Vanguard and it's been very smooth.

Five Tips for Investors

Here's a piece from MSNBC that lists what it calls five tips for young investors but it's really a good list for all investors. Here's what they include:

1. Buy stocks. Over long periods, returns in the stock market have averaged about 10 percent a year, while bonds earn a little over 5 percent. Cash, such as bank accounts or money market funds, averages about 3 percent.

2. Look at mutual funds. Though the stock market offers good returns over time, many individual stocks lose money and never recover. Fortunately, we have mutual funds, which are investment pools run by professionals.

3. Focus on fees. The average stock-owning mutual fund charges investors annual fees equal to about 1.3 percent of assets — $1.30 for every $100 in your account. That little bit adds up. If your fund held stocks that returned 10 percent, the fee would cut your fund’s return to 8.7 percent. Instead of making $10 for every $100 invested, you’d make $8.70. You’d take a 13 percent pay cut.

4. Minimize taxes. Since taxes chew away at returns the same way fees do, savvy investors use a variety of tax strategies. The best options are the 401(k) or similar retirement plans offered by millions of employers.

5. Stick with it. Investing in stocks is a long-term strategy, not something you do with next month’s rent money. If you can weather the downturns you should be pleased with the results.

My thoughts on these:

1. I'm a big believer in stocks as well. And since I have a long time horizon (20 years or more), they make up a dominating part of my portfolio.

2. Most of my stocks are in mutual funds, not in holding individual shares. I've been decreasing the number of individual stocks I own for a couple years now and I'm down to only six as I write this post.

3. Yes, costs matter if you want to maximize your investment returns. The article goes on to sing the praises of index funds. ;-)

4. Same as #3 above. Taxes are costs.

5. You need to be able to weather the storms and ride the stock market roller-coaster through its many ups and downs in order to be successful. You may even need to swim against the current. It's tough to do, but financially rewarding if you can learn the discipline.

The article doesn't include the most obvious tip to young investors in it's list of five, but it does start by saying how important time and compounding are in a young investor's success. A summary:

Time is the investor’s best friend, and you have plenty of it — perhaps two decades to save for a child’s college costs, and probably four decades to build a nest egg for retirement.

If you invest a little each month starting now, you won’t have to invest as much as you would if you were to wait another 10 or 20 years to get going.

Start early with whatever you can afford. It will make life much easier later.

I've written about this quite a bit. For reference, see these posts:

• An Example of the Power of Compound Interest

• Key to Investing: Start Early

• The Richest Man in Babylon, The Power of Compounding

• How to Retire Rich: Use the Power of Compounding

I know this information is very basic for many of you reading it. However, I think it's good to regularly review the basics so we keep ourselves on track doing what will most help to grow our net worths.

Is It Better to Rent and Invest Rather than Buy a House?

Here's a very, very interesting argument from a Smart Money writer. He looks at the returns people have historically seen on real estate versus those in stocks and concludes it's better to rent a place to live and invest in stocks than it is to buy a house. His thoughts:

So to sum up why I rent: Shares right now cost 16 times earnings and over long time periods return 7% a year after inflation. Houses right now cost 19 times their "earnings" and over long time periods return zero after inflation. And they look likely to return less than that for a while.

If I understand this correctly, he's saying that buying a house is more expensive (you have to include taxes, insurance, repairs, etc. in the total costs). So if you rent and invest the difference into stocks, you'll be much better off financially in the long run. By extension he's also saying that it's a bad idea to pay off your mortgage early (you have more money into a non-producing asset) and to buy a huge house (again, the more expensive it is, the more money you have tied up in an asset returning 0%.)

But it seems to me that if you buy, at least you get part of your "rent" back (even though it may earn 0% -- according to his analysis.) So if I'm paying $1,500 on a mortgage, a certain part of that is money that I'll see again (it doesn't go towards interest but to the principal of the loan.) So my effective "cost" of owning is less than $1,500 -- making the spread between renting and buying even lower.

Hmmmmm. I'm not sure what to think of this. The numbers seem to support his conclusion (if he's using the right information) and he even addresses major questions people will have about his thinking. Anyone have a perspective on whether this guy is on target or a complete looney? I know that at least Lord will have something valuable to comment. ;-)

BTW, one of the points he makes in his answers sections deals with the mortgage interest tax deduction. It's used as an argument for not paying off your mortgage early, but he says:

The tax breaks aren't really breaks at all. Moreover, a majority of homeowners don't claim them. Their incomes are low enough to make the standard deduction a better deal.

Precisely the argument I use for paying off your home early. However, he'd disagree with this as well.

So, what do you think? Is it really better to rent and invest rather than buy a home? It's such a radical concept for me, but it does seem to at least have some validity.

Low Costs Usually Equal a Better Investment (And the Various Costs You Need to Look For)

I've noted before that costs matter if you want to maximize investment returns. In fact, this is one reason I like (and use) index funds as a major part of my portfolio. They keep expenses down which helps to keep my returns up. It's a great deal all around. ;-)

Recently, Yahoo columnist Laura Rowley detailed the impact costs can have on investment performance. She started out comparing two different funds and how they performed based on their associated expenses. The funds:

Fund A

• Annual return before expenses: 10 percent
• Annual operating expenses: 1.5 percent 
• Value of investment in 20 years: $49,725 

Fund B

• Annual return before expenses: 10 percent
• Annual operating expenses: 0.5 percent
• Value of investment in 20 years: $60,858

And here's a summary of how they performed:

Choosing Fund B would give an investor 18 percent more money over the 20-year period.

Rowley then goes on to detail what she calls the "big three" investment expenses. They are as follows:

1. Expense ratio. This represents the fund's total annual operating expenses (including management fees and other expenses), expressed as a percentage of average net assets. If a fund with $100 million in assets charges $1 million to manage the fund, that's an expense ratio of 1 percent.

2. Load or sales charges. This can be a front-end load, charged to pay a broker upfront when you buy the fund. Or you can get spanked with a back-end load when you sell the fund. There are also level loads that can be charged over a period of years.

3. Account management fees. These are charged to maintain your account, and sometimes levied if the value of your account falls below a certain dollar amount.

I would add taxes to this list as well, but taxes are as much under your control (what you invest in and how you invest) as they are the fund manager's, so maybe that's why she left them off.

Rowley's list is basically a list of "why you should invest in index funds." They have low expense ratios, no sales charges or loads, and no account management fees (usually.) For further details, see Why I like Index Funds.

Finally, Rowley also points to Calculating Mutual Fund Fees and Expenses, an SEC page that gives some additional thoughts on mutual fund fees. This page, in turn, points to an NASD page that features a nice little expense calculator.

Investment Smackdown: Index Funds Versus Actively Managed Funds

I think most of my regular readers will know how this post is going to turn out. ;-)

In a piece called The Joy of Index Funds, Money magazine's Walter Updegrave gives his thoughts on index funds versus actively managed funds in response to a reader's question. I've selected some of his comments that summarize the article. the highlights:

Many [index funds] charge 0.2 percent a year or so, and some have expenses that are even lower, sometimes as low as 0.07 percent. That's a pittance compared with the 1 percent to 1.5 percent or more than most actively managed funds collect from investors.  There's no guarantee, of course, that a particular fund will outperform just because it has low fees. But whenever I've compared the performance of high-fee funds vs. that of low-fee funds over long periods, I've found that as a group the funds with lower charges typically do generate higher returns.

Yes, we know that costs matter if you want to maximize investment returns and it's hard to beat index funds on cost. But there's more to celebrate about index funds:

Like certainty. Index funds slavishly follow an index or benchmark, so you always know what you're getting. You don't have to worry about your large-company fund manager poaching in small caps to juice his returns, or a value manager picking up a few growth stocks to boost performance when value stocks are on the outs.

Index funds' consistency makes them ideal building blocks for creating a diversified portfolio that contains all sizes of stocks, styles of investing and different types of bonds as well. As if that's not enough, index funds tend to be tax-efficient, which is a fancy way of saying they generally give up less of their gains to taxes.

Unlike actively managed funds whose trading can generate realized gains that must be passed on to shareholders and then taxed (assuming the fund isn't held in an IRA, 401(k) or other tax-advantaged account), index funds' buy-and-hold approach results in less trading and triggers fewer taxable distributions.

But he doesn't recommend index funds for 100% of your investing needs (neither do I):

But as much as I love index funds - and think most people would improve their prospects by taking an index-funds-only approach - I'm not such a purist that I think you would be sabotaging your financial future by deciding to put a bit of your money into actively managed funds.

There are some managers who have special insights in some areas and have a chance to add value beyond what they charge in fees. Granted, I think it's a small minority of managers who can do this over long periods of time. I also think it's extremely difficult to identify those managers in advance. I can understand that some people want a shot at market-beating performance with a portion of their savings.

My advice, though, would be to keep that portion relatively small and make index funds your core holdings. If you do invest in actively managed funds, I'd also recommend that you stick with ones with relatively low expenses. And while past success certainly doesn't guarantee more of the same in the future, I'd still prefer managers with a solid record of achievement over a variety of different market cycles.

I've listed all the reasons I like index funds in my post titled Why I Like Index Funds. Check it out if you'd like more information on why I think they make a great investment for the long term.

See, I told you that you'd know how it would turn out. ;-)

Six Steps to Stock Selection Success

Here's a piece from the author of Portfolio Planning for Individual Investors on his recommended method for selecting stocks:

Most individuals desire to invest well, but somehow with the information overload we are all subjected to on a daily basis, many become hopelessly lost in the stock selection process.  These individuals eventually either turn over their investment decisions to investment professionals, or just settle for mediocre results.  It is important to remember that no outsider is more interested in your wealth maximization than you are; therefore, it is essential that individual investors have the tools necessary for common stock selection. 

The six-step stock selection process explained below provides the investor with a time-tested method for successful stock selection. The steps in this method are screening tools used to reduce the number of stocks under consideration from over 5,000 to a workable number, less than 100. Many individuals fall in love with various stocks and tend to select those stocks even though they fail one or more of the six steps.  It is imperative that stocks that fail any of the six steps are discarded!

The first step requires that each stock has continuous earnings per share (EPS) growth for the most current three periods.  The last four years contain three periods (2003-2004, 2004-2005, 2005-2006).  The six-step method is based on the concept of value investing, where value is a function of EPS.  When one considers that stock price is equal to price/earnings multiple (P/E) multiplied by EPS, it is easy to see that if P/E is held constant and EPS is increased, stock price will increase.  Numerous studies have found that a company’s EPS has a sense of inertia, that is, a body in motion tends to remain in motion.  Therefore, a company with a history of continuous earnings growth has a much better chance of maintaining that growth than a company with a poor earnings growth record. This first step will eliminate the number of stocks under consideration by about 90%.  A second part of this step is to calculate the EPS growth rate of all stocks with continuous EPS growth for three periods, using a financial calculator.

The second step requires that each stock’s EPS growth rate exceeds its required rate of return.  The required rate of return is calculated using the Capital Asset Pricing Model (CAPM) as follows:  Required ret. = Risk-free ret. + Beta(Market ret. – Risk-free ret.).  The risk-free return is the 20-year average return for T-Bills (4.6%), the market return is the 20-year average return for the S&P 500 Stock Index (13.2%), and the beta for each stock is found in The Value Line Investment Survey.

The third step requires that each stock must pay a dividend.  During the market boom years of the 90’s, most investors paid little attention to dividends.  However, since the 2000 – 2002 bear market, investor sentiment concerning dividends has changed for two primary reasons.  First, in 2003 the maximum tax paid on qualified dividends was reduced from 38.6% to 15%.  Second, for the past 20 years dividend paying stocks have out-performed non-dividend paying stocks by approximately 3% per year. In addition, since there are only two possible cash flows associated with common stock investing, dividends and the final sale of the stock, why would a prudent investor choose non-dividend paying stocks?

The fourth step requires that each stock have good ratings from Standard and Poor’s and The Value Line Investment Survey.  To pass the fourth screening stocks should have a Standard and Poor’s rating of at least “B” and Value Line ratings of at least 4 for timeliness, 3 for safety, and “B” for financial strength.

The fifth step requires that a stock only be considered for purchase if its intrinsic value is greater than its present market price.  The stock’s intrinsic value is calculated by discounting its estimated dividends and selling price over the forthcoming three years as follows:
V = D(1 + g) /(1 + R ) + D(1 + g)2/(1 + R)2 + D(1 + g)3/ (1 + R)3  + (P)(E)(1 + g)3/(1 +R)3
While this calculation appears difficult, it is actually very simple.  The notation is as follows:  D = current dividend, g = growth rate in EPS, R = required rate of return, t = time in years, P = price/earnings multiple, and E = current EPS.  The first term is the discounted value of the estimated dividend in year 1, the second term is the discounted value of the estimated dividend in year 2, the third term is the discounted value of the estimated dividend in year 3, and the fourth term is the discounted value of the stock’s estimated price at the end of year 3.

The sixth step requires that each stock pass a financial statement analysis (FSA), either a full blown FSA, or an abbreviated FSA.  A full blown FSA consists of a trend analysis (trend of financial ratios for past three years), a comparative analysis (comparison of company’s financial ratios to its industry averages), a common-size income statement analysis (a percentage analysis of the income statement), and a bankruptcy prediction, if deemed necessary.  Although a full blown FSA is more accurate, most investors settle for an abbreviated analysis which typically includes one financial ratio from the areas of liquidity, debt management, efficiency, and profitability as follows:

Current ratio (liquidity) = Current assets/Current liabilities – this ratio should be above 1.8 for firms with inventory and accounts receivable, and 1.0 or above for all others.

Debt/Equity ratio (debt mgmt.) = Long-term debt/Stockholders’ equity – this ratio should be less than 100%.

Average collection period (efficiency) = Accounts receivable/Average sales per day – use
the company’s industry average from Risk Management Association Annual Statement Studies for the acceptable average collection period.

Return on equity (profitability) = Net income/Stockholders’ equity – The return on equity should be greater than 10%.

10 Retirement Pitfalls, Pitfall #10: Investing Too Aggressively

Yahoo has a list of 10 retirement pitfalls and I'm going to list and comment on them all. Here's today's pitfall:

Investing too aggressively: While you don't want to invest too conservatively, you also don't want to be investing in things that promise huge returns but are extremely risky. You should determine a set amount of money each month to put into something like a stock index fund for your retirement. If you can spare more money after you have contributed to the retirement fund, it is acceptable to invest in something a bit more risky. However, you don't want to be risking the main portion of your retirement money in risky investments that could very well leave you with no money in the end.

If anything, I could be a bit too aggressive in my investments. Not that I'm investing in Russian oil futures or pork bellies in Columbia. And it's not that index funds are that aggressive. But my asset allocation is almost 100% stocks. I'm moving more into bonds to be a bit more balanced, but if anything, I'm being a bit too aggressive currently. That said, I do have a long investment horizon (20-25 years) and I can handle the market ups and downs (remember the internet bubble? I rode that one all the way down -- buying all the time) so I can afford to be a bit more aggressive than most.

For more thoughts on investing, see these links:

• A Simple Way to Cut Costs and Improve Your Investment Return

• An Example of the Power of Compound Interest

• Savings Smackdown: Which is Better -- Pre-Paying a Mortgage or Saving for Retirement?

Click here to read part 1 of this series.

10 Retirement Pitfalls, Pitfall #9: Investing Too Conservatively

Yahoo has a list of 10 retirement pitfalls and I'm going to list and comment on them all. Here's today's pitfall:

Investing too conservatively: Investing too conservatively in your retirement fund means that you will not grow it adequately to meet your needs when you retire. You need to take into account that over time, inflation will take part of the purchasing power away from your retirement fund. As you get closer to retirement, you can make your investments more conservative, but in the early years you want to make sure that you are not investing too conservatively to yield the gains you need for retirement.

For me, investing means stocks and, in particular, index funds. I have a long time horizon and am not afraid to take some risks. If anything, I may be a bit too aggressive as I'm almost completely in stocks and have little in bonds.

For more thoughts on investing, see these posts:

• Portfolio Rebalancing Boosts Returns

• Key to Investing: Start Early

• The Greatest Enemy of a Good Investment Plan

Click here to read part 10 of this series.

Click here to read part 1 of this series.

How to Get a Double Tax Deduction When Contributing to an IRA (And Avoiding the Wash Rule)

Here's a tip I found in a recent promotional copy of Bottom Line Personal on how to get a double tax deduction when contributing to an IRA:

Sell a stock that has declined in value...and use that money [to contribute to an IRA.] You'll be able to fund your IRA and write off a capital loss at the same time!

Bonus: If the stock is one you want to hold on to, you can have the IRA buy it back. Since you and your IRA are considered separate entities, the IRS's "wash rule" will not apply.

For those of you wondering what the wash rule is, check out The Wash Sale Rule.

So, there are a couple things to comment on here:

1. Instead of taking cash and putting it into an IRA, you can sell a stock, take the loss, and then contribute, huh? Is there anything "magical" here or are they simply saying you should get as many tax breaks as you can, so if you have a stock loss, take it?

2. Interesting note about the wash sale rule -- that you are a separate entity from your IRA. Is this true? Anyone had experience with it or know the associated legal rules around the issue?

Hedge Inflation Risk with Hard Assets

Here's a piece courtesy of Marotta Asset Management on how we should consider hedging inflation risk with hard assets:

Diversifying your portfolio will help to lower your risk and increase your returns. One of the asset classes that we use to build diversified portfolios consists of hard asset stocks. These hard asset investments include companies that own and produce an underlying natural resource. Examples of these natural resources include oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel, and other resources such as diamonds, coal, lumber, and even water. We recommend broadly diversifying your hard asset stocks by resource type, by geographic location of a company's reserves, and by company size.

Keep in mind that investing in hard asset stocks is not the same thing as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities or their volatility. Whereas, buying a gold mining company is a hard asset stock investment.

Over time, dollars lose their buying power and the goods and services we buy cost more. Commodities, as an asset class, generally maintain their buying power in dollar terms. Stocks, as an asset class, generally appreciate over inflation after dividends are factored in. And, recently, hard asset stocks have been appreciating nicely.

Jeremy Siegel, author of the book "Stocks for the Long Run" did an analysis of investments over the past 200 years. Gold, on average, maintains its value over time. If you bought a dollar's worth of gold 200 years ago, after adjusting for inflation, it would be worth $1.07 today. Because of inflation, a dollar today has only the buying power of about seven cents back then! However, the stock market, on average, has been appreciating about 6.5% over the long-term rate of inflation. Hard asset stocks give you the best of both worlds: the stability of a real asset plus higher market returns.

One index that tracks hard assets is the Goldman Sachs Natural Resources Index. This index is comprised of 70% energy and 11% materials. As of the end of April 2007, this index is up 9.36% year-to-date. Its three-year annualized return is 28.96% and its five-year annualized return is 19.17%

We segment hard asset stocks into their own asset class because they have a unique set of characteristics. First, the movement of hard asset stocks is generally less correlated with the movement of other asset classes such as bonds. Second, hard assets have a unique (and positive) reaction to inflationary pressures. And third, there are periods in the longer term economic cycle when including hard assets helps boost returns.

The beauty of hard asset stock is the fact that they are not highly correlated to US large cap stocks as a whole. The correlation between the Goldman Sachs Natural Resources Index and the S&P500 Index is only 0.38. Importantly, the correlation between the Goldman Sachs Natural Resources Index and the Lehman Aggregate Bond Index is even lower at -0.21. A negative correlation means that bonds and natural resources, as separate asset classes, are often moving in opposite directions. Balancing a bond portfolio with hard asset stocks can help hedge the risk inflation poses to a bond portfolio.

Short and intermediate-term bond investments are usually stable investments if their value doesn't fluctuate much from day-to-day and they pay recurring interest. The danger of having a large bond portfolio is that you will be exposed to greater inflation risk. Inflation causes the buying power of your fixed-income payments to decrease. If we have a period of high inflation like the 1970's or a rapid devaluation of the dollar, a bond portfolio will lose a significant amount of its buying power to inflation even though its value may not have changed much in nominal dollar terms. In order to balance inflation risk, it's important to include investments that provide a true inflation hedge.

Hard asset stocks provide an inflation hedge. Due to the underlying value of the tangible commodity that natural resource companies produce, their earnings are tied to inflation as their resources are worth more as the dollar declines in value. This can occur in times when the supply of money and credit is increased to fund government spending and budget deficits.

Consider a gold mining company whose expenses and overhead allow it to pull gold out of the ground for $290 per ounce and sell that gold for $300 per ounce making the company a $10 per ounce profit. As gold jumped 33% from $300 per ounce to $400 per ounce, the company's profit jumped from $10 an ounce to $110 an ounce - a 1,000% jump in profit - which then caused the company's earnings and stock price to soar. Now that gold is over $650 per ounce the current price level of gold stocks is much higher than it was in 2001.

During 2002, when the S&P 500 dropped over 20%, mutual funds that specialized in precious metal stocks (gold and silver miners) appreciated over 50%. Having an asset class that appreciates while other asset classes are falling helps both smooth and boost your investment returns over time.

Investing in commodity-rich foreign countries is also an investment in hard assets. The MSCI Canada Index has approximately 28.43% energy and 15.92% materials. This index has 0.80 correlation to the Goldman Sachs Natural Resources Index. Latin America (particularly Brazil), the emerging markets such as South Africa, and other developed countries like Austria and Australia are significant producers of natural resources and are strongly correlated to the global demand for commodities.

Because hard asset stocks are negatively correlated to bonds and other inflation-sensitive economic sectors, they provide a unique opportunity for diversification. Adding hard assets to your investments is not as simple as just increasing or decreasing their portfolio allocation to create a more aggressive or conservative mix. When a portfolio has very few bonds and mostly stocks, it needs less hard asset stocks to balance the inflation risk. When you are increasing bonds and decreasing stocks to make a portfolio more conservative, it helps to add more hard asset stocks to counter the bond risks.

Getting your hard asset allocation correct is made even more complicated by the recent changes in the volatility and historical correlation of all asset classes and sectors worldwide. The S&P 500 Index is currently comprised of 10.50% energy and 3.04% materials. If your portfolio contains any bonds, over-weighting this allocation to hard assets could boost your returns and decrease your volatility.

How to Invest Using Only ETFs

I noted in a previous post how someone could invest using only index funds. Now here are some thoughts on how to invest using only ETFs:

• Start with Vanguard Total Stock Market ETF (VTI), which charges just 0.07% annually in expenses. The fund tracks the MSCI Broad Market Index -- which means it essentially gives you the entire U.S. stock market. Put three-quarters of your stock money in this ETF.

• For the final quarter of your stock money, Vanguard again has the best ETF: Vanguard FTSE All-World ex-US ETF (VEU). For 0.25% annually, this ETF gives you the entire world except the U.S.

• It's a similar story with bonds. Vanguard Total Bond Market ETF (BND) is the low-cost option, with annual expenses of 0.11%. If you're investing in a taxable account, however, substitute Vanguard Intermediate-Term Tax Exempt (VWITX), a regular mutual fund that invests in high-quality, tax-free bonds.

• All that's left is to decide what proportion of your money you want in stock ETFs, and how much in bond ETFs. Keep 90% or more of your money in the two stock ETFs until you're about six years from retirement. Then, gradually sell some stock ETFs until you have about 40% in bonds during retirement. For your children's college savings, put 90% or more in the stock ETFs until your child is about ten years from college. Then, gradually sell your stock ETFs and then your bond ETFs until you're entirely in cash by the time your child's junior year of college begins.

I've said before that I prefer index funds over ETFs because I buy additional shares every month and after awhile those ETF transaction fees can really add up. That said, for those of you who do buy ETFs and want a simple yet effective way to invest, this seems to be it!

For more on this topic, see these links:

• Which is Better: Index Funds or ETFs?

• Why I Like Index Funds

• The Basics of ETFs

The Best Online Brokers

In its June issue, Consumer Reports rates the top online brokers. In the article, they give some advice on who may or may not want to use an online broker:

If you are the kind of investor who makes two or three stock trades a month at most and adds steadily to your core mutual fund holdings, our online broker Ratings can help you find a worthy online broker. If you need a lot of hand-holding, you might be much happier sticking with a traditional full-service broker. But if you're trying to cut the costs of buying and rebalancing your investments, the low prices offered by online brokers are appealing.

I've used online brokers for years (to hold my stocks, my index and other funds are with Vanguard), and I have thoughts on several of them. More on that later.

Next, they get to the ratings of the brokers. They rated the brokers based on the following criteria:

• Trading costs (half of each firm's total score)
• Minimum trade fee
• Each broker's mutual funds program
• The number of no-transaction-fee funds available
• Banking and asset-management services
• Free research and education tools
• Customer support

Given these, here are their top five:

• Firstrade Securities
• E*Trade Financial
• TradeKing
• Charles Schwab
• Scottrade

My take on each of these:

1. Never used Firstrade and don't know anything about them.

2. I've been a long-time E*Trade user. If they are #2, the rest of the lot must really stink.

3. Never heard of TradeKing.

4. I used to have an account with Charles Schwab, then their fees got so high I went to E*Trade and TD Ameritrade. Now they've lowered their fees (though they and E*Trade have the highest fees in the top five), so maybe I should consider them again.

5. I've never used Scottrade, but have heard great things about them.

Other notables to comment on:

1. TD Ameritrade was #7. You know what I think of them.

2. Fidelity is #11. My company uses them for our 401k and I invest in their funds -- I don't buy stocks through them. They are too expensive.

3. Vanguard was dead last. As you know, Vanguard is a favorite of mine for index funds (as well as other mutual funds) but I agree that they do stink as a broker. Here's how Consumer Reports put it:

Apparently its low-cost mutual-fund philosophy does not carry over to the brokerage business. Vanguard's basic trading fees were the highest we surveyed this year, at $25. Vanguard's brokerage might be an OK choice if you do very little stock trading and already have a good chunk of your money in its mutual funds because its scores for research and asset management were above average.

Strangely, they listed Vanguard's customer support as average. This is surprising since I've always seen Vanguard rated highly in this area. Maybe it's because the funds side of Vanguard is managed differently (different part of the company) than the stock side.

Portfolio Rebalancing Boosts Returns

Here's a piece courtesy of Marotta Asset Management on how portfolio rebalancing boosts returns:

Rebalancing your investments can help boost your returns and minimize risk. This simple contrarian move can help you compound your investment gains over time. With the markets at an all-time high, this may be a good time to rebalance your portfolio.

On May 18, 2007, the Dow closed at another all-time high of 13,556.53 setting its 24th record high this year. The S&P 500 recently broke its all-time high of 1,527.46 set in March 2000. Many investors are getting nervous that these records mean that the markets are overvalued and due for a large correction.

Maybe. Maybe not.

One way to look at the S&P 500 is that this index of U. S. large cap stocks has not made investors any money in the last six and a half years. The S&P 500 has only just returned to where it was seven years ago. However, at the height of the bull market in the late 1990's, the P/E ratio of the S&P 500 index spiked above 30. Now, the P/E ratio is about 17, meaning the stocks look much more attractive to buy now than they did in 2000.

Other indexes such as the MSCI EAFE Index of international stocks, the MSCI Emerging Markets Index or the Russell 2000 Index of U. S. small cap stocks have been quietly setting new highs for some time now. One way to look at the markets is that when the markets are behaving well and appreciating at 11% percent each year, on average, they will be setting new highs almost on a daily basis.

But, of course, we know from experience that the markets are not that well-behaved. They generally do not return a nice steady 11% per year. Over time, market returns are more like 18% for three consecutive years and then negative 10% another year. Perhaps this is the year for negative 10% return.

If you have set a diversified asset allocation, then whenever you aren't sure about what to do, simply rebalance your portfolio every year. Rebalancing your portfolio is a contrarian move which will help you buy low and sell high and will save you from chasing performance.

Imagine your portfolio has only stocks and bonds. If stocks have done well, then applying a rebalancing strategy will help you sell some stocks when they are high and put money into bonds when they are low. If stocks have performed poorly, then rebalancing to sell some bonds and buy stocks will most likely be a good contrarian move. Rebalancing, will save you from trading too much to chase recent market performance, which is nearly always a bad idea.

Let's imagine you have an investment account with a value of $100,000 and your target asset allocation is half stocks and half bonds. Because you neglected to rebalance your portfolio for several years, the stocks have increased in value and now represent 70% of your account with bonds comprising only 30% of the account's value.

Imagine that bonds are expected to return 6% for the next two years, and stocks are either going to go up 10% for two years or else they are going to go down 10% the first year and then go up 10% the second year.

If you don't rebalance your portfolio and the markets correct by 10% the first year, and then rebound by 10% the second year, you will earn 3.01% over the two years. If you rebalance each of the next two years and the markets correct you will earn 6.23%. Failing to rebalance will cost you 3.22%.

In this case rebalancing takes money out of stocks before they correct and then puts money back into stocks before they rebound. Rebalancing moves the money in exactly the right direction.

If you neglect your portfolio and let your winners ride and the markets continue to go up, you will earn 18.41% over two years. If you choose to rebalance each of the next two years and the markets continue to go up, you will earn 17.07%. Rebalancing will only cost you 1.34%, and you will still earn 17.07% for the year.

In this case, rebalancing takes some of your money out of stocks. Then, in the second year, you take more profits off of the table as the remainder of your stocks continues to rise. In this case, rebalancing can save you 3.22% on the downside, but cost you only 1.34% on the upside.

While implementing a dynamic asset allocation may allow you to boost returns, the average investor usually does not have the time or the expertise to follow the numerous factors needed to construct this kind of model.

More often than not, trying to follow sector trends results in the exact opposite of what following a more sophisticated approach would suggest. You can avoid this temptation by simply rebalancing your investments annually, or more frequently, whenever the markets are hitting new highs as consistently as they have been recently.

Key to Investing: Start Early

Ok, this will be a bit basic for many of you reading this, but every once in awhile (ok, quite frequently) I like to review the basics of personal finance. You know, the simple, little things that anyone can do to make a HUGE difference in their net worth.

Today, I want to highlight a piece in USA Today that says one of the keys to investing is to start early. It details what a big advantage this is by giving an example of the power of time and compounding in investing:

Let's say you [17-year-old] and a 47-year old start investing at the same time. And let's say you both want to have $1 million by the time you turn 65 and you both get 10% annual returns.

To reach that goal, the 47-year old will need to save and invest nearly $22,000 a year, or $396,000 over 18 years. You, on the other hand, can have a cool $1 million waiting for you by investing just $1,000 a year, or $50,000 over 48 years.

Man, I love time and compounding when it comes to investing!!!! ;-)

As I've noted in other posts, I've been investing for 15 years or so and I'm just starting to see some pretty big gains from compounding. It takes awhile for the effects to kick in, but when they do, they are massive.

Just think of a snowflake rolling down a hill. Eventually it turns into a snowball, then a snow mass, and then an avalanche. That's just the way compounding works when it comes to investing. I'm now between the snowball and the snow mass phases and am eagerly anticipating the avalanche phase. ;-)

For more of my thoughts on this issue, see An Example of the Power of Compound Interest.

A Simple Way to Cut Costs and Improve Your Investment Return

Here's a valuable comment left on my post titled All Index Funds Are Not Created Equal:

Vanguard is by far the best, in my personal opinion.

I have been recommending them to my friends. Many of them took up on it, but most have made a crucial mistake.

Instead of buying Vanguard funds directly from Vanguard, they are buying them through their own brokers. These brokerage firms are charging (excessive) fees on top of the fees that Vanguard charges.

Getting out of that mistake is costly as well, as some of my friends find out. They charge a lot just to sell those funds.

Buy Vanguard, but make sure you buy index funds from Vanguard directly.

I don't understand why anyone would buy Vanguard funds through their broker -- Vanguard makes it so easy and cheap to buy them directly. Maybe convenience? Not wanting to open another account? Whatever the reason, it's probably not worth the cost when you compare buying directly versus through a broker. Remember, those costs result in lower returns which in turn compound throughout the years. Just compare an 8% return to an 8.5% return for 30 years and you'll see what I mean.

For more thoughts on this topic, see these posts:

• Costs Matter If You Want to Maximize Investment Returns

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

• How to Invest Using Only Index Funds