Investment Guide

Updated Book

2010-10-11T09:17:00.000-07:00

Please check out the newly revised edition of this book. Now titled:

Road Map for Investing Success

You will find an expanded chapter on risk and asset allocation plus a new chapter on behavioral mistakes.

Paul

Making Sense of Investing: A Guide to the Essentials

2006-02-10T06:42:00.000-08:00

PREFACE

Whether you are a new investor, or an experienced investor looking for a way to make sense of it all, this guide is for you. The guide will introduce you to a comprehensive investing strategy you can understand and put together step-by-step.

The Guide Will Enable You To:

Implement the five essentials of investing
Understand and manage risk
Evaluate and select mutual funds
Recognize and control the devastating effects of cost
Develop and write an Investment Policy Statement
Evaluate and choose an Investment Advisor
Locate a large collection of reference material

INTRODUCTION

CHAPTER 1: The Five Essentials

CHAPTER 2: Develop An Asset Allocation Plan

CHAPTER 3: How Diversification Works

CHAPTER 4: Diversifying A Portfolio With Asset Classes

CHAPTER 5: Costs are a BIG DEAL

CHAPTER 6: Building Your Portfolio - A look at the Options

CHAPTER 7: Rebalancing

CHAPTER 8: Formalize Your Investment Plan

CHAPTER 9: On Your Own Or Hire An Advisor

CHAPTER 10: Final Thoughts, References, Glossary

ACKNOWLEGMENTS

Many thanks to Jan Marks, Bob N. and Tim Wright for their invaluable help. Thanks to the Vanguard Diehards for helping me make some sense of it all. Special thanks to Taylor Larimore for his tireless assistance to others. And finally, thanks to Bill Schultheis, Larry Swedroe, Rick Ferri and all authors and contributors who are giving us the investing education we never had, and never knew about.

The comments button can be found at the bottom of Chaper 10

2006-02-10T06:12:00.000-08:00

FORWARD

In the past thirty years, there has been a dramatic shift in retirement funding. An employee could go to work for a company and remain there for an entire working career, and on retirement receive a monthly pension and health benefits, and no worries about the future. That system was called a defined benefit plan. The system now in place is called a defined contribution plan.

In the old system your retirement plan was administered by your company. You didn't have to worry about learning how to save and invest because making sure there was adequate funding was your employer's concern, not yours. All you had to do was put your time in 'til retirement, then sit back and collect your checks.

In the new system, the plan is administered by a third party, but you, the employee, are responsible for funding it. Now you not only have to set aside part of your current income for retirement, you also have to learn how to invest it. Otherwise you risk not having enough money when you retire.

Unfortunately, our educational system has not kept pace with the changes in retirement funding. Investing fundamentals are not taught at the high school level as they should be, and even college does not address investing fundamentals unless you take an economics course. When it comes to knowing what to do, you're pretty much on your own.

Depending on where you work, your defined contribution plan might be called a 401(k), 403(b), 457, or something else. The numbers refer to the part of the IRS code that covers the plan regulations. Although your employer may match all or part of your contribution amount, you probably won't receive the information you need to get the most out of your retirement plan.

What little education you're given comes from those selling the product.

Many plans are provided by insurance companies that charge very high fees and offer poor fund choices. Others have more reasonable fees and better choices, but that doesn't help much if you don't know how to use them.

The challenge before you is clear: you must make retirement savings a top priority and take charge of your future by becoming an educated investor.

A General Perspective on Saving and Investing for Retirement

While this book is about investing, a few comments about saving are in order because the two are so closely tied together. Before you can invest, you have to save. Your investment money can come from money you have put aside in your savings account, or it can bypass that and simply go directly to an investment from your wages. Saving is the real key to future wealth. No one is going to make you save, but no one is going to hand you a nice check every month after you retire either.

For some of you, serious saving may require a new perspective. Think for a minute about why you work. The answer is easy because the goals are readily apparent – you work so you can provide the necessities for yourself and your family, and earn enough to enjoy a better life.

Now, you have to add another goal that isn't quite as apparent: saving for a better life when you stop working. Saving for something so far away doesn't seem too important because more immediate goals appear to take priority. But preparing for that time is a very big part of your job now. You can't afford to ignore it.

Where do you think your income will come from after retirement? It will come from the money you have saved and the money you have invested. You have to save (pay yourself enough while you're working) to be able to support yourself after you no longer receive a check from someone else. Want to pay yourself well and enjoy a comfortable retirement? Then you have to continuously save and invest a portion of your earnings. With each paycheck, pay yourself first. Do it automatically and you won't even miss it.

How much will you need for your retirement nest egg? The general guideline is that you need to set aside 25 times the amount you plan to withdraw each year. This amount has a high probability of lasting 30 years without reducing the original principle.

This is where investing comes in. To accumulate what is needed is going to require higher returns than you can get by simply saving your money in a bank. Investing in the stock market has provided those higher returns. In addition, you want to start as early as possible in order to have the power of compounding those returns work for you.

The stock market has provided higher returns than savings accounts and bonds, but the reason is there is more risk involved. And the risk does show up—Investing is a bumpy road. Individual companies can go bankrupt and the stock market as a whole can crash as it has done several times. Also, the stock market can go a decade or more without providing the expected higher returns. It is important to understand this so you can make intelligent decisions about how much of your savings you are willing to expose to stock market risks.

The probability that the businesses you buy will reward you in the future is high. The value of all companies (the stock market) has an upward slope over time, but no one can guarantee the market or your investments will provide what they have in the past. On the other hand, you have to take some market risk to have a good chance of reaching your goals. The need to have enough money for retirement offsets the risk you have to take.

Remember, you'll need to accumulate total assets of about 25 times what you intend to withdraw in retirement. So, if you want to retire with an income of $40,000 a year at age 62, you need to accumulate one million dollars (today's dollars).

Assuming an average annual return of 8%, here is what you need to save each month starting at different ages in order to draw down that $40,000/year. Note that the 8% used is an attempt to represent a portfolio of approximately 75% stocks and 25% bonds. Since future market returns are unknown, the 8% and the associated savings/investing rates should be viewed only as an example. Actual returns will vary.

Beginning at age 22, you'll need to save $300 per month.
Wait 'til age 32, and you'll need to save $670 per month.
At age 42, you'll have to save $1,800 per month.

The catch is you can't get an 8% return on your money if you put it into a savings account. In the above example, if you start saving at age 22 but only earn a savings account rate of return, instead of $300, you'll have to set aside $1,000 per month. That's over 3 times more than if you invest some of your savings in the stock market. Also notice that waiting until age 32 requires you to save more than double the amount of age 22. Waiting until 42 requires six times the amount. These big increases are due to the power of compounding investment returns over longer time periods.

But wait, using the 22 year old as an example, what if it said instead of making 1 million over that 40 year period, you could make an additional $400,000 more using the same mix of investments, but with one very small adjustment—earn 9% instead of 8%. Wow, who would settle for 8% when they can get 9%? Well, many investors do exactly that. The adjustment needed to get the 9% is in the cost you pay for investing. It goes like this: no one actually receives all of what the market returns because you lose what you pay in costs. You can't control what the market returns, but you can control costs and there is a proven relationship between the costs you pay and the returns you get. If you pay 1% higher costs, you lose 1% in returns. And over time, that 1% can cost you $400,000.

The example demonstrates four things:

1. The need to take some stock market risk.
2. The big advantage of time and starting to save at a young age.
3. The power of compounding returns.
4. The relentless stranglehold costs have on returns.

Nothing can be guaranteed—risk is real. Smart investors do not forget this. And that is why they use every means at their disposal to minimize the elements of risk by investing in the most efficient way. The idea is to get the maximum return for the amount of risk taken and each dollar spent. Or actually, for each dollar unspent. That is what this book is all about.

INTRODUCTION

In the coming pages, you will be introduced to an efficient, comprehensive and easy-to-understand investing strategy that is proven and backed by academic study. Over longer periods of time, this strategy will provide you with higher than average returns without large commitments of time or study. The fundamentals in this guide are relevant whether you use active funds or index funds.

The secret to investing and achieving higher than average returns is simply the elimination of mistakes most investors make. The stock market provides returns everyone hears about, but the truth is that investors as a group net substantially less than those returns.

With the aid of this guide, you will learn how to protect yourself from throwing away returns due to behavioral mistakes, unnecessary costs, and the more serious risk of bad advice. If you are considering an advisor, or already have one, you should find chapter 9 on evaluating and choosing an advisor very helpful.

The investment guide begins with an examination of the risks associated with investing. Then we move on to creating an investment portfolio that targets your goals and matches your desired risk exposure. And finally, in chapter 8, we cover the differences between active funds and index funds and how to use them in the most effective and efficient ways.

Throughout the guide you will find many links to additional information that you may want to explore. A glossary of investment terms is provided along with many additional links and references in the final chapter.

No matter if you manage your own investments or decide to hand the job to someone else, understanding essential investing principles is a must. With this book as your guide, you will gain the knowledge needed to learn and apply these essentials.

Taylor Larimore, Dean of the Vanguard Diehards as Money Magazine has named him, and one of the three authors of "The Bogleheads' Guide to Investing", has summed up the secret of successful investing in one concise sentence: The best way to beat the average investor, professional or otherwise, is to save regularly, avoid mistakes, keep your costs low (including taxes), diversify, and stay the course. The sentence is a true investing "gem."

Best wishes as you begin your journey along the pathway to investing success!

On to Chapter 1.

2006-02-08T09:21:00.000-08:00

Chapter 1
The Five Essentials

Making Sense of Investing
It is understandable that beginners find the subject of investing daunting and confusing. Where do you start? Are there guidelines? How do you make sense of it all? In addition to newer investors, there are also millions of people who have been investing for years and they still have an uneasy sense that they don't have a compass. There is so much information out there, but oddly, looking to Wall Street provides no answers.

What’s traditionally been drummed into your head is that investing is very complicated and should only be attempted by professionals or with the aid of very expensive and risky strategies and software programs. Don’t buy it. Investing doesn't need to be complicated.

The portfolio selection method, as we will call it, provides investing with structure. It enables average investors to implement the method step-by-step. The know-how of a Wall Street analyst isn't needed to understand it or use it successfully, nor is the ability to analyze and select individual stocks.

If it’s so easy, then why haven’t you heard of it before?

Wherever money is involved, there are people who want a share—and on Wall Street, it is your money they want to share. Simply put, it is extremely difficult to find someone from a large, mainstream investment firm that will level with you on your best investment options. They need to sell you expensive products that make their firm money because they are employees and that’s their job. So, what you really need to learn is what Wall Street doesn't want You to know, which also happens to be the title of a very good book by Larry Swedroe.

Here are the five investing essentials necessary to successfully use the portfolio investment method:

1. Define your goals, set targets, and decide on an asset allocation that fits your needs. Asset Allocation is simply the percentages of your money you plan to place (allocate) into stocks, bonds and cash. It determines most of your investing risk.

2. Diversify your holdings. Diversifying means placing some money in different kinds of investments in order to spread your risk.

3. Keep costs as low as possible. Whatever you spend on buying and maintaining your investments comes directly out of the returns you receive.

4. Rebalance your portfolio when necessary. Rebalancing is simply readjusting your allocation percentages back to where you originally set them so you can maintain your chosen exposure to risk.

5. Formalize your investment plan. Developing a plan and then writing it down is a way of demonstrating your commitment. It also serves as a compass to insure you stay on course.

The following chapters will explain what the essentials are and how they work with each other to create a portfolio with maximum benefit.

For those who like the technical stuff, here are two links offering an excellent introduction to the portfolio selection method.¹

http://travismorien.com/invest_FAQ/content/view/221/58/

http://www.moneychimp.com/articles/risk/riskintro.htm

Note 1. Harry Markowitz, "Portfolio Selection," 1952

On to Chapter 2.

2006-02-08T09:19:00.000-08:00

Chapter 2
Develop an Asset allocation
in line with your risk tolerance.

Asset allocation (AA) is a financial term that simply refers to what percentage of money you decide to put into stocks, bonds and cash—the primary asset classes. It is the most significant decision regarding risk and potential returns you can make.

Before you make the decision about your asset allocation, you need to know what it is exactly you are trying to accomplish. No, to grow your investments as much as possible is not the right answer.

You begin by defining your goals and the target amounts needed as best you can. Younger investors may have several goals they’re working toward such as retirement, college for the children, and a new home. Each of these goals has a different time frame and a different target amount of assets needed. And each requires a different asset allocation.

Since asset allocation is all about risk management, that’s where we will begin. The more you understand about risk, the more able you will be to make good decisions about asset allocation and the more you will understand about investing in general.

This link to Vanguard’s How to Create Your Investment Plan will help you get organized.

What is Risk?
There are a few different ways in which risk is measured and discussed, but we will start with this definition: The risk of putting your money into stock investments is that it may not be there for something important when you need it.

The higher percentage of stocks you own, the higher your potential for big returns. But risk is a double-edged sword. Risk means in no uncertain terms that you might not achieve those big returns, and you may not have the money when you need it. Investing offers no guarantee, otherwise there would not be any risk.² Knowing this, smart investors always seek a good balance between risk and potential reward.

Asset Allocation and Risk
Jack Brennan, former CEO of The Vanguard Group and author of Straight Talk on Investing has this to say, "The very first step in assembling an investment portfolio is to decide how to spread your dollars among stock, bond, and cash investments--Spend a lot of time on this decision--it is the most important one you will make."

Controlling risk and maximizing potential returns for the chosen level of risk is the goal of your overall investment strategy. When making the choice of an AA, you have to seriously consider each goal, it’s time line, and how much you are depending on the money being there.

Your decision on how much risk you are willing to take is a personal choice. That’s why one recommendation for how much stock to own should not be suggested to all investors. Don't compare your allocation to those of others, it isn't relevant. Risk management is as much a personal behavioral issue as it is a calculated assessment of need and willingness.

This link leads to a good article on risk by Pete Bernstein.
http://biz.yahoo.com/nytimes/080621/1194787217711.html?.v=1

Here is a good perspective on how risk should be approached by Zvi Bodie, professor of finance, and Paula Hogan, CFP, CFA.
http://www.aaii.com/features/jrnl200506p16.pdf

Emotional Temperament and Risk
Newer investors often overestimate their tolerance for risk. That has been clearly confirmed by the number of investors who abandon their asset allocation and bail out of stocks at the bottom of a bear market.

Here is what Vanguard has to say:
Our experience suggests that even long-term investors pay attention to short-term downside risks during the holding period. Furthermore, their real-time reaction to downside risk is much more significant than indicated prior to the realization of the downside risk.

So, how much of a loss is really going to keep you pacing the floor at night? How much of a loss is going to make you flinch?

What makes investors flinch?
1. Inexperienced investors move into defensive mode under stress and fall back on gut instinct, which quickly overrides the AA decision they made in good times.

2. Perception of risk is not constant. Risk may be perceived to be practically non-existent in good times and extremely high in times of market stress or personal emotional stress. If you have not been through a full market cycle, including a bear market, it will be very difficult for you to properly asses your reaction in times of real stress.

3. Choosing an asset allocation seems so simple to do that it's often done without much planning. After all, you just have to pick a number. And with many newer investors, that’s exactly what they do. Investors making the choice of an AA in good market conditions often tend to focus only on returns. They don’t see any risk. And that’s a point worth remembering—if you can see the risk, then it really isn’t a risk because you can take measures to avoid it. No, risk is all about surprises that can spoil the party.

So, what should you do? First, realize that your assumed tolerance level is likely to be lower under severe market conditions when it’s most important. Second, focus on your goals and your plan and set up asset allocations that match them. If you get that right, then you will find it easier to stick with your plan.

Risk Analysis Questionnaires
Some investors who talk with an advisor are given a risk analysis test. Others might be referred to web sites that have questionnaires designed to help choose an allocation. These can be helpful, but often investors fail to get a full appreciation for the impact that market risk can deliver.

Here is what William Droms, CFA, and Steven Strauss, CPA/PFS, had to say about questionnaires in an article in The Journal for Financial Planning titled "Assessing Risk Tolerance for Asset Allocation: "Virtually all experienced financial planners and investment managers would agree that a questionnaire by itself cannot possibly lead directly to a definitive asset allocation plan."

The biggest problems with questionnaires are that they either ask you how much risk tolerance you have, for which you have no reference to determine, or they attempt to quantify your need for returns and then offer a portfolio without consideration for your emotional risk tolerance.

The level of risk you choose should be based on factors including age, job type and security, marital status, contingency plans, back-up resources, and several other possibilities. Then these factors have to be balanced against your emotional tolerance for risk. If your needs don’t match your tolerance, you are likely to dump your strategy at the worst possible time.

Here are two links to questionnaires. But don’t take questionnaire recommendations at face value. It is possible to score high on risk tolerance and not be suited for high risk because of your personal circumstances. Consider the questionnaires as just one part of your overall assessment.

Vanguard Questionnaire:

Rutger’s Questionnaire:

Basic Market Behavior and Risk
To help understand normal market risk, let’s look at typical market behavior.

Here is what William Coaker, CFP, CIMA, says you will encounter in your investment journey: Investment professionals often tell clients, "I think the S&P 500 will be up 10 percent next year," and clients like to hear that. But it almost never happens. From 1926 to 2004, the S&P 500 rose between 8 percent and 14 percent in only six years, an 8 percent occurrence. In fact, just 25 times in 79 years the S&P 500 returned between 0 percent and 20 percent, which is only 32 percent of the time. That means the index has been more than twice as likely to lose money or gain more than 20 percent than to experience returns between 0 percent and 20 percent.

The first thing to note is markets are volatile and you cannot expect things to go smoothly, nor can you rely on past behavior as a predictor of future behavior. Normal markets are random and unpredictable in the shorter term. And contrary to popular belief, they are not less risky in the long term.

Jack Duval, Registered Investment Advisor has this to say in his article, The Myth of Time Diversification: the idea that the longer an investment is held, the less likely it is to produce a loss. It is an idea that enjoys wide circulation on Wall Street. It is wrong.

A Look at Historical Market Losses - Downside Risk
You can get a fair perspective on risk by looking at actual stock market losses compared to how much money was allocated to stocks.

The table below is based on actual market losses (price) encountered in the brutal 1973-74 bear market. A bear market is normally defined as a market decline of 20% or more. Drops of 10% to 15% are called corrections.

Note in the table that a 100% stock portfolio lost nearly 50% of its value in two years. If you had 50% stocks and 50% bonds, your loss would have been limited to 20%.

Max Equity Exposure....... Max loss
20%.......................................5%
30%.....................................10%
40%.....................................15%
50%.....................................20%
60%.....................................25%
70%.....................................30%
80%.................................... 35%
90%.................................... 40%
100%........................... ...... 50%
Data provided by Author Larry Swedroe on Morningstar's Vanguard Diehard's Forum

On average, a bear market has occurred about every 5-6 years.

Here are two links to historical bear market data
https://www.globalfinancialdata.com/articles/bull_and_bear_markets.doc
http://allfinancialmatters.com/2008/02/11/a-look-at-the-nine-bear-markets-since-1950/

When you have many years to go until you need the money and you have a reliable income, larger percentage losses may be tolerated. When your time-line is getting close, retirement for instance, you will want to reduce your allocation to stocks to reduce the risk of loss.

The Highly Improbable
Author Larry Swedroe likes to remind us to never confuse the highly improbable with the impossible.⁴ What Mr. Swedroe means is that over a lifetime of investing one or more extremely remote possibilities may occur and you should not dismiss the possibility of such events as if they were impossible.

So, you have to consider the "highly improbable" when building your portfolio. The risk of a worst-case scenario is real and should be respected—it can happen when you least expect it.

While the stock market has provided far greater returns than any other investment class, the ride is a bumpy one. If you don't wear a safety harness, you may get hurt.

Making Up A Loss
Another way to help you decide on an asset allocation and risk level is to look at how much you have to earn to make up for a loss. Here is a table that shows the required gain for a given loss. Notice the make-up rate is not linear. The higher the loss, the higher the required gain to get even.

Loss (%)....... Req'd Gain
5%................. 5.2%
10%................. 11%
15%................. 18%
20%................. 25%
25%................. 33%
30%................. 43%
35%................. 54%
40%................. 67%
45%................. 82%
50%............... 100%

As you can see, a 50% loss from an all stock portfolio required a 100% gain (it needs to double), but a 20% loss, which would equate to a portfolio of 50% stocks and 50% bonds, only required a 25% gain. As Terry Savage notes in her book, "The Savage Truth on Money," "Getting even with the bear is tougher than getting ahead." What Ms. Savage is saying is it is much easier to moderate a major loss than try to make up for one.

To take this one step further, let’s look at what happens to two portfolios, one 100% stock (investor A) and one 50% stock (Investor B). Let’s assume each is 10 years from retirement and each has accumulated $600,000 in assets.

If a severe bear market occurred, investor A’s portfolio would drop to $300,000 and Investor B’s would drop to $480,000. Investor A must now double his assets—a 100% return—to get back to where he was before the bear. At the historical rate of return of 10.4%, this will take him 7 years.

Investor B only needs a 25% return to get even again. With an 8.4% return—the historical return of a 50/50 portfolio—he can do this in 3 years. Recovering losses may not take as long as these example because in many cases substantially higher returns were generated in market recoveries. But quicker recoveries can’t be relied on if your future goals depend on the money being there.

One thing to note in these examples is that when the AA is reduced from 100% stocks to 50% stocks, the returns don’t get reduced by half. See 'model portfolios on Vanguard's website.

When assessing your risk, consider your ability, willingness and need to take the risk. A younger investor will have more ability and may have more willingness if he has a secure job and a regular income and is continuously adding to his investments. He also has more need. Young investors need to grow their portfolios with a larger allocation to stocks.

Ultimately, your asset allocation should be based on your entire financial situation. For instance, an older investor who has a pension or other steady income plus his investments has some stability and therefore may have some ability to take additional risk. A retiree depending only on withdrawals from his portfolio may not.³Most retired investors need to think in terms of asset preservation with larger allocations to bonds.

Author Larry Swedroe, in his book, The Only Guide to a Winning Investment Strategy You'll Ever Need suggests you not develop an asset allocation in isolation. You need to thoroughly review your financial and personal circumstances. Consider things like your need for cash reserves, job stability, job correlation to the economy and the stock market, investment horizon, insurance, estate planning, and back-up resources.

Jack Bogle, former CEO of The Vanguard Group and author of "Common Sense on Mutual Funds" says it clearly: "Choose a balance of stocks and bonds according to your unique circumstances—your investment objectives, your time horizon, your level of comfort with risk, and your financial resources."

Suggested Allocation Ranges
The stock exposure an investor can choose ranges from 0% to 100% of course, but there are some guidelines. Young, inexperienced investors believe that with time on their side they can go 100% in stocks. And some retired investors believe they don't need and don't want any stock at all. Neither of these extremes seem to be a very good choice.

Legendary value investor Benjamin Graham recommended holding no more than 75% stock and no less than 25%. William Bernstein points out in his book The Four Pillars of Investing that a portfolio with 80-85% stocks and 15-20% in bonds and cash reduces downside risk to a significant degree while hardly reducing returns at all. Here are the numbers. Please note that the returns used are historical. Future returns may be lower. Potential losses, however, are related to asset allocation and not returns, so they would remain about the same.

If you think about this for a second, you will realize that the lower the expected returns, the less incentive there should be to take the risk of very high stock allocations. There is less on the up side without a reduction on the down side.

Average Annual Return 1960-2004
100% Stock Portfolio = 10.6%
80% Stock, 20% Bonds = 10.1%

Loss in 1974 Bear Market (Worst Year Loss)
100% Stock Portfolio = -28.4%
80% Stock, 20% Bonds = -22.7%

On the other end of the spectrum, having no stocks at all exposes older investors to no growth, which may mean faster drawdown of their portfolios. Also, having 15-20% stock and the rest in bonds and cash actually provides little or no additional risk and better returns. Here are the numbers for the reverse portfolios of 100% bonds and 80% bonds and 20% stock:

Average Annual Return 1960-2004
100% Bond Portfolio = 7.2%
80% Bonds, 20% Stock = 8.1%

Loss in 1969 (Worst Year Loss)
100% Bond Portfolio = -8.1%
80% Bonds, 20% Stock = -8.2%
Data from Vanguard

One last note on choosing an allocation: Kahneman and Tversky discovered in their research study⁵that a loss of $1 is approximately twice as painful to investors as a gain of $1 is pleasant. Why? The gain is expected, anticipated, and exciting. But the loss is not only somewhat of a surprise, it is a setback and may be seen as failure of the plan. People do not like losing their hard-earned money.

E. F. Moody, CPA clarifies this in his online article "Risk and Other Stuff About Investing: Though rarely commented upon, recent studies show that investors are not necessarily risk adverse as much as they are loss adverse."

Frank Armstrong, CFP, author of "The Informed Investor," likes to say "The impact of asset allocation on investment policy swamps the other (investment) decisions."⁶

You have just covered the first essential. Asset Allocation is the main risk management tool in any kind of investing. It is the shape of your portfolio framework. Take a rest and let this brew a bit so you can connect the idea of risk to your own tolerance level and how it will be integrated into your asset allocation.

Notes:

2. Vanguard Group study, "Use Asset Allocation to Build a Better Portfolio, 2003."
3. Frank Armstrong, Investing During Retirement, Part II Constructing the Investment Policy, www.Brill.com
4. Larry Swedroe, from the book, "What Wall Street Doesn't Want You to Know."
5. Daniel Kahneman and Amos Tversky, “Prospect Theory”, 1981
6. Frank Armstrong, "Investment Strategies for the 21st Century", Ch.6, The Asset Allocation Decision, www.Brill.com

On to Chapter 3.

2006-02-08T09:15:00.000-08:00

Chapter 3
Chapter 3 Diversify Your Holdings

Diversification - A simple explanation; Spreading your money into many broad areas is called diversification and it works something like this. Let's say you are packing for a trip to a place you’ve never been and you don’t know what the weather will be like. What do you do? You pack a variety—some light clothes, some heavier ones you can layer, and finally a coat. You want to be prepared for any kind of weather. You are reducing the risk that you won't be prepared, no matter what. You do the same thing with your investments because you are investing in the future - a place you’ve never been and where you can never be sure what awaits you.

Diversifying in the market
Before you can substitute market diversifiers for clothes you need to understand some basics about how the stock and bond markets are organized.

Part I. Market Basics

The Stock Market
The stock market is exactly that - a market for shares of about 7200 publicly owned businesses of all types and sizes. To organize the market, the companies are divided by size, represented by their worth, into large, medium, and small sized companies. Company size is also referred to as market capitalization (market cap).

Market cap is all the shares of a company times the price of the shares. All of the buyable shares are owned by all investors, so the market actually works much like an auction with the sellers trying to get the highest price and buyers trying to get the best deal.

From the view point of investor money, market organization can be thought of in terms of where that money is invested. For instance, if you invested $1.00 in the total stock market, almost three cents would go into one stock, GE, one of the largest companies in the market. Less and less money would be allocated to all the other stocks as they got smaller, but each would receive an equal amount according to their worth.

The top 10 companies represent about 18% of the entire market capitalization. In other words, 18% of all investor's money is in those top 10 stocks. The top 25 stocks represent almost a quarter of the whole market.

The stock market is generally divided up into three size categories; large capitalization (large cap), mid cap, and small cap. Different methods are used to categorize the size ranges. For instance, Morningstar defines large cap as companies with market caps above 10-11 billion.

Currently, General Electric has a market cap of a whopping $306 billion. Other companies in the top ten are giants like Microsoft, Exxon Mobil, Walmart, At&T, and Johnson and Johnson.

Companies with market caps between 10-11 billion and 1.2-1.8 billion are classified as mid size. Some companies currently in the top 10 mid-sized category are MEMC Electronics, US steel, Noble Corp, and Smith International. Small size companies have market caps below about 1.2-1.8 billion. Companies currently in the small cap category include Priceline, FMC, Cabot Oil and Gas, and Reliance Steel and Aluminum.

Indexes have been created to track the whole market as well as various segments of it. The Wilshire 5000 is one index that tracks the whole market, but the Standard and Poors 500 (S&P 500) is the best known index and it is used as a benchmark for overall market performance. The S&P500 tracks the largest 500 companies in the market, but because of the market cap weighting, those 500 companies represent about 70% of the whole market.

The S&P500 follows the total market’s movements very closely. The 500 stocks in the index contain all the market’s large cap stocks, those with market caps above 10-11 billion, and about half of the mid cap stocks, those between 10-11 billion and 1.8 billion. The remaining 6700 stocks in the total markets are the rest of the mid caps and all the small caps. As you can see, there are many more small stocks than large, but in investor’s dollars or market movement, they don’t have much impact. They make up only 30% of the market’s overall capitalization. This weighting makes the market look like an inverted pyramid with large boulders on top, some pebbles in the middle, and grains of sand at the bottom.

In addition to the three size separations, the market is also divided into value stocks, growth stocks and those somewhere in between, which are called blend. There are various measures used to indicate whether a company is a value type company or a growth type company.

So now we have nine "boxes" that segment the market: Large value stocks, large blend stocks, and large growth stocks. Then the same three separations for mid and small stocks. Incidentally, the S&P500 and the Total Stock Market indexes fall into the large blend category because they are dominated by a broad spectrum of large cap stocks. Table 1 shows the holdings of the S&P500 as defined by Morningstar (5/08).

Table 1
Composition of the S&P 500

Large Value 30%	Large Blend 30%	Large Growth 27%
Mid Value 5%	Mid Blend 5%	Mid Growth 3%
Small Value 0%	Small Blend 0%	SmallGrowth 0%

Compare this to a profile of the total U.S. stock market (7200 stocks).

Table 2
Composition of the Total Stock Market

Large Value 24%	Large Blend 25%	Large Growth 22%
Mid Value 6%	Mid Blend 6%	Mid Growth 7%
Small Value 3%	Small Blend 3%	Small Growth 3%

Some market segments act differently enough from one another or the overall market that they are called different stock asset classes. For instance, small value stocks as a group do not follow the movements of the large blend group.

Large value (LV), Large growth (LG), Small value (SV) and Small growth (SG) are like different kinds of clothes and are called asset classes for purposes of diversifying stock. These sub asset classes are just for stocks and should not be confused with the primary asset classes of stocks, bonds and cash discussed in the asset allocation section.

In addition to the four classes of stock mentioned, international stocks and REITs (Real Estate Investment Trusts, pronounced Reets) are also well recognized asset classes because they too act quite differently than the total U.S. stock market. There are other groups as well that some investors consider classes, but you can do very well with just those I’ve mentioned. Asset classes are the real key to diversification Owning two mutual funds in the same asset class does not increase diversification.

Major Stock Asset Classes
Large value
Large blend/growth
small value
small blend/growth
international
REITs

The Bond Market
Like diversifying with stock funds, it is also wise to diversify with bond funds. Bonds are loans called debt instruments (DI). There are a large variety of them and they are categorized by type and quality. There are government treasury bills, notes and bonds, state bonds, municipal bonds and corporate bonds of short, intermediate and long maturity. There are treasury inflation-protected bonds (TIPS), tax-deferred bonds (I-bonds) and low-quality bonds know as hi-yield or "junk" bonds. When you purchase a bond you are essentially loaning money.

There are two main concerns with bonds or bond funds: one is quality, and the other is duration. As with stocks, quality and risk are intertwined.

Treasury bonds are backed by the U.S. government and carry no loss of payment risk. Corporate bonds are issued by companies seeking needed money. These can be of very good quality or very risky. Lower quality equals higher yields and higher risk. Companies in poor financial shape have to offer higher interest rates or no one will loan them money, but the higher interest comes with the risk of the company failing to return the loan. Each bond has a quality rating and each bond fund has an average rating. Hi-Yield funds carry mostly all higher-risk low-quality bonds that are often called "junk bonds." Limit your riskier bond fund exposure to 10%-15%.

The other consideration with bonds is the duration. The price of a bond, once issued, goes up or down depending on interest rate changes. Duration provides a sensitivity measurement for how much the price might change with rate changes. The longer the duration of a bond, the more the price will fluctuate with interest rate changes.

Link to Vanguard Interest Rates and Bonds
https://personal.vanguard.com/us/VanguardViews?FW_Event=vviewsnewsletters&Year2=2004&Season2=Summer

The price of a bond already on the market fluctuates to keep the older bond competitive with new bonds that have different rates. For instance, the price of a 10 year bond that pays 4.0% will go down if a new 10 year bond comes out paying 4.5%. This is because no one will buy a bond paying 4.0% unless they can buy it at a discount. Bonds with higher rates are issued when the borrower can't find enough investors to loan money at lower rates.

Longer term bonds have higher yields, but they also have higher durations, which makes them more volatile than short and intermediate term bonds.

A bond fund has a mixture of many bonds maturing at different times so funds use an average maturity of short, intermediate or long term. And each fund will also have a duration. Durations range from about 2 for short term bonds to 8 or 9 for long term bonds. A fund with a duration of 4 means the fund’s net asset value (NAV) will go down 4% for each 1% interest rate increase and it will go up 4% for each 1% interest rate decrease. Inflation-protected bonds have a built in component that moves with interest rate changes so it protects the bonds from being worth less because of inflation.

Link to Morningstar bond tutorial - http://news.morningstar.com/classroom2/home.asp?colId=167&CN=COM&t1=1212884234

Link to Treasury Inflation Protected Securities (TIPs) tutorial -
http://www.bogleheads.org/wiki/index.php/Treasury_Inflation_Protected_Securities

General Investment Risks
In finance, risk has a number of different meanings. We have already examined the most basic definition in the asset allocation section - the chance the money won't be there when you need it. A second type of risk is called specific stock risk. If an investor holds a high percentage of his money in one stock he holds a high risk of losing a lot of money if something goes wrong with the company. This type of risk is about a small chance of a major catastrophe. Something like your house burning down.

The chances of a fine company going bad is small, but if it happens, and it does occasionally, the consequences will be big if most of one's money is in that stock. This type of risk can be eliminated by holding many stocks, and that is one of the reasons for holding mutual funds. It’s kind of like fire insurance. In a fund of 100 stocks, one company crashing doesn't create much of a ripple.

Be careful about putting too much into the stock of the company you work for. Most recommendations say to limit investments in one stock to no more than 5%. You might be able to stretch this some, but don't ignore the long-shot possibility of unseen risk.

Additional discussion on risk
http://travismorien.com/invest_FAQ/content/category/8/431/61/

Part II. Diversifying Your Investment Portfolio With Asset Classes - the core of the portfolio selection method.
Once you have set your overall asset allocation—the percentages in your portfolio assigned to stocks, bonds and cash—you can turn to diversifying your equity holdings with the sub asset classes of large value, large growth, small value, small growth, international and REITs.

Diversifying with these different asset classes can provide some reduction of a third kind of risk called volatility.

Volatility is a risk which measures how much a fund’s returns might fluctuate. It is technically defined as standard deviation (SD). And standard deviation is a mathematical risk factor used for tracking the swings in returns for stocks, bonds, and funds. The bigger the SD number, the larger a fund's returns may fluctuate.

Volatile Assets in a Portfolio
Portfolio volatility reduction occurs because the returns of the different asset classes do not move together. They do not correlate with each other. Combining asset classes with different volatilities has the effect of lowering the volatility of the overall portfolio.

Graphic illustration of volatility and correlation.
http://www.investorsolutions.com/v2content/book/ch4/ch4.cfm

But diversification does something else that is quite remarkable: it can increase your returns given the same amount of volatility risk.

As Larry Swedroe remarks in his book, "What Wall Street Doesn't Want You to Know “Diversification of risk through the ownership of low-correlated assets is the only free lunch in investing."

In the following example, 30% of small international is added to the S&P 500 and the overall volatility (SD) of the portfolio is lower than either of the two asset classes alone. And the returns are improved by 2% over the S&P500 alone.

Example of asset class diversification:⁷

1970-2002

Asset class Return SD
S&P500 10.8% 17.5
Small International 15.0% 30.1
Mix 70 S&P/30 Int. 12.8% 17.2

The S&P500 is a large blend/growth asset class and small international stock is a class of stock that doesn't act like the S&P - It doesn't correlate with the movements of the S&P500. In fact, one may be going up while the other is going down—that makes it a good diversifier.

Small international is very volatile on it’s own. In statistical terms, the SD of 30.1 means that in any year the annualized returns of 15% might be anywhere between +45% and -15%, 67% of the time. The other 33% of the time the swings can be much more, even twice as much.

In practical application, standard deviation (SD) can be viewed as a measure of unpredictability. in short time frames, the returns can vary widely. For instance, small international could have two or three years with returns of +35%, but in the year after you invest the return could be minus 10%. This is one reason why you should never invest in a fund based on passed returns. And the higher the SD of a fund, the more unpredictability and the less you should hold.

When investors diversify properly, one of two of their asset classes might be down at any given time while others are doing well. But which asset class might be favorable in the market changes from time to time and those changes cannot be predicted. This is like changes of weather on your trip. But if you are diversified, you will have a much better chance of having something in your portfolio that is outperforming.

Eric Tyson says in his book, Mutual Funds for Dummies "To decrease the odds of all of your investments getting clobbered at the same time, you must put your money in different types or classes of investments."

Let’s try one other example, this one with REITs. Data from 1972-2003

Portfolio 1
Stocks 50%, Bonds 40%, T-Bills 10%, REITs 0%
Return = 10.9%, SD = 10.8%

Portfolio 2
Stocks 45%, Bonds 35%, T-Bills, 10%, REITs 10%
Return = 11.2%, SD = 10.4%

Portfolio 3
Stocks 40%, Bonds 30%, T-Bills 10%, REITs 20%
Return = 11.5%, SD = 10.1%

Notice again that the returns go up and the standard deviation goes down.
Data provided by T. Rowe Price Investor Magazine June, 2005

There you have it, the magic of asset class diversification in action. It is the different correlations interacting together that make it work. Correlations between asset classes are always changing to some degree due to different market forces, but that's not something to be too concerned about. In the example above, the percentages of REITs won’t always give the listed returns and SD, but you can be sure diversification will be working at some level as long as you don’t add too much of the more volatile asset class.

Link to a good article demonstrating the positive effects of diversification
http://www.indexuniverse.com/component/content/article/3220.html?issue=121&magazineID=2&Itemid=11

On to Chapter 4.

Note 7: Paula Hogan, CFP

2006-02-08T09:13:00.000-08:00

Chapter 4
Diversifying a Portfolio with Asset Classes

Diversifying a Portfolio with asset classes
A good approach to diversifying with stock asset classes begins with viewing the U.S. equity portion of a portfolio. The total U.S. market profile is about 72% large cap, 19% mid cap, and 9% small cap (refer to the table on market organization in Ch. 3). Using this profile as a gauge gives you something to use as a comparison for your own individual portfolio holdings. Getting too far out of line with the market profile by adding a very large portion of one asset class may cancel the benefits of diversification and actually add additional volatility (SD). It will also introduce something called tracking error.

Tracking Error
Tracking error occurs when a portfolio that is much different from the market profile is used. Such a portfolio will not follow the movements or returns of the total stock market.

A non-conforming portfolio will at times have higher returns than the market, but it will also have lower returns at times. Inexperienced investors are quite pleased if their portfolio is beating the market, but many simply cannot stand to see the reverse. Having a portfolio that is down when the market is up causes many investors to abandon their strategy and change things, which hurts returns.

Portfolio Examples
The following portfolios are typical examples of those used by many investors, but they are not recommendations. What I'm trying to show is the process of developing a risk-controlled portfolio structured with recognized asset classes. It will be up to each individual investor to define their own risk profile and portfolio.

One of the simplest ways to build a portfolio is to use a mutual fund that tracks the entire market. A total market fund provides a lot of diversification because it has large cap value and growth stocks plus mid and small stocks in the exact proportion as the market. To further diversify, an investor should next add a total international fund. Usual recommendations for international exposure run from 20% to 40% of the equity allocation.

In the following examples all fund holdings add up to 100%. That is one recognized way of listing a portfolio. Viewing all accounts as part of the whole portfolio helps you get an overall view of everything you own. It also enables you to put assets in the most advantageous places.

Sometimes allocations are separated into percentages of stocks and percentages of bonds. Be sure you are clear on which way a portfolio's holdings are being presented or recommended.

In the following example, total international is 20% of the equity allocation. Equity is 60% of the portfolio and 12 is 20% of 60.

Fund Total U.S. Market Fund Total International Bond Fund Total	Percent 48% 12% 40% 100%

This simple equity allocation contains all the major stock asset classes except REITs.

William Bernstein writes in is book, The Intelligent Asset Allocator, "If over the past 10 or 20 years you had simply held a portfolio consisting of one quarter each of indexes of large US stocks, small US stocks, foreign stocks and high quality US bonds, you would have beaten over 90% of all professional money managers, and with considerable less risk."

If you wanted to add REITs, recommendations for allocations usually run from 5% to 15%. Although REITs are U.S. equities and mostly small and mid cap stocks, they are not considered in the market profile because they don't act like any other asset class, and the market does not contain a significant amount of REITs.

In many cases an investor may not have access to total market funds, especially in tax-deferred accounts through work or at various brokerage houses. When that occurs, a S&P 500 fund or a large blend actively managed fund would be a good choice. If an investor uses one of these choices, she might add a small cap fund. Then the portfolio might look like this:

Fund Large Cap Fund Small Cap Fund Total International Fund REIT Bond Fund Total	Percent 35% 5% 12% 6% 40% 100%

Here is example that includes all the asset classes:

Fund Large Blend or Growth Fund Large Value Fund Small Cap Fund Small Cap Value Fund International Fund REIT Fund Bond Fund Total	Percent 15% 15% 6% 6% 12% 6% 40% 100%

You could add a mid cap fund in the mix too, but mid caps aren't considered the best diversifiers because they act a lot like a combination of large and small. However, they can provide better-than-average returns at times.

Bond allocations
The fixed income portion of your financial assets is the safe part of your portfolio. It has been described as a portfolio's belt and suspenders.

Bond funds are great diversifiers and the main controller of overall portfolio risk management.

Like stock investments, bond investments do not have to be complicated. One typical bond portfolio in a tax-deferred account might look like this:

Fund Total Bond Market Fund Inflation-Protected Securities (TIPs) Hi-Yield Bond Fund Total	Percent 60% 30% 10% 100%

It the example above, there is a total bond market component which covers many kinds of bonds and provides lots of diversification. The TIPs component will add an inflationary hedge. And finally, there is a higher-risk/higher return component in hi-yield bonds. You don’t want to add too much of a riskier component like hi-yield because the first purpose of bond holdings is to moderate risk, and there are times when hi-yield bonds can act much like stocks. For this reason, there are a few experts you do not recommend hi-yield bonds.

Bonds in a taxable account might look like this:

Fund Limited Term Tax-Exempt Bond Fund State Tax Exempt I-Bonds Total	Percent 40% 30% 30% 100%

When using taxable accounts, it's best to go with tax-exempt or tax-deferred bond funds or taxes will eat up much of the return.

Cash
The cash portion of a portfolio might consist of money market funds, CDs, stable-value funds, and savings accounts. Putting all three primary asset classes together results in a full portfolio that looks like this:

Example of a diversified Total Portfolio: Stocks = 65%, Bonds=25%, Cash=10%. Note at all funds add to 100%

Stocks=65%
Large cap value fund - 16%
Large cap blend or growth fund - 16%
Small cap value fund - 6.5%
International fund - 20%
REIT fund - 6.5%

Bonds = 25%
Total bond fund - 15%
TIPS - 7.5%
Hi yield fund - 2.5%

Cash = 10%
Money Market - 5%
CDs - 5%

Other examples—You add the allocation appropriate for your situation.

Taylor Larimore’s Thrifty Three
Total Stock Market
Total International
Total Bond

Rick Ferri’s Core Four
Total Stock Market
FTSE All-World ex. U.S.
REIT
Total bond

More Examples -
http://www.geocities.com/finplan825/ModelPortfolios-Data.html
http://seekingalpha.com/article/73042-craig-israelsens-seven-asset-portfolio

Here are a few final thoughts on asset classes. Historically, over long time periods, value stock and small stock asset classes have produced higher returns than the overall market.⁸ Some investors deliberately overweight these classes. If you consider something like this, remember that you will have higher tracking error and the results may not be see immediate results.

Note 8: Larry Swedroe, "Explaining the Value Premium," 2/2002, www.indexfunds.com

On to Chapter 5.

2006-02-08T09:07:00.000-08:00

Chapter 6
Building Your Portfolioio - A Look at Fund Options

While individual stocks may be an option for some highly skilled investors, they are not the best choice for most investors. Here's why: When you invest by purchasing individual stocks, you are competing head to head with professional money managers. Individual stock picking demands a lot more knowledge and attention than most average investors are willing to put into it, and even then the odds are high against you beating half of the professionals.

An investor needs at least 50 stocks spread into different asset classes to be diversified, and no one stock should be more than 4-5% of equity holdings or the investor will add "specific stock risk" to his portfolio. So, for most investors, and especially those who don't want to spend a lot of time on their portfolio, using mutual funds is a far better choice.

Mutual Fund Basics
A mutual fund is a pool of stocks or bonds purchased by the fund’s manager. An investor can buy the mutual fund and thus own all the stocks or all the bonds in that fund. There are also funds that contain both stocks and bonds. I’ve mentioned that there are around 7000 stocks available for purchase, and there are even more mutual funds! You can find a fund that covers any area of the stock, bond or international markets you wish to invest in.

There are two basic kinds of mutual funds—closed-end funds⁹ and open end funds. Open ended funds are far more popular and are the ones you hear about and see advertised. All references in this guide are for open-ended funds.

Mutual funds can buy and sell stocks at the manager’s discretion; therefore, the stock selection can change. If you wish to purchase a fund you would call the fund company or brokerage that has the fund you are interested in and place an order during a market trading day, but actual purchase will not occur until the close of the market that day. The price of a fund is called the net asset value (NAV) and it always reflects the average price per share of all the stocks held in the fund.

Mutual funds can further be classified into load funds, no-load funds, actively managed funds, index funds and exchange traded funds (ETFs). Index funds and index ETFs are also known as passive funds because they are designed to track a particular asset class or segment of the market without any managerial attempt to increase returns or moderate risk.

Mutual Fund Expenses - How they earn money
All mutual funds and ETFs have management fees. These fees are expressed as a percentage of assets removed from the fund before the total return is reported. Other fees, usually advertising expenses or commissions, can be attached as well under what is known as a 12b-1 fee. 12b-1 fees and management fees are combined and expressed as a fund's expense ratio. Expense ratios can range from a very low 0.10% for some index funds to over 2.0%. On a $10,000 investment, that’s $10 per year compared to $200 per year.

Load Funds
Load is another word for commission. Funds that carry loads are sold by commissioned agents, advisors and brokers. Loads are applied most frequently in three ways:; front end (A shares), back end (B shares), ongoing (C shares). There are several other letter designations for other asset classes as well.

A shares of a fund usually have a commission of around 5.75% of the money you invest, and it is taken even before the fund is purchased. If you hand the agent or advisor $10,000, $575.00 will go into the advisor’s pocket and only $9425 will actually be invested.

The commission is sometimes not obvious because the real value of the fund—the net asset value (NAV)—is not reported to you when it appears in your account statement. Instead, you might see a buy price, market price or something similar so it will appear that all the money was invested. Commissioned advisors do not like to show you what you paid, which ought to put you on the alert about their methods. A shares do offer discounts on the commission based on the purchase amount, but you probably won’t get a discount unless you request it.

Mutual fund B shares designate a back-end load. This is a commission taken when you sell the fund. Back end loads usually get reduced each year you own the fund. An example would be a 5% charge the first year, 4% the second, 3% the third and so on. But it may take 6 years or more to get out from under a redemption commission. And all the while you will pay a higher expense ratio for B shares than A shares because there is normally a 12b-1 fee (commission) attached. Most B share funds convert to A shares once the redemption fee is phased out.

C shares have the commissions built into the expense ratio and they show up in a 12b-1 fee, which is part of the overall expense ratio. These are called level loads, and they are applied as long as you own the fund. This commission can raise the total expense ratio to over 2%.

Additional information on share classes
http://www.saveandinvest.org/Military/manageMoney/investorAlerts/P005975

In recent years more classes using different letter designations have been developed which further complicate the costs of these funds. These loads have nothing to do with operating the fund—the money goes strictly to sales profit.

The idea behind these commissions is that they are supposed to get you investment advice. But, advisors who make money this way often recommend investment choices that make them the most money. There is a lot of conflict of interest here that can bias an agent's recommendations.

No-Load Funds
No load funds are just that—they have no commissions at all. You buy them direct from the mutual fund company, a discount brokerage or through a fee-only advisor.

Index Funds
An index is a group of stocks chosen to represent the whole market or certain parts of the market. The performance of an index represents the average returns of the market segment being followed. The Morgan Stanley Capital International (MSCI) broad market index is one of several indexes that track the total U.S. stock market. You cannot buy the actual indexes, but you can buy mutual funds that track them.

There are index funds for all of the asset classes and the nine market segments shown previously plus some others as well. The most famous index fund is the Standard and Poors 500 (S&P 500). The S&P 500 is used as the standard for the total market because it tracks the whole market very closely and it was created before there was a total market index.

The hallmarks of true index funds are they are capitalization-weighted and track their asset class closely. Most, but not all, are very low cost because they don’t have an active manager, they don’t need to spend money on stock research, and they have very low turnover.

Exchange Traded Funds-Index
ETFs are put together and sold as a single unit like a stock, which means you can buy or sell them at any time during a trading day. But like a stock, you have to purchase through a broker and you will pay a commission for the trade. Buy/sell commissions can run from zero dollars at a discount broker to over $100 at a full-service broker.

When ETFs first arrived on the scene, they were all copies of true index funds. But now there are many more that index something other than a pure asset class. Like index funds, most ETFs have very low expenses. Avoid those that don’t. ETFs can be a good choice if you refrain from frequent buying and selling.

Actively Managed Funds
As the name implies, these types of funds hire a manger to put together and maintain a fund. The objectives of active funds as a group are far more varied than index funds which just have the job of tracking an index. In general terms, fund managers are trying to beat their benchmark index, although some actually try to limit downside risk as well. The ways in which mangers try to achieve their goals is where the creative variations come in.

More on actively managed funds
http://en.wikipedia.org/wiki/Active_management

Choosing Passive or Active Funds
The better an investor is educated in the area of finance, the more likely he or she is to choose index funds. But most investors are not interested in doing a lot of academic research. Average investors respond to only what is right before their eyes—lists of current top performing funds and big returns. But, what you see is not likely to be what you are going to get.

The benefits of indexing are not obvious nor intuitive. Index funds do not crowd the top of the hot fund lists, but they definitely do produce higher returns over longer periods of time. There are two simple reasons for this: 1) Index funds have lower costs. 2) Index funds are not subject to several problems that active funds encounter.

It’s difficult to connect these two simple advantages to higher long-term returns. What happens is index funds continue to produce benchmark returns minus low costs, whereas the great majority of active funds simply cannot continue to overcome their higher costs and avoid problems.

The following data shows the percent of funds beaten by their index for all nine market segments over a ten year period ending 2/31/2004.¹² Over longer periods the numbers are even higher.

LV=66%
LB=82%
LG=84%
MV=89%
MB=79%
MG=95%
SV=68%
SB=93%
SG=63%

This following link provides a list of index fund advantages and a series of quotes from professionals compiled by author and investor advocate, Taylor Larimore.
http://www.bogleheads.org/forum/viewtopic.php?t=881

Beating the Market
One critical mistake uneducated investors make is to believe they can and must select managers that can beat the market. Successful investors, however, understand that trying to beat the market long-term is a losing proposition. It is not a competitive game. Those who treat is as a contest usually do not make good investors.

The purpose of investing is to achieve financial goals with an efficient, systematic plan. Investing is always a balancing of risk against reward—not a contest to see who can get the highest returns.

Investor Returns
Investors do not actually capture the returns funds produce because of:
behavioral mistakes

behavioral mistakes
costs
problems active funds incur that hurt performance

So, the smart play becomes eliminating things that can reduce returns. To put it simplified terms, don’t shoot yourself in the foot. Maximum long-term gains are the result of capturing the highest percentage of market returns—Increase the odds of long term success with low costs and avoidance of potential problems.

To use a car trip analogy—, the way to win is not to get from point A to point B first; it is to achieve the best gas mileage.

Active Funds Additional Risk
As mentioned, managed funds start off with the handicap of higher costs and an array of potential problems that can suddenly sink a fund. Investors need to understand that this handicap equates to higher risk of success because it’s not possible to identify those funds which will outperform in the future, and that is where the additional risk lies.

If an investor holds 10 active mutual funds, the odds are extremely high that several will fail to do the job for which they were purchased. Managing a portfolio of all actively managed funds requires more time evaluating performance and searching for replacement funds. Because some will fail, they are not good choices for taxable accounts where big tax penalties will add to the problem.

Potential Problems
Asset bloat - Popular funds draw a lot of new money. And ironically, too much success is one of the biggest causes of eventual failure. As the fund's assets grow it becomes harder and harder for the manager to find good stocks to buy. A fund company with true fiduciary responsibility to its investors will close the fund, but most will just keep taking in the money until performance sinks to the bottom of the list.

Manager changes - Managers who have put up good numbers and received lots of media attention tend to move on to other, more lucrative positions. It’s worth noting, though, that some very good active funds have multi-managers, which suggests that the company’s underlying philosophy is more important than the manager.

Fund Purchase- it’s not uncommon for successful smaller fund companies to be bought-up by big firms with mediocre records and high fees. The funds with the good records are heavily advertised, but once the higher fees and new company management interference is in place the outstanding funds from the smaller company lose their luster.

Style drift - A managed fund that you purchased to cover the small value asset class can change to small blend, mid value or something else. When this happens, your target allocation gets shifted.

Objective changes - Managed funds can decide to change what they are investing in or how they invest, which dismisses the carefully chosen reasons you bought the fund in the first place.

Choosing Good Funds.
Why concern ourselves with choosing actively managed funds if it is an inferior strategy? For one reason, lots of investors use actively managed funds, and some who are informed and experienced are successful. Using active funds does demand more time and vigilance, and success absolutely depends on using proper fundamentals.

Another reason to know how to select active funds is sometimes investors have no choice. Tax-deferred plans like 401ks, 403bs and 457s usually do not offer index funds or even top rated managed funds. Participants in these plans are forced to work with what is available.

Selecting Active Funds
1. The most important thing to look for when choosing an actively managed fund—and the hardest to recognize—is a fund’s commitment to shareholder fiduciary responsibility. Investors need to evaluate the company’s philosophy and how they interact with shareholders.

2. Select funds with low expense ratios and never buy load funds. High expense ratios and 12b-1 fees are a drain on higher returns. The best funds also seem to hold advertising costs to a minimum.

3. Look for funds that have low turnover. Hidden transaction costs and capital gains taxes add to fund costs. Also, the best funds seem to be those that buy carefully and then hold their chosen stocks.

4. Look at five and 10 years past performance records. There is no way you can make a judgment based solely on past performance, but the farther back you can trace performance the better. Be very leery of funds with spectacular gains. Look for consistency and discipline.

5. Pay special attention to how much money the fund is managing (asset size). When a good fund is recognized by the crowd, it can receive a lot of new money that can cause problems. The best fund pickers will have identified a good fund like this several years earlier. The best funds will close rather than continue to accept money that will harm the investors. This is a sign of fiduciary responsibility.

6. Pay particular attention to balanced funds. They seem to be the most consistently reliable over time, perhaps because they aren't competing against, and not trying to beat, some stock fund benchmark. Unfortunately, these types of funds are not very good choices for taxable accounts.

Additional considerations -
http://www.mymoneyblog.com/archives/2007/09/flip-side-finding-the-best-active-mutual-fund-managers.html

Moderating Downside Risk
One other reason an investor might consider actively managed funds is to reduce downside risk. Some actively managed large value funds and equity income funds have lower downside risk.¹¹ Note that while past performance of returns is not an indicator of future performance, historical risk characteristics are somewhat useful in getting some sense of what to expect from a mutual fund as long as the objective has not changed.

It may be a good idea to offset your large blend fund or large growth fund with a large value fund or an equity index fund having a lower beta number if you wish to moderate your risk profile. This is common practice for investors in or near retirement. These types of funds usually throw off dividends too. And since the total market and the S&P 500 are naturally weighted toward growth, a large value fund is a good compliment.

Three measures of risk to look at are a fund's volatility (standard deviation), its bear market ranking¹¹, and it's beta number.¹¹ Beta is a number that indicates a fund’s swings in returns relative to movements of an index. For stock funds, the index used is usually the S&P 500, which as a beta of 1.00.

A fund with a beta of 0.85 means the fund might go up or down only 85% as much as the index. In up markets it will underperform by about 15%, but in down markets it will lose roughly 15% less than the index. Part of the reason for some of the lower risk is probably due to these funds holding some cash. Index funds do not hold cash. And be aware that there is no guarantee that the calculated performance will match the actual performance.

Building Your Portfolio - An Example
"The greatest enemy of a good plan is the dream of a perfect plan."
A favorite quote of John Bogle originally attributed to Prussian general Karl von Clausewitz.

There is no perfect investment plan. No one fund, no one allocation, or one strategy will be correct for every investor in all market conditions. And as you will discover, the investment options at your disposal will not always be exactly what you want.

When first starting out, things are usually quite simple. Your first investment venture might be an IRA or Roth IRA. Using these types of accounts allows you invest in almost any fund you want, but you will not have enough accumulated money to add to every asset class. One of the best ways to begin then is to use an asset allocation fund. These can be simple balanced funds or they can be fund-of-funds such as life strategy funds, or retirement funds.

These types of funds create an instant diversified portfolio for you. Be careful where you buy these funds though. Some companies tack on a management fee on top of the expense ratios of the underlying funds, which makes them too expensive.

Balanced funds and most asset allocation funds hold both stocks and bonds and you can find them in different allocations to match your needs. These are the simplest worry-free funds you can get. You can buy them and forget them because even the rebalancing is done automatically within the fund. You can get fund-of-funds and balanced funds in both managed and index varieties.

At work you hopefully will have access to 401k, 403b or other retirement accounts. These can be great investment vehicles because of their tax deferral, but it’s the rare plan that doesn’t come with some compromises or problems, including high costs and limited choices.

You will probably find you cannot build a well balanced, fully diversified portfolio with the options you have in one plan. Most investors use their traditional IRA accounts, Roth IRAs and taxable accounts to round out their portfolios.

To keep track, break things down like this example:

Overall Asset Allocation = 60% stock, 40% bonds and cash (define your own chosen allocation here)

Equities (equaling 60%)

401k
large value fund - 18%
international fund - 15%

Roth IRA
large blend - 9%
sm cap fund - 6%
REIT - 6%

Taxable
Total stock market - 6% (tax efficient)

Bonds (equaling 40%)

401k
intermediate bond - 28%

Roth IRA
TIPs- 12%
_________________
Total = 100%

Notes:

9. For information on closed-end funds, see www.closed-endfunds.com
11. Add a fund name or ticker symbol to Morningstar's Mutual Fund "Quotes" box, and then click on "Risk Measures” Measures." www.Morningstar.com
12. Gus Sauter, "Vanguard Chief Investment Officer Discusses State of Indexing,'" 1/25/2005, www.Vanguard.com

On to Chapter 7

2006-02-08T09:03:00.000-08:00

Chapter 7
Rebalancing

Rebalancing is the rather simple but important process of resetting your asset levels back to their original percentages (allocations). You will need to do this once or twice a year as some assets will gain faster than others or some may lose ground.

John Brennan says in Straight Talk on Investing "People tend to think about investing only in terms of making money. Making money is why we invest, but the reality is that if you don’t remember to manage risk along the way, you won’t do well at making money."

That is a very important statement. Keep risk at the level you originally decided it should be. As assets grow, your stock allocation will become higher than you originally intended. There may be a temptation to let it ride, but this increases your risk, which you have carefully evaluated in your asset allocation model.

In down markets your stock allocation will shrink. You may find it tough and counter to reason to add money to losing assets, but this is a way of buying when stocks are cheaper. Rebalancing in down years forces you to be a bit of a contrarian investor—one who doesn't follow the crowd. This strategy can provide a bit of a return bonus and keep volatility in check over time.

There are several methods used for rebalancing,¹³ but it's not critical that you follow an exact formula. Check your allocations once a year to see if the primary allocations have changed by more then 5% and watch smaller allocations to volatile asset classes to see that they haven't gotten too far off the target. If you are adding new money on a regular basis, you can allocate it where needed to adjust to your targets.

Here are some general rules for rebalancing from author Larry Swedroe;

1) the main thing about rebalancing is the discipline of buying low and selling high, and restoring the risk profile.

2) you must consider costs of rebalancing (taxes and transactions costs) in taxable accounts as they will impact the frequency and timing of rebalancing.

3) rebalancing should always be done whenever you have new dollars to invest (no tax implications).

4) rebalancing can be done more frequently and more tax efficiently of course in tax deferred accounts.

5) given the evidence of short term momentum, it may not be best to rebalance too frequently (let the winners ride for short time, but not too long) . But again risk control is biggest issue to me—not returns.

6) once per year if you don't have cash is fine—but even then I wouldn't do it unless you had significant style drift"

Mr. Swedroe advocates what he calls the 5/25 rule. When a major asset moves more than 5% off target, it’s time to rebalance. Example: Your asset allocation is 70% stock/30% bond. If equities grow to be 75%, then it’s time to rebalance.

If the an equity asset is 25% or less than total equity, then you use the 25% trigger. For instance, if you have 10% REIT, then the rebalance points would be plus or minus 25% of 10, which = 12.5% and 7.5%. Rebalancing at this level would not be critical for bond holdings.

Rebalancing isn't difficult, but it is important and part of your investing discipline.

Note 13: Walter Updegrave, "Rebalancing Act," 11/2003, www.money.cnn.com

On to Chapter 8

2006-02-08T09:01:00.000-08:00

Chapter 8
Formalize Your Investment Plan with an Investment Policy Statement

You have already done most of the work in making a plan by developing your asset allocation and asset class percentages. Now you have to formalize it by writing it down. If that seems a bit excessive, it isn't. Writing down your objectives, goals, and strategies:

declares you are serious
helps you remember the details
helps you stay focused
makes you aware of something you may have missed.

Preparing for the future—managing money, saving, and investing—is a serious responsibility. It is no different and no less important than earning a living, maintaining a house, or protecting the things you’ve worked hard to get.

The formal plan follows the same logic you might use for your next vacation, remodeling your home, or planning for your children’s education. Not planning results in nothing being done or making mistakes that waste time and money. To put it in more graphic terms, not planning and not following the plan can have a serious negative effect on your retirement life.

None of the other investment rules will work in the long term without a plan and the discipline to stay with it. A plan doesn’t need to be complicated, but it is so important that the experts agree that an investment policy statement be written and signed. A vision without a plan is an illusion.

Here is what Lewis Schiff, author of "The Armchair Millionaire" has to say: "Define your financial goals and time horizon. What goals do you need to achieve in order to be financially secure or independent? For most of us, these goals would include having a certain amount to secure retirement. Your plan might target long-term growth, current income, protection of your capital, or some combination of all three. Other major goals might include college education or purchase of a home. These goals, with different time frames and different priorities will require their own investment strategy.

Define your risk tolerance.
Define your target asset allocation.
Define your individual investments.

The bottom line: All of your investing decisions should be grounded in your own investment policy statement (IPS). By taking a 'top-down' look at your finances and writing out a road map, your policy will add an important element of discipline to your approach."

Sticking to a plan can be difficult at times. Any investment plan will be occasionally challenged by the market and second-guessed by the investor. The market will challenge your asset allocation decision at times by making it look like you’re doing it all wrong. Various sectors and segments of the market can get hot and everyone around you is jumping in. Even your best friend is clobbering your returns. On the other hand, the whole market may take a nose-dive and all you hear is gloom and doom. Temptation to join the crowd or rein in stock allocations can be very strong.

Ninety percent of what you read and see is useless noise and must be ignored. That's easy to say, but actually very tough to do. Listening to noise is one of the major mistakes investors make and why you absolutely need to commit to a strategy and put it in writing.

I don’t mean to say you should not alter your asset allocation when life style or goals change, but don’t flinch for any other reason. Take into account what might make you flinch, then set your allocation accordingly from the start.

This is the sort of blitz you are up against as Paul Farrell notes in an April 2005 Marketwatch article: "Last year, I estimated that the average investor was being overwhelmed by 43,000 fund and stock recommendations, via newspapers, magazines, cable television, radio and the Internet. The intensity of this noise confuses and brainwashes investors, resulting in costly mistakes.”

Chandan Sengupta, in "The Only Proven Road to Investment Success," also warns of the danger: Noise is a constant problem and you have to recognize it and then dismiss it as not only worthless, but harmful. If you are not going to stick to your chosen investment method through thick and thin, there is almost no chance of your succeeding as an investor."

John Brennan, in “Straight Talk on Investing" sums up the planning process nicely: "Making a plan need not be complex. It is all about looking ahead and assessing where and when your needs for money will occur. Then you decide on how you’re going to meet those needs. It’s essentially a three-step process:

1. Determine how much money you’ll need to have.
2. Figure out which kinds of investments should provide you with the money.
3. Calculate how much you need to set aside in order to make those investments.”

Your plan needs to consider building assets and managing existing assets in all accounts, including tax-deferred accounts at work like a 401(k) or 403(b), IRA, Roth IRA, as well as taxable accounts and emergency funds. Once that is done, you can subdivide your plan into individual goals.

Goals with different time horizons will require different allocations, but it is best to keep the overall top-down view for a full perspective. Generally, money allocated to goals within a five-year time period should not be in stocks. The one exception, of course, is retirement. You will need to keep some stock in retirement because you will still be investing throughout your retirement years.

You can come up with a plan yourself or get some assistance from a financial advisor. Just remember, you need to have some idea of where you’re going and how you want to get there. If you don’t, an advisor may not be able to provide effective help.

Here is an example of how a long-term plan for retirement might look:

IPS (Investment Policy Statement)

1) Investment Horizon - 30 years

2) Risk Tolerance - High due to investment horizon and acceptable risk tolerance.

3) Financial Objective—2 million dollars. This objective can be achieved by starting with a sum of $30,000 and adding $12,000 per year for 30 years while getting a return of 8.5%.
This financial goal will allow me to withdraw $80,000 per year (4%) beginning at age 62 for at least 30 years with a high probability of preserving the principal.

4) Rebalancing: I will review my allocations once per year (Feb.) and I will make adjustments by adding new money to adjust percentages back to targets.

5) Primary Asset Allocation: 75% equities, 25% fixed income

Equities - 70% domestic, 30% international
Fixed income - 100% domestic

Equities:
Domestic allocation - Total market 25%, Large Value 25%, Small Value 10%, REIT 10%,
Total International 30%

Fixed income:
25% Series I Savings Bonds, 65% total bond market, 10% hi-yield

6) Fund Selection:

Equities, (domestic)
Large - Vanguard Total Stock Index
LgV - Vanguard Windsor II
Small - Vanguard Small Cap Value Index
REIT - Vanguard REIT

Equities, (International)
Vanguard Total International Index.

Bonds -
TIPs
Vanguard Total Bond Market Index
Vanguard hi-yield

7) The plan allows for reduction in equity allocation as retirement gets closer and risk tolerance decreases. Allocation changes may also be evaluated if life-style changes or significant new goals occur. I will not let investor sentiment and Wall Street noise influence my allocation.

Signed.....

When should you get serious about an investment plan? Right now!

Here is a link to additional Information on Investment Policy Statements. Note that the first part is a quite detailed overview of what you need to think about. The second part is a detailed example. The third part is a real-world example. Notice that it is not complicated or lengthy.

http://www.bogleheads.org/wiki/index.php/IPS

On to Chapter 9

2006-02-08T08:56:00.000-08:00

Chapter 5
Costs ARE a BIG DEAL

Jack Bogle is a giant in the mutual fund industry. He is the founder of the Vanguard Group and the creator of the first universally available S&P 500 index fund. And yet, Mr. Bogle is not too popular with his peers. Why? Because he has spent his life rallying against high fees associated with mutual funds. Mr. Bogle's message is very simple: Costs Matter. How much? A Ton!

Unfortunately, this statement is so simple that investors can read right over it with just a nod of their head. But Jeff Acheson, director of retirement planning at Pittsburgh-based Schneider Downs & Co. puts it in perspective, “Hidden fees are a little bit like high blood pressure. You don't really feel it, and you don't necessarily see it, but it'll eventually kill you.”

If you Google mutual fund costs, you will get dozens of articles all saying the same thing—high costs hurt returns. It seems simple enough if you are paying attention, but many investors do not believe it because they can point to a fund with high expenses that is outperforming. What they miss is the fact that no fund can outperform all the time. The extra hurdle of overcoming the costs eventually will take it’s toll.

Jim Peterson, vice president for Schwab's Center for Investment Research says "You have to care about expenses. It is the most predictable characteristic of explaining future returns of funds. It's more reliable than past performance. It can't be said enough: with funds, costs matter.

The Beach Lesson provides a clear example of how costs work against you:
http://www.employeefiduciary.com/fees.htm

This is from the Securities and Exchange Commission (SEC) website: As you might expect, fees and expenses vary from fund to fund. A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858.

Cost control is the very heart of long-term better-than average returns. It is a fact that causes Mr. Bogle's peers to squirm. And yet, they cannot dispute it. Costs, and hence returns, are subject to “the relentless rules of humble arithmetic.” The quote is a favorite of Jack Bogle. It is originally from Louis D. Brandeis in "Other People's Money," first published in 1914.

People are used to the common idea that you get what you pay for, but in investing it is just the opposite. In the keynote speech at the opening of the 2006 Money Show in Las Vegas, Jack Bogle summed it up this way: "The great irony of investing, then, is not only that you don't get what you pay for. The reality is quite the opposite: You get precisely what you don't pay for. So if you pay for nothing, you get everything." Our goal then is to pay as close to nothing as possible.

In his book, “Common Sense on Mutual Funds," Mr. Bogle says "Asset allocation is critically important; but cost is critically important, too—All other factors pale into insignificance."

Costs, including tax consequences, take a direct bite out of the returns that go into your pocket. Every penny that goes to costs requires that much more return to break even.

Money Magazine columnist Walter Updegrave in his article, The Single Best Retirement Strategy, has this to say: If I told you there was a risk-free way to boost your retirement savings by 20 percent or more, would you be interested? In fact, what I'm suggesting is the soul of simplicity: Rein in your investment costs.

By favoring low-cost funds over high-cost alternatives, you can dramatically increase your chances of having a secure retirement.

A 401(k) of low-fee funds will grow faster than a 401(k) with higher fees.

Nest Egg at 65 -

Expenses High Moderate Low Ultra-low	1.5% 1.0% 0.5% 0.25%	Nest Egg $663,600 $732,400 $809,700 $851,800

Note: Assumes a 30-year-old earns $40,000 a year and gets a 3% annual raise.
Sources: T. Rowe Price and MONEY research.”
Walter Updegrave, Money Magazine, 12/17/04

Cost damage is even more dramatic in retirement. Consider a person in retirement who has accumulated a $1,000,000 nest egg and withdraws $40,000 a year for living expenses. He also pays 2.0% in fees and fund expenses per year for maintaining his assets. Two percent is fairly typical for large full-service brokerage houses. But that’s 2% of all he owns, which equals $20,000 per year. So every year, on top of the $40,000 he takes out to spend, another $20,000— or 50% more—is lost to unnecessarily high expenses.

The costs come out every year, even if nothing is withdrawn at all, and even if the investments lose money. Over 30 years six hundred thousand would be lost to expenses. The portfolio has to have returns equaling the withdrawals plus the costs just to break even. That’s an awful lot to ask with a portfolio that isn’t being pumped up with new money.

Performance can come and go, but costs are forever. Imagine someone saying invest with me and I’ll take half your retirement nest egg for my fee. An exaggeration? I think you can clearly see that it is not.

In the following chart, Mr. Updegrave points out how lower expenses increase the odds of retirement funds lasting your lifetime.

"ODDS OF SAVINGS RUNNING OUT

Expenses high moderate low ultra-low	1.5% 1.0% 0.5% 0.25%	Odds 31% 23% 16% 13%

Note: Assumes 7% expected annual return before expenses, initial withdrawal of 4%, which is increased 3% annually for inflation.
Sources: T. Rowe Price and MONEY research."
Walter Updegrave, Money Magazine, 12/17/04

Taxes
Tax costs seem to get even less respect than fund costs. Many investors use the phrase, “don’t let the tail wag the dog” To which, Duncan Richardson, chief equity investment officer at Eaton Vance Management in Boston, adds this caveat: "It's not like the tax tail is this cute, little puppy dog tail," he said. "It's like an alligator's tail. Ignore it to your peril.

Investors tend to dismiss taxes because they don’t directly see the impact of tax costs in their fund returns. The taxes are paid out of another pocket, income tax, and somehow the connection isn’t associated with the cost of owning tax-inefficient funds in taxable accounts. The fact is that taxes can reduce returns by as much as twice the fund’s expenses. Managing tax costs with careful planning can increase returns significantly.

According to a study by Joel Dickson and John Shoven, "Taxes and Mutual Funds: An Investor Perspective" in James M. Poterba's (ed.) "Tax Policy and the Economy" as much as a quarter of a mutual fund investors' annual returns are consumed by the taxes payable on dividend and capital gains distributions.

And from the Mutual Fund Center, "Mutual Fund Costs," at MotleyFool.com: "Over time, the compounding effects of an average equity return of 10% being reduced by one-quarter are truly dramatic. Over the course of thirty years, with 10% annual returns, $10,000 will compound to nearly $175,000. At 7.5% returns, it will compound to $87,500—almost exactly half the amount."

If you want to argue that the tax rates are lower than 25% that’s fine, but it isn’t likely they will remain there.

And author Larry Swedroe cites a study by Charles Schwab: Schwab measured the performance of sixty-two equity funds for the period 1963-92. It found that while each dollar invested would have grown to $21.89 in a tax-deferred account, a taxable account would have produced $9.87 for a high-bracket investor. Taxes cut returns by 57.5%."

The above information demonstrates the need to be aware of how tax-efficient a fund is¹⁴. Funds create taxes by distributing dividends, interest, and passing along to you capital gains from trading stocks in the fund. Short-term capital gains and interest are taxed at regular income rates. Long-term capital gains and most dividends are currently taxed at 15%. Funds vary in how much taxable income they generate. Funds that return interest or significant dividends and funds that have high turnover are usually considered tax-inefficient.

Funds that are not tax-efficient should be held in tax-deferred accounts. There are funds that are naturally very tax-efficient like the total market index and there are funds that are purposely managed to be tax-efficient. These types of funds are best used in taxable accounts.¹⁵

Here is author Taylor Larimore’s list of securities in approximate order of their tax-efficiency (Least tax-efficient at the top.):

Hi-Yield bonds
Taxable bonds
TIPs
REIT stocks
Stock trading accounts
Balanced funds
Small-Value stocks
Small-Cap stocks
Large Value stocks
International stocks
Large Growth stocks
Most stock index funds
Tax-Managed funds
I-Bonds and EE bonds
Tax-Exempt bonds

More on tax efficiency and mutual funds:
http://www.slate.com/id/2139671/
http://www.bogleheads.org/wiki/index.php/Principles_of_Tax-Efficient_Fund_Placement

Suffice to say that costs are a corrosive element in investing and the effect is compounded over time. Remember the compounding effect of returns? Well, you get the same compounding with costs. The larger your assets become and the longer the time, the more costs will take their toll. The more you can trim costs, including the taxes you'll have to pay, the better your returns will be. In a nut shell, it’s really about investing as efficiently as you can. Don't waste returns.

Notes

14: For information on tax-efficiency, see Morningstar’s Mutual Fund "Quotes/Reports" search box, and then click on "Tax Analysis"
15. T. Larimore, M. Lindaur, M. LeBoeuf, The Bogleheads' Guide to Investing, Ch 10

On to Chapter 6

2006-02-08T08:50:00.000-08:00

Chapter 9
On Your Own Or Hire An Advisor?

Jack Brennan in his book, Straight Talk on Investing says, "Remember, it's in the interest of many financial services companies to make you think that investing is difficult."

While Mr. Brennan’s statement is true, many recent news items and magazine articles have noted that Americans on average are not saving enough. And many of those who are saving and investing aren’t doing a very good job of it. Investing isn’t rocket science, but while knowing the right way to go about it is one thing, actually doing it right may be quite another.

If you are just starting out and you haven’t accumulated a large asset base, you probably do not need advice. However, if you are not disciplined, then you might need someone to keep you on track.

If you have accumulated a hodgepodge of investments in various places, you may need some help in sorting things out. There is also a large percentage of people who simply do not want to mess with finance. Before you decide one way or the other, evaluate your own situation and personality.

Jonathan Clements in a Wall Street Journal article comments “If you want to see the greatest threat to your financial future, go home and take a look in the mirror."

Jane Bryant Quinn in The Washington Post gives a similar warning “The green—in our eyes and in other peoples wallets—brings out the worst in us. I don’t mean morally, I mean our worst instincts as investors. We think we make rational decisions. More often, we veer from hope to fear and back again, with out putting our brains into gear at all.”

Investor, Know Thyself
Do you need an advisor? You now know that building a good portfolio is not difficult, but there may be unseen hazards awaiting the unsuspecting investor. Ask yourself the following questions:

* Am I impulsive?
* Do I jump to conclusions?
* What will I do when markets inevitably go against me?
* Do I have the temperament to act without panic?
* Do I second-guess myself?
* Do I have the time to oversee my investments?
* Can I view my situation objectively?
* Can I stay with the plan through thick and thin?
* Am I too competitive?
* Do I have the ability to see and adapt to life and goal changes?

Any of these traits can cause behavioral mistakes which cost money, but mistakes are generally made by investors who do not know the fundamentals. Knowing what you should and should not do goes a long way in overcoming natural tendencies.

Belsky and Gilovich in "Why Smart People Make Big Money Mistakes” suggest that when we consider important financial decisions, instead of asking knowledgeable friends or professionals what they think about the changes we are considering, ask them what they think about the process used to make the decision. It is far more revealing.

A good advisor may save an investor from making major errors, which would more than justify the added expense. So, there are very valid reason to use an advisor. But then, the investor needs to avoid another major mistake—choosing the wrong advisor.

If you decide you need professional guidance, there are two ways to get it. One is to put your assets under management (AUM). The other is to manage your own investments but consult with an advisor occasionally on an hourly basis to ensure you are on the right track.

Here are the general ways advisors are compensated:

Commission only: No direct charge for financial planning or investment advice. Recommendations consist of investments and financial products that have commissions or fees that will come out of your investment.

Fee-based or fee and commission: A fee is charged for financial planning or investment advice. Recommendations consist of investments and financial products that have commissions or fees that will come out of your investment.

Salaried: No direct charge, but incentives and awards are often provided in addition to the salary when certain financial products are purchased based on the advisor’s recommendations. Recommendations may also include investments and financial products that charge commissions or fees.

Fee only: Charges an hourly fee for consultation or a percentage of your assets if the advisor manages your investments. Recommendations consist of investments and financial products that assess few, if any, commissions or fees. The advisor receives no commissions; his or her only compensation is the fee you pay directly.

Choosing An Advisor
The great paradox of using an advisor is that you must know some basics in order to evaluate the advice, and once you do, you also know enough to consider doing your own management.

If you have gotten this far through the primer, you are already a more knowledgeable investor. You now have some sense of what proper investing fundamentals are, which means you have some defense against really bad advice. The professional advice you receive may or may not be in your best interest, but from what I’ve seen, you are far more likely to get biased or even harmful advice. Unfortunately, because of extremely loose industry standards, it isn’t easy to find an advisor who is qualified and one you can trust.

What comes to mind when you hear the terms financial planner, financial advisor, investment counselor or wealth manager? You might be surprised to learn that these titles mean absolutely nothing. Anyone can use such titles and no training, education or experience is required. The Financial Institution Regulatory Authority (FINRA), formerly NASD, does not recognize these generic titles.

Here is some enlightenment from Chartered Financial Analyst (CFA), Rick Ferri: “The financial industry plays the game like no other. Every advisor calls himself something that makes him seem like an expert, but few people are. At brokerage firms, everyone is a Vice President. If they are not a VP, they are either very new or on their way out the door. In addition, everyone calls himself or herself a Financial Consultant, Financial Advisor, Financial Coach, Retirement Specialist, or some other nonsense title that means nothing. These are all self-appointed titles, and they can change with the wind.”

In the section on costs you saw how high costs and commissions can really cut returns. The type of advisors who hold no useful credential almost always promote high cost commissioned products. These are the high profile guys. They're the ones who advertise heavily and aggressively look for your business. They promote through “free” seminars, dinners, mailing campaigns and cold calls. Friends and business acquaintances frequently recommend them simply because they’ve met them through business associations, and they don’t know any better. You don’t have to look for these advisors; they will find you!

High costs and commissions are to be avoided as they are silent wealth killers. But, an even greater danger is getting advice that can wipe out your assets. Poor recommendations and uncontrolled risk often result from a combination of lack of skill and self-interest.

I have painted a pretty bleak picture of commissioned and fee-based advisors, so it's only fair to say that there are some advisors who have high ethical standards, are knowledgeable, and try to provide fair service. You can greatly increase your odds of finding a good advisor, though, if you look for CFP or CFA credentials.

Bruce Miller, CFP clarifies, Real Certified Financial Planners (CFP) are bound by something called the 'brochure rule', that requires us to immediately disclose lots of information to a prospective client...including from whom and how much we are paid, even if by commissions. This is done by contract before any data collection or advising is done.

Brokers and other salesmen are specifically exempt from this rule as described in the 1940 Investment Advisors Act, unless they received direct compensation for advisory services, which they never do. In addition, the advisors ADV II form should be clean (no present, pending, or past disciplinary actions). The prospective advisor must offer you a copy of his/her ADV II, as required by the SEC.”

What Mr. Miller said about brokers was true, but recent changes have improved things a bit. Now, any advisor who has discretionary power to trade (the normal contract set up in fee-based managed accounts) must be a registered investment advisor (RIA) and must carry fiduciary responsibility.

That’s an improvement, but the RIA certification is a far cry from a CFP certification. The RIA requires only a home study course with one final test.

Advisors who manage accounts without full discretionary power (need the client’s approval for trades) are held to a lesser standard. And those using commission are only held to what’s called suitability standards. That standard clearly is not fiduciary responsibility.

One major point to all this is commissioned advisors still hold no binding commitment of fiduciary responsibility to their clients. The new ruling has shifted fiduciary duties from the individual to the type of account held. It’s confusing, but still better than it was.

And this is what AARP had to say in their July 2006 online magazine:
"Fiduciary” means that the person working for you owes you the highest possible duty of care and loyalty, so that a relationship of trust and confidence exists between you and the planner. While you may think that this sort of trust and confidence will naturally exist, a fiduciary relationship usually depends on the facts and circumstances of a particular situation.

Most brokers do not want to accept fiduciary responsibility and many are now converting discretionary, fee-for-services accounts to other types. That usually means if you are in another type of account you are truly in a “buyer beware” relationship because you are assumed to be knowledgeable enough to watch out for yourself when it comes to investments.

This situation also means that by using brokers and the wrong kind of accounts you are not only opening yourself up for expensive, biased advice, you are also giving up an element of protection. In a dispute, you will receive almost no help—you have no leverage—when using a broker unless he clearly carries fiduciary responsibility. With CFPs, you do have leverage against flagrant mishandling of assets. Here is an article on a recent court ruling concerning advisors, brokers and fiduciary responsibility:

http://www.reuters.com/article/businessNews/idUSN15253920070530

This link provides the definition of fiduciary responsibility as defined by The National Association of Personal Financial Advisors (NAPFA):

http://www.napfa.org/about/FiduciaryOath.asp

Author Larry Swedroe sums up the advisor dilemma this way, “Sometimes you get what you pay for, and sometimes you pay for what you get.”

In the strictest sense, there is a distinction between a financial planner and an investment advisor. Some planners do both, but you don’t have to find one that does. It’s entirely reasonable to hire a planner to prepare a plan, and an investment advisor, who is not a planner, to manage your assets. Some people feel this provides more flexibility and completely eliminates conflicts of interest.

The following is again from CFP, Bruce Miller:
There are two screening factors to consider in looking for an advisor. This won't necessarily guarantee you'll get more in investment return than what you spent, but will certainly increase the odds in your favor:

1. Credentials. If investment advice is what you seek (presumably to provide a sustainable retirement-life income to supplement Pension + Social Security), then the CFA, CFP and/or CPA credential will help to insure that formal training has been achieved.

2. Method of compensation. Fee-Only will minimize the potential conflict of interest. Fee-Based may reduce the conflict, but compensation by commission ensures it. Whether you rule out the later is up to you, but if you elect to speak with those paid exclusively on commission, make sure you know of what you speak.

Sometimes the best you can do is to find a planner who doesn't have a compensation plan that would seem to be at odds with your best interests. And if you have a planner who has decided that 'his/her own best interests are served by consistently providing a quality plan to his/her clients', that is probably as good as it gets.

Once you find several credentialed advisors in your area, call and ask them what they specialize in. Tell them what your approximate goals are and if they think they'd be able to assist you. I recommend you then set up personal interviews with at least 2.... 3 is better.

When you do meet, like a visit to your doctor, they should ask questions, listen and take occasional notes. You should do most of the talking. At the end of 30 minutes, they should be able to clearly summarize your position and recommend a general course of action. They should have no hesitation in encouraging you to think over their general recommended approach and their estimated cost range. Any talk of financial products or recommended specific solutions, or even the slightest pressure to sign an agreement at the end of this first meeting is a bad sign and suggests you should go elsewhere.”

Two links for finding an advisor:

http://www.napfa.org/consumer/index.asp

http://www.garrettplanningnetwork.com/index.asp?tohome=yes

Note: do not assume that just because an advisor is listed that he/she will meet all your requirements. Always ask the right questions. Some CFPs have been known to use the designation but not the intent.

One other option is the large mutual fund companies themselves. The fees seem to be competitive, and if you are opening a large account, the fees may be reduced or waived. T. Rowe Price, Fidelity and Vanguard are three large, respected companies who are now offering advisor services. Recommendations will be from the company you go with of course, but these three companies offer a wide variety of funds so choices should not be a problem.

Some questions to ask potential advisors;

1. Are You a Registered Investment Advisor under the Investment Advisors Act of 1940?
What are your qualifications? Licenses, certifications, regulatory agencies. What organizations, affiliations. How much experience?

2. Do you accept fiduciary responsibility?

3. Please provide a copy of your most recent and accurate disclosure form.
ADV-II (Registered Advisor), U-4 (Broker / Dealer)

4. What services do you offer?
How many clients, what type of clients, minimum asset requirements?

5. Are you independent of financial-product sponsors?
Brokerage firms, insurance companies, banks. Do others you work with or recommend provide you with benefits for your recommendations?

6. What approach to planning and investing do you favor?
Stocks, mutual funds, what kind of funds, annuities? Note: The advisor’s approach and risk management style should be in line with yours.

7. Will you be the only person working with me?
In the office, outside professionals?

8. How much do you typically charge and how are your fees applied?
Will you provide a written statement of all fees, including direct fees and fees paid to other firms or organizations? How will I pay you for various services?

Get an agreement, including costs, in writing for services that will be provided. It may be a good idea to copy these questions and send them before you meet with potential advisors. That will save you and the advisors some time. And it will send them a message that you know what you're doing.

Be leery of any advisor who suggests annuities, with the exception of low-cost single payment immediate annuities (SPIAs) . Avoid wrap accounts, separate accounts, limited partnerships, private real estate trusts, leveraged funds, equity-indexed annuities, insurance products, or any products the advisor tells you can’t lose money. Never hire an advisor that says you don’t pay him—the fund company pays him.

If you hire an advisor, remember he or she works for you.

On to Chapter 10

2006-02-08T08:32:00.000-08:00

Chapter 10
Final Thoughts, References, Glossary

While this little investment guide touches on proper investment fundamentals, it isn’t intended to cover all you need to know. It is more of a map rather than the destination itself.

I hope I have provided enough to give you an idea of the mountain of research, data and facts that exists on the subject - information that you won’t find by asking an industry that prefers you remain in the dark. I also hope you now have developed a warning radar for detecting information, suggestions and advice that are in conflict with the investing principles I’ve brought to your attention.

Don’t overestimate your abilities. “Control what you can - Asset allocation, diversification, and costs.”
From Ralph Wanger, Acorn funds.

Investing in stocks is a way to generate future income that is better than you can get without taking risk. Settle on a risk/reward measure that will help you achieve your goals while protecting what you’ve accumulated, not one designed to best the market average.

There is no hurdle you need to jump. Don’t try to beat the market, but rather balance risk against a reasonable return. Investing is not a competitive sport—don’t get fancy, don’t listen to TV or magazine hype—what Jane Bryant Quinn calls “investment porn.” Ignore temptations to go after hot funds or choose funds based on recent past performance.

“If stock returns came from history books, then the wealthiest people would be librarians.”
Warren Buffett

“Managing your money is about the unglamorous task of being a defensive lineman, not the star quarterback.”
Ben Stein, Phil DeMuth - "Yes, You Can Time The Market"

Don't begin by looking at funds. Do a risk analysis and choose an allocation first, then figure out how you want to diversify your investments - large caps, small caps, international, REITs, value, blend and growth. Only then should you consider funds.

If you're just starting out, you may not enough to invest to meet the fund's minimum investment in every category. If not, then look for funds called target retirement funds, LifeStrategy funds, or other funds that give you exposure to several funds in one. Also look at balanced funds that contain both stocks and bonds.

If you have already accumulated a larger portfolio, the process is the same. But you might wish to choose individual funds to fill your diversification slots.

And One Last Time:
The best way to beat the average investor, professional or otherwise, is to save regularly, avoid mistakes, keep your costs low (including taxes), diversify, and stay the course.
Taylor Larimore

The most important investment a person can make is in education.

Notes

1. Harry Markowitz, "Portfolio Selection," 1952.
The fundamental core of modern portfolio theory, (MPT)
2. Vanguard Group study, "Use Asset Allocation to Build a Better Portfolio, 2003."
3 Frank Armstrong, Investing During Retirement, Part II Constructing the Investment Policy, www.Brill.com
4. Larry Swedroe, from the book, "What Wall Street Doesn't Want You to Know."
5. Daniel Kahneman and Amos Tversky, “Prospect Theory”, 1981
6. Frank Armstrong, "Investment Strategies for the 21st Century", Ch.6, The Asset Allocation Decision, www.Brill.com
7. Paula Hogan, CFP
8. Larry Swedroe, "Explaining the Value Premium," 2/2002, www.indexfunds.com
9. For information on closed-end funds, see www.closed-endfunds.com
10. See Internet discussions such as Morningstar's Mutual Fund forum, www.Morningstar.com
11. Add a fund name or ticker symbol to Morningstar's Mutual Fund "Quotes" box, and then click on "Risk Measures” Measures." www.Morningstar.com
12. Gus Sauter, "Vanguard Chief Investment Officer Discusses State of Indexing,'" 1/25/2005, www.Vanguard.com
13. Walter Updegrave, "Rebalancing Act," 11/2003, www.money.cnn.com
14. For information on tax-efficiency, see Morningstar’s Mutual Fund "Quotes/Reports" search box, and then click on "Tax Analysis"
15. T. Larimore, M. Lindaur, M. LeBoeuf, The Bogleheads' Guide to Investing, Ch 10

Where to get more information

Good First Books
"The Bogleheads' Guide to Investing" by Taylor Larimore, Mel Lindaur and Michael LeBoeuf
"The Little Book of Common Sense Investing" by John Bogle
"All About Asset Allocation" by Rick Ferri
"The Coffeehouse Investor" by Bill Schultheis
"The Only Guide to a Winning Investment Strategy You'll Ever Need" by Larry Swedroe
"The Informed Investor" by Frank Armstrong

Behavioral Finance
“Why Smart People Make Big Money Mistakes” by Belsky and Gilovich

Books with More Depth
“John Bogle on Mutual Funds” by John Bogle
“Common Sense on Mutual Funds” by John Bogle
“Four Pillars of Investing” by William Bernstein
“What Wall St. Doesn’t Want You to Know” by Larry Swedroe
“Random Walk Down Wall Street” by Burton Malkiel
“The Intelligent Asset Allocator” by William Bernstein

Online Books

“Investing for the 21st Century” by Frank Armstrong, www.Brill.com/21st

“Serious Money, Straight Talk About Investing for Retirement” by Rick Ferri, www.psinvest.com

For General Information on Investment Basics
www.moneychimp.com
www.investopedia.com
www.Diehards.org (general information, recommendations, discussions based on MPT)
www.coffeehouseinvestor.com
www.jasonzweig.com/ (articles)
www.Bogleheads.org/wiki

Advanced Information and articles on Investing
www.travismorien.com (many excellent articles)
www.altruistfa.com/readingroom.htm (many good articles)

For General Information on Mutual Funds
www.bogleheads.org (Reference Library)
www.morningstar.com (fund information and leaning center)
www.troweprice.com
www.vanguard.com
www.Fidelity.com
www.fundalarm.com
www.indexuniverse.com/index.php

For Advanced Information on the portfolio selection method (modern portfolio theory)
www.efficientfrontier.com/index.shtml (theory and practice)
www.homepage.mac.com/j.norstad/finance (academic articles)

For Information on Exchange Traded Funds (ETFs)
www.indexuniverse.com/index.php
www.nasdaq.com
www.ishares.com

For Information on 401k and IRA
www.401khelpcenter.com (401k help)
http://www.irahelp.com/ (IRA help)
http://www.403bwise.com/

For Information on Financial Planners
www.napfa.org/index2.htm
www.cfp-board.org
www.garrettplanningnetwork.com/files/f_splash.htm
www.aimr.com

For Information on Retirement Withdrawals
http://bobsfiles.home.att.net/retireCH.html

Glossary

For a complete glossary try Investopedia

4x25 - A portfolio composed of equal weightings of large cap, large value, small cap, and small value

5x20 - same as 4x25 except REIT is added.

5%/25% rule - formula used to determine when to rebalance a portfolio. Rebalance when asset value moves more than 5%. For allocations less than 20%, rebalance when allocation moves more than 25%. Example: When a 10% allocation moves 25% it will be 12.5% of the portfolio.

Active Management - Mutual fund managed by someone who selects individual stocks or other assets in an attempt to meet specified performance goals.

AMT - Alternative Minimum Tax

Asset Allocation - Percent of money put into major asset classes of stocks, bond, cash

Asset Classes - A group of assets with similar risk and reward characteristics. Cash, debt instruments, real estate, and equities are examples of asset classes. Within a general asset class, such as equities, there are more specific classes such as large and small companies and domestic and international companies. Large growth, Small value, Emerging markets, foreign value, Reits, etc. are different classes of assets. Asset classes are used in diversifying a portfolio

AUM - Assets Under Management

Beta - Indicator of a fund’s movement sensitivity in relation to an index such as the S&P500. See Morningstar's definition in Ratings and Risk section of Quotes. Look at bottom of page for “show data definitions.”

Bogie (Bogy) - A benchmark, usually an index, used for tracking performance

CAGR - Compound annual growth rate

Cap – Shorthand for capitalization. A measure of how large or small a company is.

CAPM - Capital Asset Pricing Model

CMA - Cash management account

CRSP - Center for Research in Security Pricing. Located at University of Chicago. CRSP divides market capitalization into deciles. 1-2=large cap, 3-5=mid cap, 6-8=small cap, 9-10= micro cap. Also divides deciles into style. 1-3= growth, 4-7=core, 8-10=value

Couch potato portfolio - #1 - 50% Total Stock Market (TSM)(VTSMX), 50% Total Bond Market (TBM) (VBMFX). #2 - 75% TSM, 25% TBM

Coward’s Portfolio - Author Larry Swedroe usually refers to the coward’s portfolio as a portfolio of equally weighed asset classes. Takes no “bet” on over weighting any one asset class. Wm. J. Bernstein has proposed several other “cowards portfolios”. See www.efficientfrontier.com

DCA - Dollar Cost Averaging - Method of investing in the market by making regular periodic investments.

DFA - Dimensional Fund Advisors. Investment management company that applies academic research teachings to asset management.

DI - Debt instrument

Diversification - spreading money into different investments in order to manage risk

Dunn’s Law - States that if an asset class does well, an index fund in that class will outperform non-indexed funds of the same class.

EAFE - Europe, Australasia, Far East

Efficient Frontier - From modern portfolio theory (MPT). A certain combination of holdings (asset classes) that results in the maximum possible return for a given level of risk is called “efficient.” A graph plotting different risk levels results in a line of best possible results. That line is called the “efficient frontier.” Nicely explained in Frank Armstrong’s book “Investing for the 21st Century.”
Online at www.brill.com/21st

EM - Emerging Market

EMH (EMT) - Efficient Market Hypothesis or Efficient Market Theory - Proposed by Eugene Fama. EMH says that an investor cannot expect to improve returns through technical analysis, fundamental analysis, or by other means because all relevant information that might influence the price of a stock is immediately known and already priced in. Furthermore, the next piece of information received about the stock could be either positive or negative; in other words random (unpredictable).

ETF - Exchange Traded Fund. Like a mutual fund in that it contains many stocks, but it trades like an individual stock. Can be purchased or sold any time during trading hours.

ER- Expense Ratio. The annual fee charged by a mutual fund company to run the fund.

I Bonds - Inflation Bonds. A bond that provides both a fixed rate of return and an inflation protection component.

Index Fund - A passively managed fund that seeks to replicate the performance of a particular index (such as the Wilshire 5000, the S&P 500, or the Russell 2000) by buying all (or a representative sampling) of the securities in that index, in direct proportion to their weight, by market capitalization, and then changing them only when the index itself changes.

Investment pornography - Advice on market or securities values that is designed to titillate, stimulate, and excite you into action but has no basis in reality.

IPS - Investment Policy Statement

ishares - Exchange traded index funds marketed by Barclay’s Global Investors.

Load Fund - A mutual fund which has a sales commission of some type.

M* - Morningstar

MM - Money Market

MPT - Modern Portfolio Theory. Portfolio risk can be reduced for a given rate of return by diversifying with two or more investments that react differently from one another when the market moves up or down (low correlation i.e., low co-variance).

MSCI - Morgan Stanley Capital International

MVI - Multiple variable income. Method of withdrawing from a retirement account.

MVO - Mean Variance Optimization. Math program used to determine correlation of asset classes

NAV - net asset value. The share price of a mutual fund

No-Load - Mutual fund with no sales commissions attached.

Passive Management - Management of a mutual fund by NOT actively trading stocks or other assets in an attempt to outperform the market. Passive management is used with index funds.

P/B - Price-to-book Ratio. An indicator of a fund’s “value” content. The lower the ratio, the more toward value a fund is. See M* definition in portfolio section of Quotes Report. Look at bottom of page for “show data definitions”

P/E - Price to Earnings Ratio. See M* definition in portfolio section of Quotes Report. Look at bottom of page for “show data definitions.”

R² - Compares a fund’s movement against its benchmark index. A number of 100 means that the fund tracks its benchmark perfectly. See M* definitions in ratings and risk section of Quotes Report. Look at bottom of page for “show data definitions.”

RE- REIT - Real estate Investment Trust.

RTM - Reversion to the mean: A tendency of a fund that has been over- or under-performing to return to its historical average.

SD - Standard Deviation: Measure of a fund’s volatility. See M* definition in Ratings and Risk section of Quotes Report. Look at bottom of page for “show data definitions.”

S&D - Slice and Dice. An alternative to using Total Stock Market. Simple S&D uses large cap, large value. small cap, small value.

S&P 400 Index: A market cap-weighted index of 400 mid-cap stocks.

S&P 500 Index: A market cap-weighted index of 500 of the largest U.S. stocks.

S& P 600 Index - A market-cap weighted index of 600 small-cap stocks.

Spiders (SPDR) - Exchange traded funds that replicate the various Standard and Poors Indices.

TBM - Total Bond Market Index (VBMFX)

Ticker Symbols - Letters identifying a mutual fund or stock (See Vanguard)

TIPS - Treasury Inflation Protected Securities. A bond that receives a fixed stated rate of return, but also increases its principal by the changes in the Consumer Price Index.

TM - Tax Managed

TSM - Total Stock Market Index (VTSMX). Tracks the Wilshire 5000

Turnover – Transaction activity (buying and selling) that occurs in a mutual fund. Actively managed funds often have higher turnover than passively managed (index) funds. A fund with higher turnover will typically generate more capital gain distributions at year end.

Value - Most people associate value with funds that have lower than average P/E and P/B and overall lower risk than growth funds. The academic definition is quite different. It refers to funds that hold securities of companies that are indeed riskier because they are distressed and have high business risk.

WEBS - World Equity Benchmark Securities are exchange traded funds that track various foreign country indices such as the U.K., German, and French equivalents of the S&P 500 Index.