Part 20 (1/2)

During the recent stock market tumble, some folks shouted, ”Look! Buy-and-hold investing is dead!” They took the stock market's decline as evidence that pa.s.sive investing with index funds doesn't work. Well, it doesn't work if you sell after a fall, but if you hold onto your investments, you're fine-you haven't lost anything but time. In fact, many savvy investors viewed the market crash as a chance to buy-and hold onto-even more shares of their index funds.

Investing is a game of years and decades, not months. What your investments did this year is far less important than what they'll do over the next decade (or two, or three). Don't let one year panic you, and don't chase after the latest hot investments.

On The Money: The High Cost of TradingHere's a dirty little secret: Wall Street makes money on activity; you you make money on inactivity. make money on inactivity.When you buy and sell securities, you have to pay somebody else to make those trades for you. And every time you pay them, you lose a little piece of your savings. This isn't a huge deal if you don't trade often, but if you buy and sell all the time, you're giving your money away.For example, say it costs 1% each time you sell what you currently own and buy something new. If you do this once a month, you have to earn 12% more every year than the guy who sits there and does nothing. This example is an exaggeration, but studies show that speculators who trade often-usually because they're chasing the latest hot stock-tend to earn less than investors who take a long-term view.If you want to get an idea of how much money the financial industry siphons from unwary investors, read James B. Stewart's Den of Thieves Den of Thieves (Touchstone, 1992), a true-life account of the insider trading scandals of the 1980s that'll blow your mind. (Touchstone, 1992), a true-life account of the insider trading scandals of the 1980s that'll blow your mind.

Keep Costs Low What's the easiest way to tell how well a mutual fund will do? Its past performance? The fund's manager? Nope. According to a 2002 study by Financial Research Corporation, the best way to predict a mutual fund's future performance is to compare its expense ratio (Mutual Funds) with other funds in the same cla.s.s. The funds with the lowest fees tend to do better. (Remember, each mutual fund lists its expense ratio in its prospectus.) Other experts agree. In his book Your Money and Your Brain Your Money and Your Brain, Jason Zweig notes, ”Decades of rigorous research have proven that the single most critical factor in the future performance of a mutual fund is that small, relatively static number: its fees and expenses. Hot performance comes and goes, but expenses never go away.” Zweig offers the following suggestions: - Don't buy a government bond fund with annual expenses over 0.75%.

- Don't buy a blue-chip U.S. stock fund with annual expenses over 1.00%.

- Don't buy a small-stock or high-yield bond fund with annual expenses over 1.25%.

- Don't buy a foreign-stock fund with expenses over 1.50%.

You can keep things simple by sticking to index funds with expense ratios below 0.50% (or even better, below 0.25%).

And avoid buying a mutual fund with a load, or sales charge (basically, a commission). You already learned that actively managed funds have to overcome drag that index funds don't (Index funds); why would you make things even tougher by paying a 5% load, too? It doesn't matter whether the fund is front-loaded (you pay the commission when you buy the fund) or back-loaded (you pay it when you sell the fund): studies show that load funds don't offer any advantages over no-load funds. (Some index funds carry small loads, too. The same rule holds true: You're usually better off with a no-load fund.) Morningstar's mutual-fund selector (tinyurl.com/MS-selector) is an online tool that lets you sort funds by a variety of criteria, including expense ratio (Mutual Funds). For more on this subject, check out this article on predicting mutual fund performance: tinyurl.com/RA-mfund.

Keep It Simple In How a Second Grader Beats Wall Street How a Second Grader Beats Wall Street (Wiley, 2009), Allan Roth (no relation to your humble author) writes, ”If you can't explain your investment strategy and every product in your portfolio to a second grader, you are probably doing something wrong.” (Wiley, 2009), Allan Roth (no relation to your humble author) writes, ”If you can't explain your investment strategy and every product in your portfolio to a second grader, you are probably doing something wrong.”

People tend to think that the more complicated something is, the better it must be, especially when it comes to finances. But that just isn't the case. In fact, the opposite is often true-complex products caused the recent financial meltdown, after all.

So if you don't understand what your broker-the person who sells you stocks and bonds-is trying to sell you, don't buy it. Don't worry about feeling dumb or looking stupid. Remember that n.o.body cares more about your money than you do; it's your job to protect your savings from people with clever-sounding get-rich-quick schemes. The bottom line: Never invest in something you don't understand.

Don't Follow the Herd People tend to pour money into stocks in the middle of bull markets-after the stocks have been rising for some time. Speculators pile on, afraid to miss out. Then they panic and bail out after the stock market has started to drop. By buying high and selling low, they lose a good chunk of change.

It's better to buck the trend. Follow the advice of Warren Buffett (tinyurl.com/WB-greedy), the world's greatest investor: ”Be fearful when others are greedy, and be greedy when others are fearful.”

In his 1997 letter to Berks.h.i.+re Hathaway shareholders (tinyurl.com/BH-1997), Buffett-the company's chairman and CEO-made a brilliant a.n.a.logy: ”If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef?” You want lower prices, of course: If you're going to eat lots of burgers over the next 30 years, you want to buy them cheap.

Buffett completes his a.n.a.logy by asking, ”If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period?” You want lower prices, of course: If you'll be investing for the next decade or two, you want to buy your stocks cheap!

Even though they're decades away from retirement, most investors get excited when stock prices rise (and panic when they fall). Buffett points out that this is the equivalent of rejoicing because they're paying more for hamburgers, which doesn't make any sense: ”Only those who will [sell] in the near future should be happy at seeing stocks rise.” Basically, he's trying to encourage you to follow the age-old wisdom to buy low and sell high.

Following this advice can be tough. For one thing, it goes against your gut. When stocks have fallen, the last thing you want to do is buy more. Besides, how do you know the market is near its peak or its bottom? The truth is you don't. The best solution is to make regular, planned investments-no matter whether the market is high or low. (For more on systematic investing, see All-in-one funds All-in-one funds.) TipNever act on a hot stock tip-they're almost always worse than worthless. It doesn't matter if the tip comes from your broker, your brother, or your best friend; in the words of Benjamin Graham, ”Much bad advice is given free.”

Ignore the Financial News Financial news can be dangerous to the health of your investment portfolio. TV and magazines are filled with hysterical hype: ”Dow tumbles 400 points!” ”Eight stocks to buy now!” ”Pork belly prices have been dropping all morning!” But how important is up-to-date financial news to the average investor? Do daily market changes-even 400-point drops-really matter?

The May 2008 issue of the AAII Journal AAII Journal included an article called ”The Stock Market and the Media: Turn It On, But Tune It Out” in which author d.i.c.k Davis argued that daily market movement is often illogical. Except in the case of obvious stuff like military coups and natural disasters, n.o.body knows what makes the markets move on any given day. Short-term changes are usually just random. Besides, they're not relevant if you plan to hang onto the stock over the long term anyway (and if you don't, you shouldn't own stocks in the first place!). included an article called ”The Stock Market and the Media: Turn It On, But Tune It Out” in which author d.i.c.k Davis argued that daily market movement is often illogical. Except in the case of obvious stuff like military coups and natural disasters, n.o.body knows what makes the markets move on any given day. Short-term changes are usually just random. Besides, they're not relevant if you plan to hang onto the stock over the long term anyway (and if you don't, you shouldn't own stocks in the first place!).

To the long-term investor, daily market movements are mostly just noise. ”What's important is repet.i.tion or the lack of it,” Davis writes. In other words, a trendline (what a stock does over a period of time) is more useful than a datapoint (what that stock is worth on any given day). ”Big market moves may be inexplicable, but a long-term...approach precludes the need for explanations.” In other words, when you make regular investments for the future, it doesn't matter what the market did today (or why it did it).

Davis isn't the only financial expert who believes that no news is good news-research backs him up. In Why Smart People Make Big Money Mistakes (and How to Correct Them) Why Smart People Make Big Money Mistakes (and How to Correct Them) (Simon & Schuster, 2010), Gary Belsky and Thomas Gilovich cite a Harvard study of investing habits. The results? ”Investors who received no news performed better than those who received a constant stream of information, good or bad. In fact, among investors who were trading [a volatile stock], those who remained in the dark earned more than twice as much money as those whose trades were influenced by the media.” (Simon & Schuster, 2010), Gary Belsky and Thomas Gilovich cite a Harvard study of investing habits. The results? ”Investors who received no news performed better than those who received a constant stream of information, good or bad. In fact, among investors who were trading [a volatile stock], those who remained in the dark earned more than twice as much money as those whose trades were influenced by the media.”

Though it may seem reckless to ignore financial news, it's not: If you're saving for retirement 20 or 30 years down the road, today's financial news is mostly irrelevant. So make decisions based on your personal financial goals and your IPS (Know Your Goals), not on whether the market jumped or dropped today.

Common-Sense Investing In this chapter, you've learned that the stock market provides excellent long-term returns, and that you can do better than 95% of individual investors by putting your money into index funds. Most importantly, you now understand that in order to have any hope of matching the market, you've got to take emotion out of investing.

But how do you put this knowledge to work? What's the best way to take advantage of the things you've learned? The answer is shockingly simple: Set up automatic investments into a portfolio of index funds. After that, ignore the news no matter how exciting or scary things get. Once a year, go through your investments to be sure your a.s.set allocation (explained in the Note on Know Your Goals Know Your Goals) still matches your goals. Then just continue to put as much as you can into the market-and let time take care of the rest.

That's it-that's the plan. (Told you it was simple.) Do this and you'll outperform most other individual investors over the long term.

Lazy Portfolios The most important investment decision you can make-besides how much to invest-is where to invest. As with so many aspects of investing, there's no one option that works for every person.

One factor that can help you decide how to invest your money is risk tolerance. That's a measure of how much uncertainty-and possible loss-you're willing to deal with in your investments. If your risk tolerance is high, you can handle big fluctuations in your investment returns in exchange for the possibility of large gains. If your tolerance is low, on the other hand, you'd rather not deal with the ups and downs-even if that means giving up a chance at making higher returns.

Some of your portfolio should be in fixed-income investments like bonds and CDs, which pay interest on a regular schedule. How much depends on your goals, needs, and risk tolerance. A common rule of thumb is that the percentage of fixed-income investments in your portfolio should be equal to your age. So, if you're 30, you should have 30% in something like a bond mutual fund. (A lot of experts dislike this guideline, but it's an easy place to start.) Most (maybe all) of the rest should be in stocks. Some of these should be stocks in American companies, and some should be in foreign companies. But there's a lot of disagreement over how much the average investor should put into foreign markets: Some say about 10%, and others say at least 30%.

These three funds-a bond fund, a U.S. stock fund, and a foreign stock fund-should form the core of your portfolio. Some folks will also want to add a smattering of other a.s.sets, like real estate or commodities, but that's beyond the scope of this book.

One good way to get started with a.s.set allocation is to use a lazy portfolio, a balanced collection of index funds designed to do well in most market conditions with a minimum of fiddling by you. Think of lazy portfolios as recipes: A basic bread recipe contains flour, water, yeast, and salt, but you can build on it to get as elaborate as you'd like. The lazy portfolios that follow are great starter recipes for long-term investing-and they may be the only recipes you'll ever need.

NoteWhen it comes to investing, there's no shame in being ”lazy.” As you learned earlier in this chapter, messing around with your investments all the time-chasing hot stocks, timing the market, and so on-will get you lower returns than taking a hands-off approach. So if you're not keen on telling your friends that you're a ”lazy investor,” just tell 'em you're being smart with your money!

The Couch Potato Portfolio by Scott Burns This two-fund portfolio from financial columnist Scott Burns may be the simplest way to achieve balance. It's evenly split between stocks and bonds, and should appeal to you if you're both lazy and risk-averse: - 50% Vanguard Inflation-Protected Securities (VIPSX) - 50% Vanguard Total Stock Market Index (VTSMX) You can read more about this portfolio at tinyurl.com/LP-potato. Burns has also created a ”couch potato cookbook” that lists several different lazy portfolios and answers some common questions; you can find it at tinyurl.com/LP-cookbook.

NoteAll the portfolios in this section consist of index funds from The Vanguard Company (). Vanguard is a good source for index funds because they have a huge selection, but it's not the only source. Also note that those crazy letter combos-VFINX, VBMFX, and so on-are just ticker symbols, abbreviations that help investors name stocks and mutual funds. Ticker symbols (also called stock symbols) make it easier to find info on various securities. Type MSFT, Microsoft's ticker symbol, into Google to see for yourself.

The Second-Grader Portfolio by Allan Roth Allan Roth is a Certified Financial Planner and a Certified Public Accountant, so he knows a thing or two about money. In his book How a Second Grader Beats Wall Street How a Second Grader Beats Wall Street, Roth explains how he taught his son about investing. Here's his lazy portfolio, which adds foreign stocks to the mix: - 40% Vanguard Total Bond Market Index (VBMFX) - 40% Vanguard Total Stock Market Index (VTSMX) - 20% Vanguard Total International Stock Index (VGTSX) This is the medium-risk version of Roth's second-grader portfolio. For higher risk, you'd put 10% into bonds, 60% into U.S. stocks, and 30% into international stocks. A lower-risk allocation would be 70% in bonds, 20% in U.S. stocks, and 10% in foreign stocks.

The No-Brainer Portfolio by William Bernstein William Bernstein is a retired neurologist who has turned his attention to financial matters. He wrote The Four Pillars of Investing The Four Pillars of Investing (McGraw-Hill, 2002), which is one of the best books on investing published in the past decade. In his book, he suggests several different portfolios, including this ”no-brainer” collection of index funds that keeps things simple: (McGraw-Hill, 2002), which is one of the best books on investing published in the past decade. In his book, he suggests several different portfolios, including this ”no-brainer” collection of index funds that keeps things simple: - 25% Vanguard 500 Index (VFINX) - 25% Vanguard Small-Cap Index (NAESX) - 25% Vanguard Total International Stock Index (VGTSX) - 25% Vanguard Total Bond Market Index (VBMFX) You can read more about this portfolio at tinyurl.com/LP-n.o.brain.

The Coffeehouse Portfolio by Bill Schultheis Bill Schultheis, the author of The New Coffeehouse Investor The New Coffeehouse Investor (Portfolio, 2009), believes that the secret to financial success is mastering the basics: saving, a.s.set allocation, and matching the market. He says you can match the market with this lazy portfolio: (Portfolio, 2009), believes that the secret to financial success is mastering the basics: saving, a.s.set allocation, and matching the market. He says you can match the market with this lazy portfolio: - 40% Vanguard Total Bond Index (VBMFX) - 10% Vanguard 500 Index Fund (VFINX) - 10% Vanguard Value Index (VIVAX) - 10% Vanguard Total International Stock Index (VGSTX) - 10% Vanguard REIT Index (VGSIX) - 10% Vanguard Small-Cap Value Index (VISVX) - 10% Vanguard Small-Cap Index (NAESX) To read more about The Coffeehouse Portfolio, head to tinyurl.com/LP-coffee.

Other lazy portfolios These are just a few suggestions. There are scores of index funds out there, and countless ways to build portfolios around them. In fact, there's a subculture of investors who love lazy portfolios. You can read more about them at the following sites: - Bogleheads. tinyurl.com/BH-lazy - Market.w.a.tch. tinyurl.com/MW-lazy - The Kirk Report. tinyurl.com/TKR-lazy There's no one right approach to index-fund investing. Yes, it's simple, but you can spend a long time deciding which a.s.set allocation is right for you. While it's important to do the research and educate yourself, you probably shouldn't spend too much time sweating over which choice is ”best.” Just pick one and get started-you can always make changes later.

If these lazy portfolios are a bit overwhelming, consider starting out with a portfolio made up of just one fund as explained next.

Single-Fund Portfolios Building a portfolio of index funds isn't for everyone. Some folks crave greater complexity or more control-or they believe (despite evidence to the contrary) that they can outperform the market on their own. Others have no interest in building portfolios (even of just three or four funds) or can't afford the minimum investments.

If you don't want to mess with allocating a.s.sets, consider plunking down some cash for just one investment. Two good options are lifecycle funds and all-in-one funds. These might not suit your needs perfectly, but they're a fine place to start.

Lifecycle funds Many mutual-fund companies now offer lifecycle funds (also called target-date funds), which try to create a diversified portfolio that's appropriate for a specific age group. For example, say you were born around 1970. In that case, you might consider a fund like Fidelity Freedom 2035, which includes a mix of investments that make sense for people who plan to retire in 2035 (when they'll be around 65).

Lifecycle funds have a lot of things going for them. For example, you get: - Automatic a.s.set allocation, since lifecycle funds include various a.s.set cla.s.ses.

- International exposure. Lifecycle funds are collections of mutual funds, including some international investments.

- Automatic rebalancing. Fund managers adjust lifecycle funds' a.s.set allocation to make them more conservative as you get older.

The main drawback of lifecycle funds is that you don't have any control over them. For example, if you want the international portion of your stocks to be 50% (or more), you're out of luck. Some people are okay with that, but the lack of control drives other people crazy. And keep in mind that not all lifecycle funds are created equal. Fees and investment styles vary from company to company; some are aggressive, others more conservative.

Lifecycle funds are perfect for investors who don't want to worry about all the jargon and nonsense that usually come with investing. If you decide to buy a lifecycle fund, buy only that fund. If you spread your money around (especially to other lifecycle funds), you defeat the whole purpose of this kind of investment.

NoteYou don't have to pick a lifestyle fund that matches your likely retirement date. Instead, choose one that matches your risk tolerance. If the Fidelity Freedom 2035 is too aggressive for you, for example, go with the Fidelity Freedom 2025 instead. You can read more about lifecycle funds in this New York Times New York Times article: article: tinyurl.com/NYT-tdfunds.