A Beginner's Guide to Investing: How to Grow Your Money the Smart and Easy Way By Ivy Bytes

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&re'ace
A !eginner"s #uide to nvesting is not $ust a boo%, but the &pilot& for a new %ind of publishing company. 'e call ourselves & vy !ytes.& (he idea is pretty simple) produce authoritative, clear, non*biased and concise guides that cut through the noise of the news and provide real context and information about a vital sub$ect. 'e produce these guides solely with digital platforms li%e the +indle, pad, and smart phone in mind, and are thus lower cost, more concise, and more interactive than existing options. (hat"s the mar%et opportunity from an economic point of view. !ut for us, vy !ytes is about a lot more than economics. 'e are passionate foremost about the opportunity for compelling digital content to &elevate the discourse& in America, and the world, right now. f you have flipped on the (,, loo%ed at the best*seller list, or browsed a news website over the past two years, you may have noticed an increasing level of divisiveness and rancor. A shortened attention span and growing illiteracy in all matters economic, financial, and political have allowed sharp opinions to replace facts, far*out conspiracy theories to replace mainstream thought, and absurd sound bites to replace carefully prepared analyses. (echnology should not be about &dumbing us down& but about ma%ing us more %nowledgeable, better, and more productive. At an important inflection point for the entire global economy, we need to do better, and we hope that our humble guideboo%s can be a start. -o why begin such a vision with an investment guide. !ecause investing is a topic that actually fits all the pieces of our thesis. (he financial news media collectively has A// and is dominated by sound bite pieces about what the mar%et has done in the last four hours, rather than reasoned analyses of where we stand and how we have gotten here. 0ven the best*seller list is dominated primarily by opinion*pieces from authors who stand far outside the mainstream. t is no wonder that an epidemic of financial illiteracy plagues individual investors, who have achieved stunningly poor returns over the past twenty years, and may be rapidly losing faith in the mar%ets and a system that they perceive as &rigged& against them. 1eanwhile, political and economic divisions are ever*widened by the ability of a relatively small segment of the population to handsomely profit off the financial illiteracy of the masses. 2ur small and humble antidote to all of this is to write the best investment guide we can. hope that you will find this boo% clear, authoritative, and interesting. f you have any comments, questions, or feedbac% of any %ind, please let us %now. (his guide * and this entire concept for a company * remain a test. f you li%e what you see, please consider leaving us feedbac% and passing along a recommendation to a friend or friends. And please let us %now personally what you thin% via one of the contact methods below) 0mail) feedbac%@ivybytes.com (witter) @ivybytes

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(ontents
3reface.........................................................................................................4 5esson 6) 7ow to double your money every seven years...............................................8 5esson 9) 1a%ing sense of the investment world .....................................................69 5esson 4) A practical guide to choosing an investment account.....................................6: 5esson ;) 7ow to use tax*advantaged accounts to avoid investing solely for the benefit of <ncle -am.....................................................................................................9= 5esson >) Forming an investing plan......................................................................9: 5esson 8) +nowing your alphas and betas...............................................................44 5esson :) !eyond the stoc% mar%et * An introduction to asset classes.............................4: 5esson ?) 3utting intelligent diversification into practice * it"s more than the -@3 >==........;6 5esson A) mplementing your target asset allocation..................................................;> 5esson 6=) 1anaging for the long*term with a loc%box Band a sandboxC...........................;A

)esson ":How to dou*#e your money every seven years

+he Bottom )ine A small initial investment can increase to a surprisingly large amount if it is held over several decades than%s to an amaDing property of returns %nown as &compound interest.& 1ost investors fail to realiDe this potential for vast wealth creation both because they start saving too late in their career, and because they fail to achieve even an average rate of return due to fees and investment mista%es. (his financial illiteracy can cost the average investor more than E6 million over the course of a lifetime. +he )esson The parable of Jill and Average Joe 'e begin with a story. 2ur story has two heroes, whose names are &Fill& and &Average Foe.& 0ach goes to a four*year college, graduates at age 99, and enters the wor%force ma%ing E;=% a year. 0ach retires at 8> and lives the next twenty years off of accumulated savings. 0ach goes through the normal ups and downs of life * unexpected $ob loss, marriage, divorce, %ids. !ut through it all, both Fill and Average Foe ma%e saving money a priority * and while some years are better than others, they each manage to put an average of 6=G of their income into a retirement fund yearly, only ta%ing a brea% for three years in their mid 4=s when family expenses and $ob concerns catch up to them. Fill and Average Foe differ in only two regards. First, Fill starts saving immediately upon entering the wor%force at age 99H Average Foe waits until he is 4= to begin saving, reasoning that retirement is still so far off. -econd, Fill buys an index mutual fund that trac%s the overall stoc% mar%et, never touching her money and earning the same return as the overall stoc% mar%et. Average Foe &tin%ers around& with his portfolio, purchasing some mutual funds through his financial advisor, and investing in stoc%s whenever he gets a particularly $uicy tip from his neighbor. Foe earns the same return as the average investor in the stoc% mar%et. 'hen they retire at age 8>, each chec%s the balance on his investment account to see what %ind of lifestyle the next twenty years will bring. Fill finds she has accumulated EA8:,=== Bin today"s dollarsC. Average Foe"s portfolio has grown to less than 6I4 of this amount * E4=A,===i. (he difference does not stop there. 3rovided their investment habits continue into retirement, Fill will able to earn as much as E?;,=== a year from her investmentsii. Average Foe will spend his retirement living from -ocial -ecurity chec% to -ocial -ecurity chec%, receiving E6>,=== a year from his investments. (he rest of this chapter will explore why this huge difference exists between two people with such stri%ingly similar earning and saving habits, and where Average Foe went so horribly wrong. !ecause at its core, the parable of Fill and Average Foe represents the difference between the %inds of investment returns millions of Americans should be receiving, versus the %ind that they actually are receiving. As a direct consequence, it

also represents the lifestyles we should be living, versus the %ind so many of us actually are. The miracle of compounded interest At its root, finance is pretty simple. (here are only two things to do with money) use it to purchase goods or services, or save it. -ince spending money is obviously more fun than saving it, one reason people rationally choose to save anyway is the hope that, in doing so, they will be able to consume an even larger amount of goods or services at a later date. 7istorically, this has indeed been the case. 2ver the past century, savings invested in the stoc% mar%et have appreciated over long periods by an average of 6=G a year Bmore li%e 8G after accounting for the fact that the prices of goods has also tended to increase over timeC,iii though there has of course been considerable variation from year to year and even decade to decade. An important feature of investment returns is something called &compound interest.& (his means that it is not $ust an initial investment that appreciates in value, but also the gains on that initial investment. For example, we might expect that an investment of E6== that appreciates at the 6=G annual rate of the stoc% mar%et over the past century would appreciate to E66= after one year and E69= after two years without compound interest. !ut if no money is ta%en out, then in the second year it is not $ust the initial investment BE6==C that grows at 6=G, but also the gains on the initial investment from the first yearBE6=C. -o after two years the investment is actually worth E696. After many years, the &gains on the gains& of an investment can become remar%ably significant, as they result in what is called &exponential growth&, meaning that the dollar value of an investment increases at a faster and faster rate over time. Jou can see this visually below.

(he &rule of :9& is a handy rule of thumb that illustrates the power of exponential growth over time. t says that to determine the approximate number of years an investment will ta%e to double in value, simply divide :9 by the average annual rate of return. -o an investment with a 6=G annual rate of return will double every seven years B:9 divided by 6= is about :C. 'hat is really interesting is the effect that compound interest has when the holding period is extended beyond those : years. An investment that doubles every seven years will double twice every 6; years B9 x 9C, resulting in a quadrupling in value. 2ver 96 years it will increase ? times B9 x 9 x 9C, over 9? years it will increase 68 times B9 x 9 x 9 x 9C and over 4> years it will increase 49 times B9 x 9 x 9 x 9 x 9C. 2ver ;9 years * well within the holding period of a typical wor%er who starts saving early in life * it will increase an astonishing 8; times in value B9 x 9 x 9 x 9 x 9 x 9C. (his is why even a small amount of money, if allowed to accumulate over a long enough time period, can grow to an extraordinary fortune. #etting bac% to the parable * !y starting his saving 6= years earlier than Average Foe, Fill was able to increase the time that compound interest could wor% for her, greatly increasing her retirement wealth. (he chart below pictures the real growth of E6 invested in the stoc% mar%et in 6A8=. 'hile the ride is more bumpy than in our hypothetical ?G return example above, a wor%er that invested E6 of income in 6A8= would have over E6== today * about a 6=G compound annual return.

Figure 1- The growth of $1 invested in the US stock market at the end of 1960

Why most investors fail to achieve this ideal 'ith the miracle of compound interest propelling Fill, with a very middle*class wage and modest savings level, to millionaire status by the time of her retirement, one might wonder why there are so many struggling retirees. (his brings us to the second reason Fill ended up sipping pina coladas while Average Foe lived from -ocial -ecurity chec% to -ocial -ecurity chec%. (he dirty little secret of the investing world is that even diligent savers li%e Average Foe largely fail to realiDe the ideal of returns that compound at the rate of the stoc% mar%et. Although the stoc% mar%et overall has increased at a 6=G average rate over the last century, the average investor in the stoc% mar%et has seen returns that significantly lag this rate. 2ver the past 9= years, research by /albar, a financial advising group, reports that the return the average equity investor achieved was more than >G below the return of the overall stoc% mar%etiv.(here are two reasons why the returns of the average investor fall far short of where they should) 1. Fees. 'hile Fill paid relatively few fees, some 9G of Average Foe"s assets disappeared into the hands of a financial advisor, investment manager, bro%er, or some combination thereof every yearv. 'ithout these fees, Average Foe"s portfolio would have been worth E;49,=== instead of 4=A,=== at retirement, even with his late*start. 2. 3oor investment decisions. 7istorically, investors have been carried away by optimism when times are good and by pessimism when times are bad. (he result is

herd behavior * with money moving into stoc%s $ust in time to capture a mar%et crash, and money moving out $ust in time to miss the start of a bull mar%et. For instance, in 9=== investors added E49> bil to equity mutual funds at a time when the -@3 >== was selling in the range of 6;== to 6>==. n 9==9, they sold a net of E69 billion when the -@3 >== was selling in the range from ?9= to 66:=vi. 'ithout the effect of poor investment decisions and fees that too% another 9G off his returns, Average Foe"s portfolio would have been worth E894,=== even with his late*start.

0ach of these factors can really be attributed to one thing) financial illiteracy. -imply put, the average investor lac%s the confidence to manage money on his or her own, and lac%s the ability to achieve even mar%et*level returns. (o put the cost of financial illiteracy into perspective, thin% of the result of the parable above. Fill and Average Foe were both ali%e * except that Fill too% the time to become financially literate at a young age, and Fill did not, pushing off savings until he was at a stage where he could hire an advisor. (o Average Foe, this advice seemed to cost only 9G a year * far less than he was ma%ing on his investments. !ut over the course of his lifetime, it would end up costing him some E>==,=== in lost savings. s putting a few hours of hard wor% in now to become financially literate worth E>==,=== dollars to you. f so, read on.

)esson : Ma,ing sense o' the investment wor#d

+he Bottom )ine At their most basic level, investments represent an exchange between two parties * one who needs money now in order to build something that will generate money in later years, and another who has money now and would li%e to exchange it for more money in later years. -toc%s and bonds represent two different ways of structuring this %ind of agreement. -econdary mar%ets li%e the New Jor% -toc% 0xchange allow investors to &trade& their initial investments to others in exchange for cash. (he intrinsic value of any investment is $ust the future income stream that it will produce, discounted bac% to the present to account for the time value of money. +he )esson What an investment really is n a modern world complete with a litany of complicated investment options, it is easy to lose sight of what an investment in the financial mar%ets actually means. t can be instructive to imagine what things would have been li%e in a simpler time and place * an ancient town where &(ed& and &!ill& are two farmers and neighbors. n our scenario, (ed"s farm is in the land of plenty. 7e has had several good farming years and has more food stoc%piled than his family will be able to eat. 7e would li%e to be able to exchange food today for food in the future, when he might not be as luc%y in his harvest, or as able to wor%. !ill is $ust starting out, and would li%e to spend time wor%ing on enlarging the farm and building a new barn so that he can expand his operation in future years in order to be more li%e (ed. 7owever, if he spends his time enlarging the farm he will not be able to harvest his crops this year. (his would not ma%e !ill"s hungry wife and %ids very happy. -ince !ill needs food now in order to produce more food later, and (ed has extra food now and would li%e to get more food later, it seems li%e a mutually beneficial arrangement should be possible. !ut the problems in structuring this trade are significant, since it is ta%ing place across time. (ed wants to be sure that he will get as much or more food in the future as he is giving up now. 2therwise he could ground his corn, put it into storage, and hire another neighbor to guard it from !ill"s hungry children. (ed also naturally worries that !ill will $ust run off with the extra food and never deliver on his end of the deal. Finally, (ed wonders whether there are other farmers li%e !ill, in towns far away, that might give him a better deal.

For all their complexity, the modern financial mar%ets evolved to solve precisely these %inds of age*old problems. n the next section, we will loo% at how stoc%s and bonds represent two different ways that !ill and (ed could have structured a mutually*beneficial agreement. Know your stocks and bonds: An introduction to financial instruments and terminology (he first way that (ed and !ill might have decided to structure their arrangement is a simple &pay you bac% later& agreement, equivalent to saying &Can borrow your car. promise will bring it bac% in two hours.& (o ma%e the deal attractive for (ed, !ill might offer to give him an additional three bushels of corn at the end of every year until the debt has been paid off Bsort of similar to &Can borrow your car. "ll fill it up with gas before bring it bac%&C. -o !ill would receive yearly corn payments in addition to the return of his initial investment at the end of the loan term. (his situation is pictured below from !ill"s perspective, with a negative number indicating he is giving up corn and a positive number indicating he is receiving corn.

f (ed and !ill had structured the arrangement in this way, they would have created something similar to a bond. (oday, bonds are a type of debt that represents an 2< from a user of money such as a company or government, to a provider of money such as a saverIinvestor. n exchange for immediate use of the saver"s money, the

recipient agrees to ma%e a periodic interest payment to the saver, as well as to return the full amount at the end of a fixed term. (he saverIlender has the opportunity to ma%e a positive return over the course of the investment because he gets his initial investment bac% when he needs it a later date, and also receives interest payments in the mean time. (ed and !ill could have also structured their arrangement another way. f the farm improvements !ill was planning were relatively ris%y * for instance, if he was building a new %ind of production machinery and there was a chance it would not wor% as planned * !ill might not want to have a fixed sum debt hanging over him, and (ed might be uncomfortable with the low rate of return from a bond, given the ris% that !ill will not be able to produce enough food to pay him bac%. An alternative would be for (ed to provide !ill with 6== lbs of corn in exchange for a portion of the ownership of the new farm, say 6=G. (his way, (ed would be entitled to 6=G of the future production of !ill"s farm. f the improvements were successful, (ed could receive much more corn than he initially gave up, earning a positive return on his investment. f the improvements were unsuccessful, he might end up receiving less than he initially gave !ill. (his %ind of arrangement allows (ed and !ill to share in the ris% of the pro$ect, and is similar to a stoc%. (oday, stoc%s are certificates issued by companies when they do not have the cash on hand to build a new factory, launch a new product, or invest in their business. n exchange for providing needed money, saversIinvestors receive partial ownership of the company. f the company ma%es profits in the future, it will give a portion of its earnings to its owners in annual or quarterly payments %nown as &dividends&. !y purchasing stoc%s, the saver has the opportunity to ma%e a positive return over the course of the investment if the total dividends received from the company are greater than the value of their initial investment. (hus far, we have assumed that the circumstances for (ed and !ill do not change between the time they enter into the agreement, and the time the agreement is complete. !ut imagine that shortly after giving his surplus food to (ed, !ill"s farm is overrun by corn*eating locusts. 7e could try to get his food bac% from his neighbor, but (ed has already held his fields fallow for a year, and there is not enough to feed both families. A solution to this problem could be for (ed to sell his contract with !ill to a third farmer, &Foel&, who also has a surplus of corn. Foel would give (ed corn now in exchange for receiving future corn payments from !ill. (he modern equivalent of this %ind of &re*selling& of contracts is secondary mar%ets li%e the oft quoted New Jor% -toc% 0xchange. 1ar%ets for financial contracts let an individual who initially invested in a stoc% or bond issue sell it to another individual that would li%e to &ta%e it over.& (he prices for stoc%s and bonds that are frequently quoted in newspapers and the internet are simply the most recent price at which these secondary exchanges between individuals are ta%ing place.

2ne downside of both stoc%s and bonds is that many individual investors do not have enough money or time to manage a very large portfolio of them. 1utual funds arose as a solution to this problem. A mutual fund pools together money from many different savers and invests this larger pool in a portfolio of stoc%s. 0ach investor in the mutual fund owns a portion of this portfolio and receives a portion of any income or investment gains. 1utual funds are managed by a professional investor who is usually employed by a company li%e Fidelity or (. Kowe 3rice. So what is it all worth - The theory of ntrinsic !alue 2ften, commentators will tal% about a stoc% or bond as being particularly &overvalued& or &undervalued.& -uch a description poses the question of how to define what &fair value& would mean. (he theory of intrinsic value says that an investment should have a value equal to the value it would have to a hypothetical investor who holds the investment forever Beven though, with the advent of secondary mar%ets, most investors do not actually do soC. ntrinsic value rests on the idea that there is what economists call a time value of money" (he basic idea is that receiving E6 today is worth more than receiving E6 in the future, say five years from now. (here are three inter*related reasons for this. First, a dollar today can be invested in various productive ways to produce more dollars in the future. -econd, a future dollar will buy less real goods than a current dollar due to inflation. Finally, there is a very human preference for immediate gratification over delayed gratification Bi.e. most people would rather have ca%e now than one wee% from nowC. A good estimate for the time value of money today is the interest rate on a very safe investment, such as <.-. (reasury bonds B .2.<.s from the <- governmentC. f we %now or can observe what the time value of money is, than we can place a dollar value today on the promise of E6 five years from now. n doing so, we are &discounting it bac% to the present.& And if we can place a current dollar value on the promise of E6 five years from now, then there is no reason we cannot place a current dollar value on any stream of future dividends or interest payments. (his is precisely what is needed to value a stoc%, bond, or any other %ind of investment * simply estimate the income the investment stream the investment will provide, and discount it bac% to the present at an appropriate time value of money. n the !ill and (ed example, the intrinsic value of !ill"s investment would always be his best guess on how many pounds of food that (ed would give him in the future. (his would vary with the probability of success of the pro$ect andIor !ill"s credit worthiness. n today"s mar%ets, intrinsic value equates to the estimated future dividendIincome stream of a company into perpetuity Bor as long as the company or bond remains alive and income*generatingC, discounted bac% to the present to reflect the time value of money and the ris%iness of the investment. #$plaining market volatility

t may seem difficult to explain the wild gyrations of the stoc% mar%et in the context of a theory that says stoc% prices should, in principle, never diverge from their intrinsic value. 5arge mar%et gyrations can be a result of two factors. First, it is exceedingly difficult to estimate what the intrinsic value of a company is, since this rests on estimating profits forever into the future and discounting them bac% to current dollars at an equally uncertain time value of money. 0stimates can change dramatically based on changes in technology, competition, regulatory environment, wars, natural disasters, overall economic growth, estimates of future inflation, and changes in the individual preference for money now vs. later. -ince we live in a dynamic world where all of these things are changing on a daily basis, rational estimates of intrinsic value are certain to change with time. -econd, the mar%ets are composed of human participants and may not be immune from emotional factors li%e &fear and greed.& 7uman emotions could have a particularly large role today because the average holding period of a stoc% is now only four months according to The #conomistvii" (his short holding period creates an incentive for mar%et participants, especially those such as professional fund managers who are $udged by short*term measures li%e the performance of their fund over the past quarter, to play what prominent economist Fohn 1aynard +eynes referred to as a &beauty contestviii.& (he idea is that the mar%ets can, in periods of intense speculation, come to resemble a game where the ob$ective is not so much to figure out which companies are more valuable, but to figure out which companies the most investors will thin% are most valuable. Apparently rational investors may buy into shares trading at prices that are much higher than any reasonable estimate of their intrinsic value if they thin% that others will be willing in the future to purchase those shares at even higher prices still. (his %ind of dynamic can create mar%et volatility independent of changes in the fundamentals of a business or the economy. t gets somewhat beyond the scope of an introductory guide, but an important piece of the volatility puDDle may also come from what billionaire hedge*fund speculator #eorge -oros describes as &reflexivity.& (he idea is that movements in stoc% prices do not $ust reflect estimates of the future, but they can, in fact, directly impact the future. An easy example to see this is the 9==? financial crisis. Falling prices on investments li%e stoc%s at first reflected lower intrinsic value of assets as a result of deteriorations in the real economy. !ut falling prices then caused even further deteriorations in the economy because households loo%ed at the lower values of their stoc%s, bonds, and houses, realiDed they were not as wealthy as they once had thought, and cut spending. 'hen everyone cut spending at once, the economy deteriorated further, causing even more pressure on investment prices. &Keflexivity& can create mar%ets that are susceptible to wild $umps from one extreme to the other.

)esson -: A .ractica# guide to choosing an investment account

+he Bottom )ine 2pening an investment account is a crucial first step to saving wisely. nvestors have the option to invest through a discount bro%erage account, a mutual fund account, a full*service bro%erage account, and even a ban% account. (hey should pay extremely close attention to fees when choosing an account, since seemingly small yearly charges can act as bra%es on the amaDing effects of compound interest. /iscount bro%erages will be appropriate for many, since they combine low fees with the widest selection of investment options. +he )esson Why e$penses matter - a lot Coo%ing is something that a lot of us have a love*hate relationship with. 'hile we love being able to control exactly what goes into our bodies, having an unlimited array of culinary possibilities, and saving money versus eating at restaurants, we hate figuring out what combinations of food will taste good, burning rice for the third time in two wee%s, and spending time in front of a stove with a potholder and not in front of a (, with a beer. Frequently this tradeoff ends up with a ta%eout order being placed. 1any are perfectly o%ay with this because it is still relatively affordable to outsource this part of our lives at E6= a meal or so. !ut if our local ta%eout places were charging E6=,=== a meal you can bet we would be in a ba%ing class as soon as possible. No one would eat out at those %inds of prices. Jet an equivalent price structure exists in the world of investment accounts, and rather than learning to coo%, most people are instead opting to buy a E;==,=== bad hamburger. (o see why, let"s go bac% to loo%ing at Fill and Average Foe. magine each ma%es an identical E6==% investment that earns ?G a year before fees. Fill invests directly in a low cost index fund that charges a fee of .9G of assets. Average Foe invests in an average mutual fund through an average financial advisor. (he mutual fund charges a management fee of 6.4G of assets Bnot all funds are as expensive, but 6.4G is about average for an actively managed fundC and his financial advisor charges a fee of 6G of assets for managing the investment on his behalf. 'hile it might seem li%e it is worth it to Foe to pay roughly 9G of his assets a year for the convenience of professional management, especially since his investment returns more than this every year, in actuality he is reducing his returns by a stunning amount over time. After 4= years, Fim"s account would have grown to EA>9,=== while !ill"s account would have grown to only E>9?,===. Fust as a virtue of paying 9G a year less in fees, !ill will be nearly twice as wealthy as Fim. (he fees that Foe paid did not seem high relative to the returns he was ma%ing at the time, but over the course of 4= years they ended up &costing& him E;9;,===, or four times his initial investmentL

%ow to cook your own stock market stew (he first step to figuring out the right place to open an account is to decide what %ind of company to deal with. (here are four general choices) full*service bro%erages, mutual fund companies, discount bro%erages, and deposit ta%ing ban%s. /iscount bro%erages, the &eat your own coo%ing& account, are compelling choices for many. /iscount *ro,erages are low*cost online accounts from firms li%e 0trade, Charles -chwab, and Fidelity. (hey allow do*it*yourself investors to purchase a large variety of common stoc%s, mutual funds, and 0(Fs Bexchange traded funds... 'e will discuss these in chapter :C, ma%ing them a great one*stop shop for financial products. (here is often no annual fee for using a discount bro%erage. nstead, these accounts ma%e money by charging a small fee every time you buy or sell a stoc% or fund, usually > to 6> dollars per trade. (his fee is only assessed on the purchase or sale of a stoc% or 0(F position. /iscount bro%erages are the lowest cost option for most investors, and also offer the widest selection of investments. A mutua# 'und account from a company li%e ( Kowe 3rice or ,anguard is the investing equivalent of going to a chain restaurant. (hese %inds of accounts generally allow investors to purchase funds sold by that company, but not directly invest in stoc%s themselves Bthough larger firms li%e Fidelity and ,anguard will li%ely also offer discount bro%erage accounts * these may be a compelling value since they let you invest in stoc%s alongside their own fundsC. 1utual funds appeal to those that see% the professional management capabilities of a mutual fund manager. 7owever, mutual funds often come with higher fees that, as we have seen, can lead to huge amounts of lost wealth over time. 1utual fund fees can vary enormously from one company to another Band from one fund to another at the same companyC. -ome firms charge 6.4G of assets or more to manage your moneyH others even add on a &load& fee that will cost you as much as >G of your money up*front $ust for the privilege of investing in their fund. 'ell*run mutual funds from companies li%e ,anguard and (. Kowe 3rice offer much lower fees and no load. %u## service *ro,erage accounts from the li%es of 1organ -tanley and #oldman -achs are the financial equivalent of hiring a private chef. (hese accounts are li%e discount bro%erages except they offer more personal services li%e wealth management and advice, and they generally charge more. !e aware that the advisor may be tempted to recommend investments that pay him or her a high commission Bfinancial term for a %ic%bac%C rather than what is best for you. 0ven if the advice is un*conflicted, it is extremely difficult to ma%e up the cost of these additional expenses over a thirty year period. 'hile generally not considered investment accounts, *an, chec,ing and saving accounts are the financial equivalent of microwaving a (, dinner. 5i%e the humble microwaveable dinner, ban% accounts have their advantages. (he return earned from

them is free of any ris%, and money invested is guaranteed by the government. 1oreover, money can easily be withdrawn from the account at full value whenever it is needed, a feature that economists call &liquidity.& Nonetheless, the compounded return you can get over a lifetime from a ban% account pales in comparison to the wealth creation opportunities from investing in the stoc% mar%et. Chec%ing and savings accounts are great places to %eep money that might be needed in the next couple of years, but higher return assets li%e stoc%s and mutual funds will, on average, offer much higher returns over the long*term. (, dinners have their time and place, but you do not want to live on them. %ow to choose a discount brokerage 5uc%ily, finding a good discount bro%erage is a lot easier than learning how to coo%. Competition amongst online providers has pushed trade costs to all*time lows, leaving more money in the poc%ets of smart individual investors. 5arge players li%e (/ Ameritrade, 0(rade, -cottrade, and Fidelity all have compelling offers and are good places to start. A few factors to consider) * Jou should not have to pay much more than E6= per trade * Jou should be able to avoid paying any monthly maintenance fees, or having a minimum monthly level of spend that you have hit. * Jou should have free access to online tools, calculators, and stoc% quotes * (he minimum account siDe should be in the range of what you are loo%ing for and there should be no charges for contributing or withdrawing money 2nce you have decided on an appropriate provider Band it is difficult to go to wrong in choosing between the main playersC, opening an account is easy. Jou will $ust need your -ocial -ecurity number, personal information, and have access to a funding source li%e a ban% account. <sually, you can electronically transfer money from a ban% account to a bro%erage account if you have the routing number and account number Bwhich should be on your chec%sC. 2nce an account has been opened, you may need to wait a few days for everything to clear, and then you can begin investingL (he remainder of this boo% will focus on what to do with your new account.

)esson 0: How to use ta$1advantaged accounts to avoid investing so#e#y 'or the *ene'it o' 2nc#e Sam
+he Bottom )ine t is essential to consider the role of taxes in devising an investment strategy, as they will represent the largest investment expense for most investors. (ax*advantaged accounts such as the ;=6B%C and the KA were set up by the government to encourage citiDens to save for their own retirement. (hey offer compelling tax advantages and should be properly utiliDed by $ust about everyone. +he )esson For thousands of years of history, the best retirement planning that was available to the middle*class was to have a lot of %ids. n an agrarian lifestyle, %ids could grow up, ta%e over the family farm, and tend to their elderly parents when they were no longer productive. #overnment did not have much of a role to play. (his changed in the #reat /epression and '' . (he #reat /epression brought the government into the retirement industry in the form of -ocial -ecurity, a program that taxes people during their wor%ing years and pays them during their retirement years. #overnment price controls during '' also encouraged private companies to compete by offering pension plans, starting a tradition of employer*provided retirement coverage. n the late 9=th century it became evident that neither -ocial -ecurity nor private pension plans would be sufficient to pay for the retirement of the baby boomer generation. (he government responded again by offering tax brea%s that encourage wor%ers to save and invest for their own retirements. (he combination of these forces produced the ndividual Ketirement Account B KAC, and the ;=6B%C employer*provided retirement account. (his chapter will loo% at how you can ta%e advantage of the KA, ;=6B%C, and traditional BtaxableC investment account in planning for your retirement. (his complicated amalgamation of different account types has made things more confusing for the individual investor, but it has also opened the door to enormous tax savings that you do not want to pass up. Ta$es are the most significant investment e$pense you will pay Fust as paying seemingly small amounts for money management every year adds up to stunningly reduced wealth over time, paying apparently modest amounts of taxes every year can ta%e a K-*siDed bite out of your wealth. 1oney that is not in a tax* sheltered retirement account Bmore on these belowC is sub$ect to three layers of taxes. nterest payments on bonds as well as short*term gains Bmoney made from selling investments at a higher price than they were purchased atC on investments held for less than one year are taxed at the ordinary income rate. 5ong*term capital

gains as a result of selling an investment held for longer than one year at a higher price than it was purchased for, are taxed at a special capital gains tax rate of BusuallyC 6>G. !e aware that tax rates have changed mar%edly in the past and are li%ely to increase in the future. Finally, all dividends received from stoc%s are taxed either at the ordinary income rate or at a qualified dividend rate which may be lower Bcurrently 6>G for most tax payersC. (hese taxes act as a sharp bra%e on the amaDing effects of compound interest that we went over in chapter 6. (o see the huge potential impact that taxes can ma%e, imagine an employee is in the 44G tax brac%et and has E6==% invested in a long term bond that pays out 8G interest a year, and is able to reinvest the interest in this bond at a similar rate. nside a tax* sheltered account, this money will actually compound at 8G, growing to E>:>,=== over thirty years. 2utside a ;=6B%C, this money would compound at a true after*tax rate of ;G Bsince 6I4 of the income goes to the government every yearC, growing to only E49;,=== Bsee belowC. t is easy to see that ta%ing advantages of the tax savings inside of a ;=6B%C can ma%e a material difference to the lifestyle that you are able to afford in retirementL

(he two ma$or account types that you must become familiar with to be an informed investor are the ;=6B%C and the ndividual Ketirement Account B KAC.

The &'()k* - Worth opening for the free contributions and keeping for ta$ savings A ;=6B%C is a retirement account that is provided by employers. 0mployees can elect to have a portion of their wages deducted directly from their paychec% and invested in the ;=6B%C. (his is often referred to as a direct contribution B/CC retirement plan because employees bear all investment ris% in the account. t is the contributions, not the benefits, that are guaranteed. (o see the advantages of a ;=6B%C, we"ll loo% at Fanet, a 4> year old middle manager ma%ing E>=,=== a year. nvesting in a ;=6B%C has three huge advantages for Fanet. First, employers will usually match a portion of employee contributions up to a certain level * this means that if you put in a given amount, your employer will ma%e an automatic contribution on your behalf. Fanet"s company matches half of an employee"s contribution up to 8G of his or her salary every pay period. (his means that if Fanet puts in 8G of her salary, her employer will add another 4G out of its own poc%et. (his extra contribution can add up significantly over time. At Fanet"s salary of E>=,=== per year, it will mean an extra E6,>== a year in retirement savings $ust for ma%ing the minimum contributions. After a thirty year period, this extra E6,>== a year will add E6:=,=== to the value of her retirement account if it is invested at an ?G annual return. Automatic employer matches are essentially free money that employees would be foolish not to ta%e advantage of. -econd, the amount that is contributed to a ;=6B%C plan can be deducted from income for tax purposes. For instance, if Fanet contributes E6=,=== to her ;=6B%C her taxable income will be reduced from E>=,=== to E;=,===. Fanet is in a 9>G tax brac%et, so lowering her taxable income by E6=,=== directly saves her E9>== dollars a year in taxes. (hird, the income and gains from investments in a ;=6B%C are exempt from taxes as they accumulate. Normally, interest on investments is taxed as income or dividends, but inside a ;=6B%C this money is allowed to grow tax*free until it is ta%en out. -o Fanet"s investments inside her ;=6B%C will compound tax*free, as described above, and li%ely grow faster than if she had invested an equivalent amount of money outside the ;=6B%C. 'hile its huge benefits ma%e it an important cornerstone of anyone"s retirement, the ;=6B%C does come with a few significant liabilities. (he first is that the money is intended for retirement, and there are tax penalties that are imposed if is ta%en out and used before the age of 8=. (his ma%es the ;=6B%C a poor place to save for short* term goals li%e a new car. (he second is that withdrawals from the ;=6B%C during retirement are taxed as income at the ordinary income tax rate. -o when Fanet goes to withdraw money from her plan in retirement, she will have to pay ordinary income taxes. /epending on her income in retirement, this could result in large taxes. Finally, the investment choices in a ;=6B%C will li%ely be limited to a set approved by

the employer. 'hile some plans are quite good, this can severely limit the flexibility that a wor%er has in planning for their retirement. For this reason, many people choose to roll their ;=6B%C over into an KA if they change $obs or retire. The +A ) ndividual +etirement Account* - A great all-around retirement savings vehicle (he KA is a tax advantaged account that was created by the government to encourage people to save for their retirement outside of employer provided plans. KAs come in two varieties) the traditional KA and the Koth KA. A traditional KA has the same tax advantages as a ;=6B%C, but it is entirely self*managed, so it lac%s the constraints in investment selection of the ;=6B%C. (he KA does have two disadvantages relative to the ;=6B%C. First, for those that have a employer*sponsored retirement plan available to them, contributions to an KA are deductible from taxable income only if you Bthe saverC have a net income of less than a limit defined by the K-. For 9=66, the limit for full deductibility is E>8,=== for singles and EA=,=== for couples filing a $oint return BE68A,=== if you file $ointly and one of you is covered by a plan but the other is notC. 7igher income persons can still contribute and get the benefit of tax deferral on the income earned, but they cannot get a tax brea% on their contributions, which removes most of the advantage of the account. -econd, the contribution limit on a traditional KA is significantly lower than on a ;=6B%C BE>,=== a year for those under >= and E8,=== dollars a year for those over >= vs. E68,>== for the ;=6B%CC. (he government realiDes it is giving away amaDing tax savings and does not want people to ta%e advantage of these too much. +oth vs" Traditional, -lip a coin""" A further complication of KA and BsomeC ;=6B%C accounts is that they actually come in two different varieties, called the &Koth& and &(raditional& Bnot all employers offer a Koth ;=6B%C * if yours does not, do not worry about itC. (he basic difference is that with a traditional account, contributions are tax deductible with withdrawals are taxed at the income rate, while with a roth account contributions are after*tax but withdrawals are tax*free. !eing forced to decide between the two is exactly the sort of thing that quite understandably ma%es the average investor flee to one or more of) financial advisor, liquor store, bed. A good principle is that if your eyes start to glaDe over at any point in this discussion, flip a coin and be done with it. 'hy. !ecause it really .ust does not matter that much" n fact, traditional and Koth accounts will produce a mathematically equivalent income in retirement for many people. For those that want to delve into potential differences) f you expect to be in a lower tax brac%et in retirement than you are now then a traditional account may be the best choice since it ma%es sense to ta%e your tax deduction now, when it is worth more. (his may be the case if you have

only modest retirement savings and expect your retirement income to be much lower than your current income. Conversely, if you expect to be in a higher tax brac%et in retirement than you are now then a Koth account ma%es sense. (his may be the case if you have large retirement savings. f you expect to be in a similar tax brac%et but are worried that taxes will increase in the future in order to pay down deficits, a Koth account might be your best choice. f you are already maxing the contributions to your retirement accounts and would li%e to be able to contribute more, a Koth account may be your best choice. (his is because you are contributing after*tax dollars to the Koth, so the effective contribution limit is greater. For KA accounts, a Koth has more flexibility for when you ta%e withdrawals, which can be an important feature. Koth accounts allow you to withdraw contributions Bbut not investment gainsC at any time, they let you withdraw up to E6=,=== for a first*time house at any time, and they let you refrain from ever ta%ing withdrawals, while normally you are forced to begin ta%ing them at age := 6I9. (his last feature can increase the amount you are able to pass on to heirs.

(he following table summariDes the main points of the ma$or types of retirement accounts)

+a*#e " 3ey &arameters o' 4etirement Accounts

Ta$able )/ormal* Account - 0se it to save for short-term goals A plain vanilla taxable investment account lac%s any of the tax advantages of a ;=6B%C or KA. nvestors are responsible for paying taxes on all dividends, interest, and capital gains from the account. Nonetheless, taxable accounts merit a place in $ust about everyone"s portfolio for two reasons. First, access to money without penalties ma%es taxable accounts the right vehicle to save for short*term goals li%e a new car or second home, as well as to build up a reserve fund for contingencies. -econd, taxable accounts are an appropriate place to hold excess savings beyond what can be contributed to a retirement account, since there is no limit to the amount of money that can be saved in a standard investment account. 1ost people should have all three accounts !ecause each account type has its own particular advantages, most investors should open and use both an KA and a taxable investment account in addition to using their company*provided ;=6B%C, if they have one. t would be foolish not to use a ;=6B%C to receive an automatic match from an employerH it would be equally foolhardy to pass

up on the tax benefits and flexibility of the KAH and the need for a reserve fund that can be easily accessed at any time ma%es the vanilla taxable account an essential component of a portfolio.

)esson 5: %orming an investing .#an

+he Bottom )ine !efore $umping into investing, it is essential to have a plan composed of base case and stretch goals for wealth the amount of money you will need to retire, a yearly savings target, and a plan for how much money to invest in each account. (his lesson presents a framewor% for thin%ing about these issues. +he )esson Kunning a marathon * a 98.9 mile B;=%mC road race * is a serious effort that might seem masochistic to most. Jet millions of Americans are drawn to these races every year, often embar%ing on months*long training programs that call for them to gradually ramp up the miles they are running every wee% from 9= miles to ;=*>= miles or more. 2ne of the things that ma%es training for and completing a marathon so compelling to many is that there is a clear and concrete &goal post& at the end of the process. 2n the flip side of the coin, it is the lac% of this clearly defined goal post that is precisely what ma%es retirement planning so frustrating. (he equivalent of the &marathon date& for retirement planning is your retirement date. !y this time, you should have accumulated enough savings to comfortably last you through your idle years. Contrary to the marathon training process though, the goal posts here are not quite so clear * it ta%es a bit of effort to figure out what this &number& is, but coming up with some %ind of goal is essential to designing a &training plan.& (he exercise below will help. Setting the goal posts - -iguring out how much money you need at the time of retirement by dividing your retirement income by a withdrawal rate )23 for most* t is useful to consider first the minimum amount of income from your investments that you would be comfortable living on in retirement. From this, we can begin to thin% about the amount of money that you will have need to have accumulated in an investment account at the time of retirement. 'hen thin%ing about a minimum income level to provide a sufficient lifestyle in retirement, consider several questions) * 7ow much money are you spending today. (his can be a good starting point for what you will spend in retirement. * /o you anticipate having lower expenses in retirement. For instance, will you downsiDe to a smaller shelter. 3ay off a mortgage. -pend less on children. 1ost people can get by on 9I4 of their income or spending today since they have less expenses in retirementix.

* -ubtract any additional sources of income you anticipate having in retirement from your figure. Consider how much you are pro$ected to receive in -ocial -ecurity benefits Byou can find this on your last -ocial -ecurity statementC. /o you or your spouse have a pension plan from a company or the government. /o you anticipate holding a part*time $ob. Are you the %ind of person that is going to %eep wor%ing long past 8>. t is important to note that this does not have to be an exact exercise. 'hatever number you come up with, write it down * we will use it in the next step. Next, it is time to have some fun and come up with some stretch goals. 7ave you always wanted to travel the world. !uy a yacht. (a%e a cruise. Fust live a more luxurious lifestyle. 'rite these down and estimate the amount of money you will need to get there, in addition to what you will need to cover basic needs. Add this additional amount of income to your total from above to get a stretch retirement income target. Finally, we are set to figure out how much total savings you would have to have at the time of your retirement in order to produce this required amount of retirement income. n retirement, you will continue to invest your &nest egg& in the mar%ets so that it continues to grow while you also withdrawal money to cover your living expenses. (he goal is to have a portfolio that will last 9> years or more after retirement Bthe typical retirement lifetimeC. 7ow much of a portfolio can be safely withdrawn every year is sub$ect to fierce debate, but in general the following approach is reasonable. f you are very concerned about outliving your assets, have little room to ad$ust spending in the event of a mar%et downturn, or $ust want to be extra conservative, a ;G withdrawal rate will protect your assets in all but the worst bear mar%ets. 1ost people should be able to withdraw >G of their assets during retirement Bthis assumes a relatively modest 9G rate of return after inflation over the retirement periodC. f you have significant flexibility to ad$ust your lifestyle in the event that returns are lower than expected, you might be able to withdraw money at a 8G or :G rate insteadx. n either case, to determine the amount of retirement wealth that you will need to produce your stretch and base cases, divide the income that you will need by your chosen withdrawal rate. For instance if you need E4=,=== in retirement income and have a little flexibility to ad$ust your lifestyle in the event of a mar%et downturn, than you will need E4=,=== I .=> M E8==,=== in savings at the time of retirement. f you require only E9=,=== in addition to your other income sources and you have greater flexibility to ad$ust your income and want to be a little aggressive, than you may need to budget only E9=,=== I .=8 M E44=,=== at the age of retirement. 3erform this calculation for both your stretch and base income goals.

4esign a savings plan to meet your goals" 4etermine your yearly savings target by referring to our handy chart 2nce they have decided when they are going to run 98.9 miles, aspiring marathoners next have to figure out how to prepare their bodies to go this distance at the set date. A first step is figuring out a wee%ly training mileage. Kules of thumb are to build up to almost twice the distance of the race Bi.e. ;=*>= miles a wee%C and not to increase the miles in any one wee% by more than 6=G. (he retirement planning equivalent of wee%ly training mileage is yearly savings. !elow, we will go over some good rules of thumb to figure out how much you should be saving each year in order to meet your goal. 'e will approach each of these by calculating the percentage of your goal that you need to accumulate each year. (he advantage of this approach is that people with different goals will get the same answer * for instance, if you have 9= years until retirement, you should be putting down a minimum of 4G of your final goal every year, regardless of whether that goal is E?==,=== or E?,===. (he percentage of your goal that you need to save each year is dependent on how much you are able to generate in investment returns and the number of years of saving and investing you have ahead of you Buntil retirementC. !y using the investment strategies advocated here, it should be possible to achieve returns of ;G a year in real Bafter inflationC terms over the very long term, though actual returns could fall below this level over a long period, and nothing is certain in the mar%ets. (he chart below calculates the appropriate savings level in terms of percentage of goal as a function of the number of years remaining until retirement. 5ocate the number of years you have remaining until retirement on the left hand of the page and find the corresponding entry under the &;G return& column. Jou can also loo% to see how the %ind of return you expect to get can affect how much you need to save.

Figure 2 - Percentage of end goa that !ou shou d "e saving ever! !ear "ased on num"er of !ear remaining unti retirement and rate of return

1ultiply the numbers you $ust wrote down by the numbers you $ust found in the table. (his is the amount that you need to save on a yearly basis. For example, let"s assume you are retiring in 9= years and you need to generate E9==,=== from in additional savings to meet your conservative goal and E4==,=== to meet your stretch goals. 5oo%ing at the &;G return& column that corresponds to 9= years, you would find that you need to save 4.;G of your goal every year. .=4; x E9==,=== M E8,?== a year towards the basic goal. .=4; x E4==,=== M E6=,9== a year towards the stretch goal. Finally, compare your conservative savings target to your current income and savings rates. /oes it seem feasible with your current lifestyle, or would this require a difficult lifestyle ad$ustment for you or your family. Consider the same for your stretch goals. (hin% about how much you would have to ad$ust your lifestyle in order

to reach this goal, and consider whether it is worth it. Find a number that is hopefully between your conservative and stretch targets and that still leaves you enough income to live at a comfortable level. (his is your annual savings target. Allocate yearly savings to different accounts through a simple 2 step plan 2nce marathon runners have pic%ed a date for their race and decided on wee%ly training mileage, the final step in their planning process is to split up wee%ly miles into distinct wor%outs. (he three %ey wor%outs in any marathon training program are the long run Bwhich is as fun as it sounds...C, the tempo run, and the speed wor%out. (he retirement plan equivalent is determining how to split yearly savings into different accounts, and there are also three choices) these are $ust the KA, ;=6B%C, and taxable accounts discussed in the previous chapter. Figuring out how much money to contribute to each is a five step process. First, priority should be to start with the ;=6B%C and contribute enough to maximiDe the employer match. For instance, if your employer matches half of contributions up to 8G of salary, then ma%e sure you are contributing 8G of your salary per pay period. (urning away free money is almost never a good idea. f you do not have a ;=6B%C or if your company does not match any of your contributions, then s%ip to step two. -econd, if you do not have an emergency savings fund built up to three months of estimated living expenses, you may want to add money to your taxable account or ban% account until it reaches the appropriate level. t is nice having a buffer in a cash account that can be accessed at any time in case of an unexpected layoff, natural disasters, or other unforeseen consequence. /epending on your degree of ris% tolerance, you can choose to build this up over time, or to put all savings into this fund until it reaches the desired level. 2f course, if you have any high*interest credit card debt or anything with an interest rate above ?G, you should pay the entire balance off before you start to build up your cash reserve. (hird, if you are eligible for tax deductions on an KA Bor if you are eligible for a Koth KAC, you should contribute any excess savings to an KA account BE>,=== max, E8,=== if over >=C. 1ax out the account every year if you can and meet the eligibility requirements for deductions * the tax benefits and variety of choices in KA investing are unparalleled. Fourth, if you still have savings to invest and have maxed out your KA contributions Bor if you are not eligible for tax deductions on KA contributionsC, it ma%es sense to max out the ;=6B%C as well Bthe limit is currently about E68,=== per yearC. Fifth, contribute additional funds to the taxable account. (hough it is last in the process, for investors in high income brac%ets, the taxable account may grow to become the largest account because of the restrictions placed on the amount that can be invested in retirement accounts.

)esson 6: 3nowing your a#.has and *etas

+he Bottom )ine (he returns of any portfolio can be bro%en down into two pieces. 2ne is a result of &beta,& or movements in the overall mar%et. (he other is the result of &alpha,& or the difference in returns between the portfolio and the overall mar%et. !eta returns are compensation for ta%ing investment ris% and forgoing immediate consumptionH alpha returns are a result of s%ill Bor lac% thereof...C in pic%ing investments. 1ost investors should focus more on beta than alpha, as relatively few people in the world are truly capable of producing reliable alpha Bbeating the mar%etC, and beta is much cheaper to acquire. +he )esson have always been a believer that you can $udge how bustling and entrepreneurial a city is by visiting it in the middle of a rainstorm. n the true entrepreneurial metropolises, you will inevitably find that, shortly after the first rain drops, a smiling man carrying a pile of umbrellas will approach you and humbly offer his services to %eep you dry. "ve always appreciated the friendly neighborhood umbrella salesman, and have a collection of rain*protecting devices sitting in my closet as evidence of this. Frequently after such encounters, "ve also thought that would ma%e a pretty terrible umbrella salesmen. fundamentally lac% the same drive for relentless &customer service& as the best umbrella peddlers. !ut in the middle of a torrential downpour, even could sell umbrellas. (his highlights the rather obvious connection between the success of an individual umbrella salesman, and the weather. f you wanted to determine whether an umbrella salesman was any good at his craft, it would not be enough to examine how his sales have done over the past month. Jou would want to %now how the weather affected his sales efforts, perhaps by comparing him to other umbrella salesmen in his region. (his is no less true of money managers, but the connection seems to be less obvious to many, perhaps because mar%et movements are not as tangible as raindrops. The difference between alpha and beta !efore deciding how you will actually invest your retirement money, it is important to %now a bit about where investment returns come from. n this chapter, we will brea% down the investment returns of a portfolio of stoc% mar%et investments into two distinct sources, which can be called &beta& and &alpha&, but which you can thin% of in the umbrella example as &rain& and &salesmanship.&

'e will start with beta. n the context of the stoc% mar%et, beta measures the return you can get as a result of owning the entire stoc% mar%et. For a portfolio invested totally in <- stoc%s, the return from beta exposure would $ust be the return of a broad <- stoc% index li%e the often*quoted -@3 >==. A portfolio that buys the entire stoc% mar%et Bwhich can be easily accomplished through the use of an index fund or 0(F, instruments that will be discussed laterC can be thought of as having a pure beta exposure to stoc%s BFinance professors would say that this portfolio has a beta of 6C. !ut $ust as one umbrella salesman may have more hustle and charm than another operating in the same weather conditions, one portfolio of stoc%s may be invested more wisely than another portfolio of stoc%s, and therefore earn higher returns over time. 'e can say that differences between portfolios that arise as a result of s%ill in investment selection is a result of alpha" Alpha measures the difference between the returns of a portfolio of stoc%s and the return of the overall stoc% mar%et. 3ositive alpha means that the stoc%s in the individual portfolio have performed better than the overall stoc% mar%et, negative alpha means they have performed worse than the overall stoc% mar%et. An important distinction between alpha and beta as it pertains to both stoc%s and umbrellas is that alpha is the result of s%ill, while beta is compensation for $ust being involved in the investment or $ob. A good way to see this is to imagine a period li%e 9==? when the overall stoc% mar%et fell dramatically. A particularly s%illed portfolio manager might have outperformed the overall stoc% mar%et, but still had a negative return Blost moneyC in absolute terms. n this case, the return from beta would be negative, while the return from alpha would be positive. A %ey advantage to loo%ing at investment returns this way is to allow the investor to differentiate between the performance of the overall mar%et and the s%ill of a particular manger. (hin%ing bac% to the first lesson, which discussed generically where investment returns come from, we can thin% of beta return as the compensation that investors demand to hold ris%y assets and to forgo immediate consumption for future consumption. f there was no beta return, than investors would have no reason to own stoc%s instead of putting money into ris%*free (reasury bonds, or even guaranteed ban% accounts. (he uncertainty of stoc% investments means that investors demand to be compensated for the beta ris% that they are ta%ing, which is why stoc%s should return more than less ris%y %inds of investments over time. !y contrast, the notion of alpha did not appear anywhere in the first lesson. (his is because alpha ris% is not something that investors are compensated for, on average. !y definition, the alpha for the entire stoc% mar%et will always be =. f an investor can produce positive alpha from good selection of stoc%s, it is not a result of ta%ing any ris%s, it is simply a result of s%ill Bor luc%C in investing. n the same vein, if one investor has a lot of positive alpha Bout*performance of the mar%etC, there must be at least one other investor somewhere that has negative alpha Bunder*performance of the overall mar%etC. (his is an important point. Across the universe of all portfolios, alpha must average to Dero.

Why beta trumps alpha - t is reliable and cheap while alpha is unreliable and e$pensive From the above discussion, &alpha& should seem quite appealing, since it is the result of s%ill and not sub$ect to the random fluctuations of the stoc% mar%et. Jet there are three strong reasons that most investors should spend the vast ma$ority of their time thin%ing about beta rather than alpha. First, when comparing real*world portfolios, different beta exposures are far more significant in explaining difference in returns than are different levels of alpha. -tudy after study has indicated that the asset allocation of a portfolio Bwill be discussed more next chapter * but is a measure of betaC is not only the single most significant decision that can be made, but it totally dwarfs any other decision, accounting for more than A=G of the differences between the returns of different portfolios. 'hich particular stoc%s different portfolio managers own is far less significant than their overall exposure to the stoc% mar%et. -econd, trying to produce alpha is a losing battle for all but the most elite investors. -tudies indicate that A:G of professional mutual fund managers are incapable of reliably beating the mar%et Bapart from luc%C after deducting their fees. (he top 4G may legitimately be capable of producing alpha, but they are hard to findxi. !uying those with the best trac% records is generally not a winning strategy in itself * many of these managers have merely gotten luc%y. A few elite hedge fund and private equity managers do seem to produce consistent alpha at a high and statistically significant level, but most of these with verifiable trac% records are already closed to new capital or else otherwise inaccessible to individual investors. (hird, and this should seem li%e a recurring theme, beta exposure is very easy and inexpensive to get, while alpha is quite hard to get and also hideously expensive $ust to try achieve. 3ure beta exposure can be achieved through exchange traded funds B0(FsC that purchase diversified portfolios of stoc%s that nearly exactly match a broader mar%et. (he fees in popular 0(Fs can be as low as .6G a year. !y contrast, mutual funds that try to select stoc%s that will outperform the overall mar%et are sub$ect to multiple levels of fees, including a management expense, trading costs, and compensation to the sales person or advisor that sells the funds. (hese fees can average 6.4G or more. 1oreover, there is no certainty that the investment will actually produce alpha. 3oor decisions can cost even more money * $ust as% those that bought technology stoc%s in 9=== or real estate in 9==?. %ow to get beta - 0se an inde$ fund or #T- as a one-stop shop Alpha generation is a topic for another boo%, the remainder of this one will focus on efficient generation of beta returns. (here are a few ways to get beta

Active 1utual funds ndex mutual funds 3ortfolios of individual stoc%s 0(Fs Active Mutua# %unds 1utual funds are entities that buy a diversified mix of stoc%s on behalf of their own shareholders. (here have traditionally been many advantages to an investor to own shares in a mutual fund versus owning a diversified portfolio of stoc%s outright. (hese include convenience, the ability to split transaction costs over multiple owners, and the benefits of professional management. 1utual funds come in two varieties * &active& and &passive&. Actively managed funds try to pic% stoc%s that will do better than the overall mar%et. 1any fund companies hire hundreds of analysts and portfolio managers that meet with company management and do other extensive research on a company"s prospects, trying to determine whether the prevailing stoc% price is too high or low. Inde$ 7.assive8 'unds ndex funds have many of the same benefits as actively managed funds, except they do not spend any effort trying to pic% stoc%s that will do better than the overall mar%et. nstead, index funds $ust buy every stoc% in mar%et, or at least every stoc% in the mar%et index they are trying to match B(he siDe of the investment in any one stoc% is based on the total value of all of its outstanding sharesC. (his ensures that while they may not be able to beat the mar%et, they are guaranteed to do at least as well as the mar%et. !ecause they have no need to hire hundreds of analysts li%e actively managed funds, index funds are able to charge lower fees. E$change +raded %unds 7E+%s8 0(Fs can be thought of as index funds that are traded on an exchange li%e stoc%s. !ecause of this, they can be purchased easily through a discount bro%erage $ust li%e you would buy a stoc%. t is not necessary to understand the details of this instrument, what is important to %now is that they offer a cheap way to get pure beta exposure to a broad mar%et index while also offering many of the advantages of individual stoc%s, li%e the ease of buying and selling whenever you want. 0(Fs also have tax advantages versus mutual funds as they are less li%ely to generate taxable gains until you sell the shares. 0(Fs and ndex Funds stand out as the most sensible way for the ma$ority of investors to get beta exposure to the overall mar%et. For those with greater than E>=+ or so in savings, 0(Fs ma%e the most sense since they have the advantages of an index fund in a liquid, stoc%*li%e form and can be purchased directly from a discount bro%erage account.

)esson 9: Beyond the stoc, mar,et 1 An introduction to asset c#asses

+he Bottom )ine !y this point, you have consolidated your accounts at one or two providers, opened an KA Bif neededC, and setup contributions to your ;=6B%C and KA. (his chapter will loo% at the %inds of things that you can actually invest in. +he )esson /espite my genuine praise, may have been a bit unfair to the enterprising umbrellas salesmen discussed in the previous chapter. (he best umbrella salesmen are undoubtedly wise enough to realiDe that their sales are only really going to flourish in one particular type of climate. <nless they live in the 3acific Northwest where it is reliably rainy most of the year, the enterprising salesmen would probably balance out his exposure to the weather by also selling something that flourishes in a very different %ind of climate * li%e sun glasses. (hat way, whether it was sunny or rainy, he could always be hanging out, putting those customer service s%ills to wor%, and haw%ing something. -imilarly, in our discussion of alphas and betas to date we have been a bit unfair in concentrating too much on the stoc% mar%et, and in particular, the <- stoc% mar%et. t is, after all, possible to put your money in other %inds of investments that may do well at a time when the <- stoc% mar%et is not. ntroduction to asset classes - Stocks5 6onds5 T 7s5 +# Ts5 commodities and more (he analog to umbrellas and sunglasses in the investment world are the different asset classes of the financial world. !roadly spea%ing, these are the %inds of &things& that you can put your savings into. (hey include stoc%s * which can be further divided into <- stoc%s, international stoc%s, and emerging mar%ets stoc%s * bonds, inflation* protected bonds, commodities, and real estate. Stocks are financial assets that represent fractional ownership in actual companies. -toc%s have real value because as companies ma%e money they usually return a portion of the earnings to shareholders in the form of cash dividends that are paid every year. n the absence of any %ind of stoc% mar%et li%e the New Jor% -toc% 0xchange, the value of any stoc% would simply be the expected value of its future stream of dividends, discounted to today"s dollars to account for inflation. n the real world where stoc%s constantly trade hands on an exchange, prices fluctuate wildly because nobody really %nows for certain what the value of that dividend stream will be.

nvestors in stoc%s expect to ma%e a return on their investment in two different ways. /ividends are the annual or semi*annual payments to shareholders that represent earnings returned to owners. Capital gains result from selling the stoc% to someone else for a higher price than what it was purchased at. -toc%s can be split further into different asset classes based on where the company is from. (he logic of this divide is that the economic cycles of different regions of the world will not always exactly coincide * i.e. Chinese stoc%s may do well at a time when !raDilian stoc%s do not. 4omestic stocks are investments in <- companies that are usually listed on the new Jor% -toc% 0xchange or the NA-/AN mar%et. <- stoc%s are the safest investments for <- citiDens to hold for two reasons. First, the firmly established legal system in the <nited -tates ensures that there is a high probability that the rights of investors will be protected. (his is extremely important since any investment involves giving a certain amount of money away today for an uncertain return in the future * with a less established legal system there would be an incentive for companies to ta%e the money and not give anything bac%. -econd, since the investments are in companies whose earnings are mostly in dollars, there is less currency ris% than in investing overseas. nternational developed-market stocks are companies domiciled in places li%e 0urope, Australia, and Fapan. (hese are also countries that also have long and established histories of capitalism, though the ris%s for <- citiDens in investing in other countries may be somewhat greater than in purchasing <- assets. (he returns to these investments are usually in a different currency li%e the 0uro or Jen. (his creates the ris% that <- investors will lose money if that currency loses value relative to the dollar. 7owever, some of these economies may experience higher growth rates than the <nited -tates in the coming years. #merging markets stocks from countries li%e China, ndia, and !raDil are thought by many to have the highest potential returns as well as the highest potential ris%s of any stoc%s. (hese rapidly developing countries do not always have established histories of capitalism, and there is always a small chance that foreign shareholders will have their sta%es appropriated or seiDed by a foreign government during the time of a crisis. At the same time, the growth rates in places li%e China and ndia has been significantly higher than in the <nited -tates over the past decade, and it is li%ely that this disparity will continue into the future as living standards for the people in these countries are still far lower than in the <nited -tates. Treasury 6onds As discussed previously, bonds are li%e .o.u.s to a company or government. !ond holders lend out their money, for a fixed period of time. n return, they are compensated by interest payments every six months. !onds are considered a safer investment than stoc%s, because the borrower promises to pay bac% the full amount

of the loan at the end of the term Bwith stoc% investments, there is no such promise madeC. Furthermore, in the event that the company is unable to pay bac% its loans and goes ban%rupt Bthin% 0nron or 5ehman !rothers...C, bond holders have the first claim on the company"s assets. nvestments in government bonds Bcalled (reasury !onds because they are issued by the (reasury /epartmentC are the safest %ind of bond investments because they come with the full bac%ing of the <- government, which has the authority to tax citiDens of the largest economy in the world, as well as to print money. (here is also a large mar%et for corporate bonds, however it is debatable if these have the same diversification benefits when added to a portfolio of stoc%s Bthis is a bit of an esoteric argument that goes beyond the scope of this boo%...C nflation 7rotected 6onds 'hile ordinary (reasury bonds guarantee return of the full amount of the loan, there is no guarantee as to what that money will be able to purchase when it is returned. For instance, imagine &Average Foe& purchases a 4= year (reasury bond with a >G interest rate for E6,===. (his means that Foe will receive E>= every year as well as the return of his original E6,=== after 4= years. 7owever, in those thirty years inflation Bthe gradual increase in the price of goods over timeC may have accumulated at a >G annual rate. <sing the &rule of :9& from the first chapter, this would mean that the price of goods would double about every 6> years B:9 I > is about 6>C and 8uadruple in 4= years. -o although Foe did receive his original E6,=== bac% as planned, it will only purchase him 6I; of the things that it would have 4= years ago. (reasury nflation 3rotected -ecurities, or ( 3-, were designed to solve this issue for investors. ( 3- pay a smaller amount than nominal (reasury bonds every year as interest, but they include two extremely beneficial features. (he first is the interest payment increases at the rate of inflation. (he second is that the principal Bthe amount that is paid bac% at the end of the loanC also increases at the rate of inflation. -o in the above example, Foe would have actually received E;=== bac% after 4= years, despite only investing E6===. And he would be able to buy $ust as many things with his investment as he could have 4= years ago when he made it Bof course, in addition, he received his annual interest payments * though they will generally be smaller than a regular (reasury bond since they are being ad$usted for inflationC. +eal estate Keal estate might be the asset class that is the most familiar to the average investor. !ut many do not realiDe that in addition to purchasing a personal residence, they can also buy shares in apartments, houses, and commercial holdings li%e shopping malls. ndividuals can invest in real estate through a financial instrument called a Keal 0state nvestment (rust, but more commonly %nown by its acronym * K0 (. K0 (s are legal entities that own properties li%e apartment buildings, malls, and office buildings. K0 (s ma%e money by charging the occupants of their buildings rent every

month. (hey pass through most of their earnings that they receive every year directly to shareholders in the K0 ( in the form of dividends. !ecause a K0 ( is a special entity that is required by law to distribute most of its earnings every year, it does not have to pay corporate income taxes * a %ey advantage. K0 (s are an important asset class to the individual investor, since they often perform well in periods when the stoc% mar%et is down. 9ommodities Commodities are actual, physical resources li%e oil, gold, and copper. 3urchasing commodities outright is distinct from buying the stoc%s of companies that extract commodities from the group, such as 0xxon*1obil. nvestors can own pieces of funds that invest in actual commodities through an innovative new set of 0(Fs. (hese funds mimic the process of actually buying and holding physical commodities through the use of derivative transactions. Fortunately, it is not absolutely necessary to %now what a derivative is to intelligently invest for your retirement. Alternative assets li%e venture capital, hedge funds, and private equity are other options for high wealth and sophisticated investors, but they will not be covered here.

)esson :: &utting inte##igent diversi'ication into .ractice 1 it's more than the S;& 5!!
+he Bottom )ine Asset allocation, the process of deciding what %inds of investments to put money into, is the most important investment decision you will ma%e. (he most important principle to apply in asset allocation is diversification, or investing in multiple asset types. /iversification is the only sure way to increase the expected returns of a portfolio without increasing the ris% you are ta%ing. (o receive the most benefit from diversification, it is not enough to own a large portfolio of stoc%s or mutual funds * investors must own multiple asset classes such as international stoc%s, real estate, bonds, and commodities. +he )esson Jou might be thin%ing that by this point we have discussed umbrellas more than is warranted in any financial text. 3oint ta%en. !ut thus far one element of our umbrella story is still slightly off. 'hereas in our hypothetical umbrella mar%et, there are many professional salesman that are catering to forgetful ordinary customers, in the stoc% mar%et transactions are mainly professionals selling to each other. t would be li%e an umbrella mar%et where everyone has a more or less equal %nowledge of umbrellas. 'hat would determine success in this %ind of mar%et. 7ard wor%, customer service s%ills, and overall &hustle& might still add some value. !ut any success that an individual salesman had would come at some other salesman"s expense. (he real driver of success would be the choices that each salesman ma%es in their merchandise selection. A high umbrella to sunglass inventory ratio would lead to success in rainy times, but failure when it is consistently sunny. -alesman that gambled on sunny weather by stoc%ing up on sunglasses would run in to trouble if the weather turned rainy for days on end. As we have seen, this is a very close approximation of the situation in the financial mar%ets today. n most transactions, there is a professional on both sides of the trade. t may be possible if you are smart and dedicated and have a lot of time on your hands to produce alpha and beat the stoc% mar%et. !ut what really matters is what mix of asset classes you invest in. And, as we shall see, what matters even more is ensuring that you are investing in a diversified portfolio of different asset classes. Why diversification is a free lunch for investors - it lets you earn higher returns for the accepting the same amount of risk 2n the surface, it might seem li%e diversification is something that should $ust guarantee &average& returns. (his is actually the case in most intuitive situations. magine you are placing a bet on what number will come up on a fair dice when it is rolled. (he odds of being right on any one number are 6I8. Jou could bet on three

numbers and you would have a 4 in 8 B>=GC chance of being right, but this would cost three times as much as betting on one number, so in the end you would not really be gaining anything. !ut investing is different. n investing, diversifying actually creates valueH it does not $ust &average& outcomes. (o see why, imagine you had only two assets to invest in * stoc%s and cash. -uppose that) iC n normal years stoc%s return 69G and cash returns =G iiC n bad years stoc%s lose 9>G and cash still returns =G iiiC Jou expect about 6 in every > years to be a bad year f you $ust want the highest expected return over the long term, investing in 6==G stoc%s is the way to go. !ut losing 9>G hurts. And there is nothing to say there could not be 9, or even 4 bad years in a row. 1ost people need some minimum amount of income from their investments to survive, and are unwilling to ta%e the ris% of a huge loss that investing 6==G in stoc%s entails. -uppose you want to limit the amount you expect to lose in any one year under our assumptions to 6>G. Jou could do this by holding 8=G stoc%s and ;=G cash. 2f course this gives up some upside as well, since in good years the portfolio would now only go up :.9G. Now suppose we add a third asset * (reasury bonds * into the equation. n good years bonds return 9G and in bad years they return 6=G. f you invest in (reasury bonds as well as stoc%s, you can now hold up to :=G of your income in stoc%s, because in down years you are cushioned by the positive return from bonds. (his means that in good years the portfolio would now go up by ?.;G while in down years it would still only lose 6>G. 'ithout increasing the ris% of the portfolio at all, by adding bonds we increased the expected return. (his is why diversification is a &free lunch& * it allows you to temporarily avoid the usual tradeoff between ris% and return. f you diversify an undiversified portfolio you get higher returns without increasing the chance of losing money, or you can reduce the chance of losing money without hurting your long*term returns. Nowhere else in finance is this the case. A S:7 inde$ fund is not a diversified portfolio - you should look beyond 0S stocks to get the full benefits of diversification 1any have ta%en the diversification lesson to mean that they should own as many stoc%s as possible in their portfolios. 2ne result of this widespread belief is the extreme popularity of index funds and 0(Fs that trac% the -@3 >==, a diversified mar%et index of >== of the largest companies in the <-. (hese %inds of funds literally hold the stoc% of every company in the -@3 >==. ndex funds and 0(Fs should be a part of everyone"s portfolio, yet many investors have unfortunately drawn the wrong lesson here. (he primary benefits of diversification occur amongst asset classes and sectors, not amongst individual stoc%s. 2nce a <- stoc% portfolio includes more than about twenty*five names, most of the benefits of diversification have already been achieved, because most stoc%s Bparticularly those in the same sectorC tend to go up and down in sync with one another anyway. Fust thin% of all the stoc%s you %now that

went up in 9==? * there were not many. t is by owning multiple asset classes * foreign stoc%s, bonds, ( 3-, real estate, commodities, etc. * that the true &free lunch& of diversification can be consumed Bcase in point) ( 3- and (reasury !onds had banner years in 9==?C. <nfortunately, many investors that own index funds have not caught on to this and are not truly diversified, no matter how many stoc%s their fund owns. An intelligent asset allocation plan - look to the smartest investors with some of the best long-term records A good starting point for an asset allocation plan is one that resembles the allocations of leading university endowments. nnovative endowments li%e 7arvard and Jale were pioneers in reaching beyond the familiar asset classes of stoc% and bonds to add real estate, commodities, large allocations to international stoc%s and emerging mar%ets stoc%s, and alternative assets li%e hedge funds and private equity. As a result, the Jale endowment has outperformed the <- stoc% mar%et Band the popular - @ 3 >==C by more than ?G a year over the past 9= years, while also experiencing substantially lower volatility Ba measure of ris%C. /avid -wensen, the portfolio manager of Jale <niversity"s endowment, recommends this allocation to individual investorsxii) 4=G <- -toc%s 9=G <- Keal 0state 6>G nternational /eveloped 1ar%ets -toc%s >G 0merging 1ar%ets -toc%s 6>G ( 36>G <- (reasuries 'ith a >=G allocation to global equities, this portfolio has enough &$uice& in it to perform well in a bull or period of long economic growth li%e the 6AA=s. At the same time, the 4=G allocation to bonds Bsplit between ( 3- and standard (reasuriesC holds up well in a bear mar%et li%e 9==?, while the ( 3- and siDeable Keal 0state portion would hold up in a severe inflationary environment li%e that of the 6A:=s. (hat said, there are a few areas where some may want to twea% -wensen"s recommendation on the margins Bwarning) esoteric material followsC. First, -wensen recommends holding all bond allocation in the form of <- (reasuries, reasoning that corporate bonds do not provide significant diversification to a portfolio that already holds stoc%s in the same companies. 2thers gurus advocate holding corporate bonds, mortgage*bac%ed securities, and international bonds as well. -econd, -wensen"s recommendation results in ?=G of assets in domestic, <- dollar assets. -ome may wish to add more international exposure than this, particularly in emerging mar%ets li%e China and ndia.

(hird, -wensen recommends holding a siDeable chun% in real estate, but does not have any direct commodities exposure. (he ability to invest in commodities as an asset class through 0(Fs that are as easy to buy as stoc%s is a relatively new development in the world of Finance. Fourth, -wensen recommends a full 6>G allocation to <- (reasuries as well as ( 3-. -ome may want to lower this a bit since current historic*low (reasury yields stand in star% contrast to clear long*term budget deficits, and may in part be a result of artificial demand created by central ban% purchasesxiii. 1a%ing these ad$ustments, a large BE9==% plusC, portfolio might optimally include) 9>G <- -toc%s 6;G nternational /eveloped 1ar%et -toc%s 6;G nternational stoc%s from emerging mar%etsxiv 6>G ( 3:G <- (reasuriesxv ?G <- Keal 0state :G #lobal 0x*<- Keal 0state AG Commoditiesxvi

-ome investors may prefer a simplified version with less &tin%ering&, either because they have a smaller Bunder E9==%C account, or $ust do not wish to mess with so many asset classes. t is possible to achieve the main point of the diversified -wensen portfolio with only three or four asset classes that can each be achieved with a single 0(F or low*cost index fund. A simpler version) >=G #lobal 0quities 6>G ( 39=G <- Keal 0state 6>G <- !onds <nless it is something that interests you, it is not worth getting too bogged down in the details. (he %ey is to pic% a plan that is broadly diversified and ma%es sense to you, and stic% with it.

)esson <: Im.#ementing your target asset a##ocation

+he Bottom )ine f the steps previously discussed have been closely followed, actually investing a retirement account in a portfolio of 0(Fs is remar%ably easy. (here are 0(Fs that can provide beta exposure to every asset class in a portfolio. (his lesson will loo% at two %ey factors to consider in pic%ing individual 0(Fs * cost and liquidity * and provide a few actual 0(Fs that you can purchase right now to get beta exposure to various asset classes. +he )esson %ow to achieve a target asset allocation in five minutes or less - 0se one #T- for each asset class 2n the surface, it seems that 0(Fs should be a remar%ably simple instrument * after all the idea is simply to match the performance of an overall mar%et index by purchasing stoc% in all the companies that are in that index. Jet in its quest to create as many saleable products as possible, the financial industry has coo%ed up all different manner of funds. (here are now &inverse& 0(Fs that go up when the mar%et goes down, &leveraged& 0(Fs that go up or down by a multiple of the mar%et"s return, and sector 0(Fs that match the return of an index of companies in the same sector of the economy * such as 0nergy -toc%s or ndustrials. -ophisticated 0(Fs may have their use in various trading strategies, but for long*term, beta*driven investing it is best to stic% with a handful of well*%nown 0(Fs that match a broad asset*class index. ,anguard and !arclays Bthe company behind the i-hares lineC are two of the largest providers of 0(Fs. 2nce an asset allocation has been selected for a portfolio, it is trivial to find an 0(F that provides one*stop buy*it*and* forget*it exposure to that asset class. Selecting #T-s - 0se internet databases and find the cheapest and most li8uid in each category A list of 0(Fs by asset class can be found at http)IIetfdb.comIetfdb*categoriesI or in the list below. n cases where there is more than one fund that mimics the return of the same asset class, there are two important factors to consider. (he first is the level of fees the fund charges. 0xpenses for 0(Fs should be well under .>G of assets Boften referred to as >= &basis points&, where 6 basis point M .=6GC, with the lower the fee the better. (he second factor to consider is the level of liquidity in the fund. 5iquidity is a measure of how active of a mar%et there is for a stoc% or 0(F. f the mar%et for an 0(F is not very active, there might be a large gap between the prices that an investor is able to buy and sell a share of it, which results in an implicit

transaction cost every time you buy or sell. 5oo% for larger 0(Fs Bin terms of assets under managementC as this is generally a proxy for liquidity. (he following is a list of well*run 0(Fs that have relatively low management fees and good liquidity. (he &tic%er& is the three or four letter &code& given to all stoc%s and 0(Fs * you will need it when it comes time to enter your orders at your discount bro%erage. A starting point: ;ood #T-s for each asset class )There are mutual fund e8uivalents for each of these for those that prefer investing in that structure* All figures as of -ep 9=66

OCan use instead of combination of ,( , ,0A, ,'2 if you desire a simpler allocation with less 0(Fs. OOCan use in place of part of commodities exposure if desired Be.g. >G commodities, ;G goldC %ow to purchase #T-s - Just like stocks5 find the right ticker and use <1arket< orders 0(Fs can be purchased through a discount bro%erage exactly li%e stoc%s. -imply select the &!uyI-ell& or &(rade& option from the bro%erage home page, enter the stoc% tic%er of the 0(F you want to purchase, and enter the number of shares you wish to buy. (he 0(Fs mentioned above are fairly liquid, so it is safe to use a &mar%et& order. (his means that your order is immediately fulfilled at the prevailing price on the stoc% exchange. (he alternative is to use a &limit& order in which you manually set the price that you want to buy or sell shares at. 5imit orders are fulfilled when one person is offering to buy at the same price the other is offering to sell.

(o determine the number of shares of each 0(F to buy, simply do the following * 1ultiply the dollar value of your current portfolio by the desired percentage of your allocation to the asset class the 0(F is achieving. (his will give you the total dollar value of your investment in the 0(F. For instance, if you desire a 9=G exposure to <stoc%s and you have a E6==,=== portfolio, you would want to buy E9=,=== of ,anguard"s total stoc% mar%et 0(F. * /ivide the dollar value of your desired 0(F investment by the share price of the 0(F and round down to the nearest share. f you wanted to invest E9=,=== in ,anguard"s total stoc% mar%et 0(F and it was trading at E6= a share then you would want to buy 9=== shares. 4ealing with the &'()k* - =ook for inde$ funds5 active funds with & or 2 star 1orningstar ratings and low fees5 or bond funds 0(Fs are cheap and easy to buy in any discount bro%erage account. !ut if you are investing in an employing sponsored ;=6B%C retirement plan Band you should be if one is available to youC then you may only have a limited set of mutual funds to select from. (his is one of the reasons many choose to a ;=6B%C to an KA as soon as they leave any $ob Bthis is called a rolloverC. 7owever, there may be very good choices available to you inside of a ;=6B%C, it can $ust ta%e more wor% to separate the good from the bad. 'hile the mutual fund industry as a whole habitually fails to add any &alpha& Band charges a lot anyway...C, there are some good fund families where you have a decent shot of getting some value for your fees. (here are a couple strategies you can ta%e to deal with your ;=6B%C) !uy an equity index fund for <- or nternational -toc%s. At a minimum, most plans should offer a <- equity index fund, which you can use for your <- equity allocation. f possible, loo% for one labeled &(otal -toc% 1ar%et& or &0xtended -toc% 1ar%et.& (his will include smaller companies that are typically left out of the more common -@3 >== index. Jou may also have an & nternational 0quity Fund.& 5oo% to see if this is based off of the 0AF0 ndex. f it is, you can count this as your & nternational /eveloped 1ar%ets& exposure. Find a good actively managed equity fund. (his is a bit more tric%y, so only try it if you are willing to spend a little bit of time doing some research. Jou will want to loo% for a fund that has a reasonable expense ratio Bshould be less than 6G of assetsC and a good long*term trac% record with the same manager. (he morningstar website Bwww.morningstar.comC is a good resource for this. Jou can loo% up your fund family, see the morningstar rating for each fund Bthey go from one to five starsC, and find the expense ratio and the current manager"s tenure. (ry to find a fund with a four or five star rating. 5oo% for broad funds that would fall in one of the categories we defined above li%e emerging

mar%ets, <- 0quities, 0merging 1ar%ets, or nternational -toc%s. 0merging 1ar%ets could be one area where it might ma%e sense to use a good actively* managed fund since there may be less professional portfolio managers that are already in these mar%ets. !uy a bond fund. f you cannot find a good actively*managed fund that falls into one of your asset class categories and still have more money to allocate, use your ;=6B%C for the bond piece of your portfolio. (hese are also good funds to hold in a retirement account, since you will be protecting yourself from paying taxes on the high income they generate Bmore on this nextC. What to put where - Keep high-income bonds funds in a ta$-sheltered retirement account f you have a taxable account as well as one or more retirement accounts, then you will have to decide which asset classes to hold where. (he %ey principle to remember here is that * you should maximiDe the value of the tax shields in your retirement accounts by using them to hold the investments that will generate the most taxes * K0 (s and !onds. (hese investments throw off large amounts of income every year that is taxed at the ordinary income rate. n contrast, if you hold your stoc% allocation in the form of long*term 0(Fs then it is very easy to avoid paying many taxes on them until the time comes to actually sell them * and even at this point it will be at the lower capital gains rate Bcurrently 6>G for most peopleC. (hat ma%es equity 0(Fs a good candidate to go in your taxable account. t is very important to also hold ( 3- in a retirement account, as they have a tax rule that forces you to pay taxes on income you did not even receive Bwhen your bond principal is ad$usted for inflation, this is considered income, even though you do not see the money until the bond maturesC.

)esson "!: Managing 'or the #ong1term with a #oc,*o$ 7and a sand*o$8
+he Bottom )ine (he vast ma$ority of individual investors achieve spectacularly poor investment returns because they trade too much, often purchasing investments that have appreciated in value and selling those that have depreciated. !uy*high sell low is not a good investment strategy. A better approach is to put your investment strategy on auto*pilot by consciously not changing your asset allocation or investment mix unless there is a significant change in your own circumstances. -uch an approach is a%in to installing a &loc%box& for your retirement savings. +he )esson 2ne of the all*time great -aturday Night 5ive s%its was /arrell 7ammond lampooning Al #ore for saying &loc%box& every other word during the 9=== 3residential debates. (he root of his humor was that #ore wanted to %eep the entire -ocial -ecurity surplus segregated from the rest of the yearly government budget items. 7e did not want Congress to be able to &fiddle& with this money by using it to fund more tax cuts or spending programs. 'hile #ore"s insistence on a loc%box provided plenty of comedic value at the time, subsequent years have proven that a loc%box may have had real value, as Congress has quic%ly turned a budget surplus into an enormous deficit. n the same context, it is important for the individual investor to %eep the vast ma$ority of his or her savings invested in a long*term buy*and*hold allocation that will not change with the times, as there is always going to be a voice inside all of our heads that tells us to ma%e stupid investments. (he benefits of long term investing, and the perils of frequent trading are clear. Why should you keep most of your assets in a personal lock bo$, To protect yourself from your future self" 5i%e the one that #ore wanted to create for the -ocial -ecurity surplus, a loc%box should be a place where investment returns can pile up and not be accessed or changed from the outside. t should have the following properties) * nvested according to a target asset allocation that changes very infrequently Bperhaps neverC * Asset allocation is implemented with index funds, or preferably 0(Fs, with one Band absolutely no more than 9C funds used for each asset class in the portfolio * (here is a set schedule for chec%ing in on the account, perhaps every six months or one year. No changes will be made outside of that schedule.

* (here is a set schedule for rebalancing the account to the target asset allocation, most li%ely every one year. (his is needed because some asset classes will grow faster than others over time, and thus come to dominate a larger portion of the portfolio"s assets. -imply put, implementing a loc%box is all about setting a plan and then stic%ing to it, regardless of what is going on in the stoc% mar%et. 5et"s review some of the reasons why a loc%box is a good idea) Nuantitative studies indicate that over multiple time periods, the vast ma$ority of investors underperform the mar%ets by as much as 8G a year, earning essentially nothing for the additional ris% they are ta%ing versus $ust holding their money in cash. A ma$or reason for this atrocious performance is the psychological tendency to buy assets that have recently appreciated and sell those that have recently depreciated. (hus, much money rushed into technology stoc%s in 9=== at the pea% of the dot.com bubble and rushed out in 9==9 at the low, while the same story played out with real estate stoc%s a few years later. !y %eeping a loc%box, you will be immune to this buy*high sell*low destructive tendency, and thus automatically outperform the average retail investor. 1ost active managers fail to beat the stoc% mar%et. n trading frequently, you are ta%ing the active view that you can outsmart the stoc% mar%et. !ut this is not true even for most professional investors and traders. (he vast ma$ority of professionally managed mutual funds underperform the stoc% mar%et averages every year. 'ithout ta%ing time to do huge amounts of research, there is little reason to thin% that you will be any more successful with your own trades. (ransaction costs eat away at returns. 0very time you buy or sell a stoc%, there is an explicit commission involved, and also an implicit trading cost. (his is because mar%et*ma%ers ma%e money in the difference between the bid price and the as% price for a stoc%. (his means that if you buy a stoc% at E99.?= it is unli%ely that you could immediately turn around and sell it at the same price. nstead, you may have to offer the stoc% at E99.:= to find another buyer. (his 6= cent difference per share is an implicit transaction cost. !oth implicit and explicit transaction costs can be minimiDed by buying and holding assets, rather than trading them frequently. Creating a loc%box is relatively simple. Choose your asset allocation, pic% good assets, and %eep your account on autopilot going forward. gnore the tal%ing heads on CN!C and refrain from changing your strategy or investment mix unless at designated times and for very good reasons. Too boring for you, Then use a small sandbo$ to learn about the markets and have fun with investing >optional?

-ome investors Bauthor includedC may have cringed $ust a bit at the last step. (he issue is not that a loc%box does not ma%e rational sense * it $ust might seem a bit boring to some. f you want investing to be &fun& and dream about the &thrill& of owning a 6=*bagger stoc%, then by all means ta%e a shot at it by putting > to 6> percent of your savings into a &sandbox.& (his is where you can have some responsible fun, ma%e &bets& on individual stoc%s or sectors, and truly manage your own money. n addition to being a bit more exciting than a buy it and forget it option, the sandbox serves two extremely important functions. First, it provides an impetus to learn more a lot more about investing. f you thin% that !1 might be a great buy right now, you are probably going to want to %now how to value the company, whether it loo%s cheap or expensive on various metrics, how management is doing running the company, etc. (his is a hugely educational process that will ma%e you a more confident and informed investor that is better able to stic% to a plan. Jou might find that you hate thin%ing about this %ind of stuff, and that is fine, nothing is stopping you from investing your sandbox in 0(Fs or mutual funds, or closing it altogether. !ut you also might turn out to be one of those 9*4G of investors that do seem to be capable of consistently beating the mar%et, and it would be a shame to let those talents go to waste. -econdly, the sandbox serves as a release valve of sort. As mentioned above, one of the reasons it is important to create a loc%box is because investors have a chec%ered history with investing. (here is a huge follow the herd mentality that seems to always cause many to go headlong into technology stoc%s, or commodities, or housing at the exact wrong time. !ut the loc%box is only going to be as strong as the will of the investor that created it. And there will come some point in time, no matter how strong his will is, that every individual investor will see other people getting rich around him and want to $ump into the fray, or when he will see his wealth disappearing from in front of him and $ust want to sell everything. (he sandbox lets you ma%e a compromise with yourself * if you really thin% that pets.com is going to be the next 'al*1art, then by all means, put a little of your sandbox account money into it, but don"t endanger your retirement by investing all of your assets on it. 6est practices and caveats for sandbo$ design - Keep it small and segregated5 put it in a retirement account (he sandbox does not have to be a separate account per se, but it may be easier to ma%e it one by opening up a separate account to house it. For instance, if you use a ,anguard account to house the rest of your accounts, consider opening up an 0(rade account for the sandbox. !est practice is carve out a piece of your KA for this, since this is tax deferred and also self directed. t is important that you maintain discipline about the siDe of the sandbox, however. /o not let this creep above 9=G of your assets. 5et"s loo% at what this structure could loo% li%e for an investor who wants to put 6>G of assets in a loc%box and has E9==,=== in retirement savings * E>=,=== in a ;=6B%C, E6==,=== in traditional KAs, and E>=,=== in a taxable account. Assume the investor uses Fidelity for existing accounts.

* 6>G of E9==,=== is E4=,===, so E4=,=== should go into the sandbox and E6:=,=== into the loc%box. * (he investor decides to implement the sandbox in the KA account, but to open a separate KA at 0(rade in order to ma%e things easier. (heir accounts might loo% li%e) E>=% retirement account wI (. Kowe 3rice E4= sandbox KA wI 0(rade E:= loc%box KA wI Fidelity bro%erage services E>=% taxable bro%erage acct wI Fidelity bro%erage services 9aveats Finally, a few caveats. f you have under E6==,=== in assets, it may ma%e sense to build up your loc%box a bit before you open up a sandbox. -econdly, be careful not to go craDy and trade too much. 0ven small commissions can eat up a small account if you are trading more than a few times a month. And unless you have a huge amount of time and s%ill, day trading is almost always a losing cause.

Figures are computed in present, inflation-adjusted dollars based on 6% real returns for Jill (rate of the overall stock market) and 2% for verage Joe (inferred rate of the average investor in !"uities, see belo# data from $albar)% &f an'thing, the difference bet#een Jill and verage Joe ma' be understated, as recent $albar data sho#s e"uit' investors earning real returns of about (% for the past t#ent' 'ears% ii )his assumes Jill has a retirement lifetime of 2* 'ears, continues to earn an average investment of (*% a 'ear in retirement, and dra#s his portfolio do#n to a * balance at the end of 2* 'ears% ctual #ithdra#als ma' be lo#er than this in the earlier 'ears if Jill #anted to be prudent% )o minimi+e the chances of running out of mone', some financial planners recommend a ma,imum #ithdra#al rate of -%.%% iii )he /0 stock market had a compounded annual gro#th rate (1 23) of 4%.% in nominal terms and 6%55% in real terms from (4** through the end of 2*(*, according to the helpful calculator at http677###%mone'chimp%com7features7market8cagr%htm iv ccording to $albar9s 2*(( :uantitative nal'sis of &nvestor ;ehavior (: &;) report, e"uit' investors received 5%<5% annual compounded returns vs% 4%(-% for the 0=> .**, a broad /0 market inde,% 0ee http677###%"aib%com7public7about%asp,% v !,act number difficult to compute, but domestic mutual funds had a %?<% asset-#eighted e,pense ratio in 2*(* according to a @orningstar report available at http677ne#s%morningstar%com7articlenet7article%asp,AidB5?<-42% 3egistered &nvestment dvisors charged an asset-#eighted average of %4% according to stud' "uoted at http677###%investmentne#s%com7article72**4*4227F3!!74*42244<.% &nvestors also paid an unkno#n but significant amount in commissions and loads to advisors, brokerages, salesmen% vi $ata from the 2*(( @utual Fund Factbook, google finance vii 0ee CDot so FastC, ;utton#ood column from ug 6, 2*(( print edition% vailable online at http677###%economist%com7node72(.2.-.6 viii 0ee http677en%#ikipedia%org7#iki7Ee'nesian8beaut'8contest for a brief e,planation of Ee'nes9 theor' i, !mpirical evidence of this ratio comes from the /0 1onsumer !,penditure 0urve', conducted b' the ;ureau of Fabor 0tatistics% )his reports spending from bet#een .<% to 66% of pre-retirement income% 0ee http677###%bogleheads%org7#iki7 0urve's8of8retirement8spending for a helpful anal'sis% , 0ee http677###%fpanet%org7journal71urrent&ssue7)ableof1ontents70afe0avings3ates7 for a discussion of the #ithdra#al rates that #ould have been possible historicall'% ,i 0ee FAMA, E. F. and FRENCH, K. R. (2010), Luck versus Skill in !e Cr"ss#Sec i"n "$ Mu ual Fund Re urns. %!e &"urnal
"$ Finance, '() 1*1(+1*,-.
,ii

From /nconventional 0uccess6 fundamental approach to personal investment b' $avid 0#ensen% vailable for purchase from ma+on% ,iii )hese can arise from t#o sources% )he /0 Federal 3eserve purchases )reasur' bonds as part of its normal open market operations to manage the short-term interest rate (currentl' set at *), and as a part of an' "uantitative easing programs% Foreign central banks purchase )reasuries to maintain their currencies at levels belo# those that might e,ist in a free market% ,iv )his ma' seem to be an aggressive allocation to emerging markets to some, ho#ever it ma' be conservative relative to the economic footprint of the emerging #orld% &n a ugust 2*(( article titled C>o#er 0hiftC, the !conomist reports that emerging economies no# account for over .*% of #orld 2$> at purchasing po#er parit' and almost -*% at market e,change rates% ,v ;ond allocation could be modified to include a broader mi, of securities b' including international bonds, and7or corporate bonds and mortgages% Ge chose the narro#er 0#ensen suggestion of )reasuries onl' here because this piece of the portfolio is primaril' intended to provide some protection in the event of a prolonged deflationar' depression, a scenario in #hich corporate bonds and mortgages could suffer% dditionall', #e #ould rather get international e,posure through real estate and stocks, #hich arguabl' have less chance of default7e,propriation% ,vi &t is also some#hat controversial to include commodities in a portfolio, ho#ever the' provide clear diversification benefits, inflation protection, and since the' are globall' traded, partial protection against a collapse in the value of the /0 dollar% 3eaders #ith an appropriate bent ma' #ant to substitute ph'sical gold for part of a commodities allocation% &f desired, it ma' make sense to pull from )&>s for part of this