Your Money_ The Missing Manual Part 19

2000.

10.14% .

2005.

3.00%.

1996.

22.87%.

2001.

12.06% .

2006.

13.62%.

1997.

23.74%.

2002.

24.66% .

2007.

4.24%.

1998.

30.95%.

2003.

25.28%.

2008.

40.97% .

1999.

19.81%.

2004.

10.59%.

2009.

27.76%.

NoteThe S&P 500 is a stock-market index, which is like a thermometer: It's a single number that gives you a quick reading on the value of a group of stocks. There are all sorts of indexes, including the Dow Jones Industrial Average, the NASDAQ Composite, and the S&P 500. The latter tracks the performance of 500 of the largest U.S. stocks.

As you can see from the table, stocks soared during the late 1990s' bull market, fell during the early 2000s' bear market, and had trouble deciding what to do during the past 5 years. And note that while the S&P 500 index returned an average of 6.07% during the 15 years between 1995 and 2009, not one of those years actually produced returns near the average (2007 came closest, but that was still nearly 2% below the mark).

These fluctuations mess with the average investor's mind: He panics and sells when prices drop, but then falls victim to what Alan Greenspan called "irrational exuberance" (basically, getting way too excited) and buys when prices soar. That's a sure way to lose money. Smart investors understand that average isn't normal, so they brace themselves for fluctuations and try not to buy and sell on impulse. (You'll learn more about smart investor behavior on Being on Your Best Behavior Being on Your Best Behavior.) The future is not the past Overall, the value of the stock market increases with time. But over the short term, market movements are wild and unpredictable. During any given year, the stock market might return anywhere from 50% to +100%. Over long periods of time-think decades-the market is less volatile and its returns are smoother. Looking at 30-year periods, the U.S. stock market is likely to produce growth between 515%.

In the short term, other types of investments can and do offer better returns than stocks. During any given 1-year period, stocks will outperform bonds only 60% of the time. But over 10-year periods, that number jumps to 80%. And over 30 years, stocks almost always win: Siegel found that "the last 30-year period in which bonds beat stocks ended in 1861, with the onset of the U.S. Civil War." (For more on this concept, see this article at Get Rich Slowly: http://tinyurl.com/GRS-stock-history.) There's just one problem: Past performance is no guarantee of future results. This is true both for individual stocks and the market as a whole. Just because the market has had average annual returns of 10% since 1926 doesn't mean it'll do so in the future. (In fact, many smart folks believe returns will be modest over the next few decades.) Still, if history is any indication, investing in stocks is the best way for you to meet your financial goals. As long as businesses can make a profit-even when they borrow money-stocks will outperform bonds and inflation. All the same, smart investors hedge their bets and manage risk by adding a healthy dose of other types of a.s.sets, especially bonds.

But what exactly are stocks and bonds, anyhow? Let's take a brief detour to learn about the tools of investing.

NoteRisk and return are inseparable. If you want high returns, you have to accept that you'll sometimes suffer big losses, which may affect your future plans. If you're risk averse-not willing to risk losing money-you can find "safe" investments, but they'll offer low returns so it'll be more difficult to meet your goals.

The Tools of Investing a.s.suming you're an average individual investor, you've got two primary tools at your disposal: stocks and bonds. (Other a.s.set cla.s.ses include real estate and commodities like gold and oil-but investing in these isn't appropriate for the average Joe.) You can buy stocks and bonds directly, or you can buy collections of them called mutual funds. You're probably vaguely familiar with these terms, but it never hurts to do a quick review.

Stocks and Bonds Let's say your best friend Mary wants to open a pizza parlor, but she needs some money to do it. She comes to you with a business proposal that offers you two options. Here's the first: - For $10,000, you can own 10% of the restaurant. In return, she'll pay you a piece of the profits every 3 months. These dividends don't amount to much (maybe a few hundred bucks a year), but they'll give you a reliable stream of income. Plus, you can sell your share of the owners.h.i.+p (your stock) anytime.If Mary's business is going gangbusters and makes good profits, you might be able to sell your stock to your friend Rhoda for $15,000 or even $20,000-much more than it cost you. But if your neighbor Phyllis opens another pizza parlor next door, it'll probably dent Mary's business. In that case, you might only be able to sell your stock for $8,000 or even $5,000.

When you buy stock, you're buying small slices of equity (owners.h.i.+p) in a business. As the company goes, so goes your investment: There's always the risk that the company will make a mistake, face stiff compet.i.tion, or that the public's whims will change. When this happens, the value of the stock can drop permanently or the company can go out of business.

This sort of uncertainty might scare you. Sure, the constant stream of dividends would be nice, but you don't like the idea that the value of your investment will jump around all the time-or maybe even drop to zilch. In that case, Mary gives you another option: - If you lend Mary $10,000 for 5 years, she'll pay you 3% interest, or $300 a year. And at the end of the 5 years, she'll repay your $10,000 loan (or bond). What's more, you can sell this loan just like you could sell your stock. For example, if you decide you need the $10,000, you can sell the loan to your friend Rhoda, but she may not want to pay you the full $10,000.Again, imagine Phyllis opens a pizza parlor next door to Mary's. She, too, is asking people to lend her money, but she's offering to pay 8% over 5 years. If Rhoda can buy an 8%, 5-year bond for $10,000, why would she pay you the same amount for a 3% bond? Instead, she might offer to buy it from you for $7,500. On the other hand, if Phyllis is only paying 1% interest on the loans she's taking, Rhoda might be willing to pay a little extra for your bond, since you're offering the best deal in town.

When you buy a bond, you're lending money to a business (or government). As with stocks, there's still a chance that the company will go out of business and you'll be left with nothing, but there are ways to reduce this risk. You could buy just the highest-rated bonds, for example, or only government bonds. (Government bonds are generally considered safer than corporate bonds, but there are exceptions.) NoteBonds are given grades-or ratings-based on how likely they are to be repaid. It's difficult for individual investors to buy bonds directly. For most folks, it's best to stick with bond mutual funds (Mutual Funds). To learn more about how bonds work, see http://tinyurl.com/GRS-bonds or read or read Chapter7 Chapter7 of of Personal Investing: The Missing Manual Personal Investing: The Missing Manual.

Though the prices of both stocks and bonds fluctuate based on economic and market conditions, stock prices are far more volatile: They offer the potential for greater returns-and greater losses. On the other hand, if you own a bond until it matures (that is, until the end of the time period you agreed to), you know what kind of return you'll get.

As you learned in the last section, stocks-as a group-tend to outperform bonds over long periods of time. The challenge is trying to pick which stocks will do well and which won't; even the pros get it wrong much of the time. It's not as easy as it sounds. If investors knew for sure which stock would perform best, they'd dump all their money into it. But they don't know-n.o.body does.

If you own just one stock, your fortunes are wholly dependent on what it does. So smart investors diversify (see the box on Mutual Funds Mutual Funds) and build portfolios containing many stocks and bonds. You could build a portfolio of stocks and bonds yourself, but doing so properly requires a lot of time, effort, and money. For most people, it makes more sense to invest in mutual funds, explained next.

On The Money: Don't Put All Your Eggs in One BasketOne way investors reduce risk is through diversification diversification, which means not putting all your money into one investment, whether it's a stock or bond or something else altogether. By spreading your money around, you smooth out the market's wild ups and downs while getting a similar return on your investment.You can diversify your investments in several ways, including: - Within a.s.set cla.s.ses. The more different stocks you own, the better your diversification. Same goes for bonds. a.s.set cla.s.ses. The more different stocks you own, the better your diversification. Same goes for bonds.

- Among a.s.set cla.s.ses. In general, the movements of stocks, bonds, commodities ( a.s.set cla.s.ses. In general, the movements of stocks, bonds, commodities (The Tools of Investing), and real estate aren't strongly correlated; for example, just because the stock market is down doesn't mean the real estate market will be down, too. The same is generally true of the returns on these a.s.set cla.s.ses-they're normally independent of each other. (But sometimes, as in the recent financial crisis, there's a whole lot of correlation going on!) - Over time. "Risk is also reduced for investors who build up a retirement nest egg by putting their money in the market regularly over time," writes Burton Malkiel in The Random Walk Guide to Investing The Random Walk Guide to Investing. By using techniques like dollar-cost averaging (see All-in-one funds All-in-one funds), you ensure that you're not investing all your money when the market is high.

There are other types of diversification, too. For example, when you buy foreign stocks, you're diversifying by geography.How much should you diversify and how should you do it? There's no one right answer-it depends on you and your financial goals. To learn more about this concept, check out this guide from the U.S. Securities and Exchange Commission: http://tinyurl.com/SEC-a.s.sets.

Mutual Funds Mutual funds are collections of investments. They let people like you and me pool our money to buy small pieces of many investments. There are a lot of benefits to doing this, including: - Diversification. For less than a thousand bucks, you can buy shares in a mutual fund that owns pieces of every company on the stock market. Such broad exposure reduces your risk, and it's something you couldn't possibly achieve on your own.

- Focus. There are over 10,000 different mutual funds available in the U.S. alone. You can find funds that buy stock only in companies that support the environment, or that follow Biblical principles. You can buy bond mutual funds or funds that invest only in Canadian companies. You name it, there's probably a mutual fund for it.

- Professional management. When you own a mutual fund, somebody else does the research and buys and sells the stocks so you don't have to.

Because mutual funds offer these advantages to individual investors, they've soared in popularity over the past 25 years. But they're not without drawbacks. The biggest is cost: With stocks and bonds, you usually pay only when you buy and sell, but mutual funds have ongoing management costs. (You don't pay these costs directly; instead, they're subtracted from the fund's total return.) Some of these costs are obvious, but others aren't.

NoteThe U.S. Securities and Exchange Commission (SEC) has a run-down of various mutual-fund fees and expenses here: http://tinyurl.com/SEC-costs.

One obvious cost listed in every mutual fund's prospectus (the booklet describing the fund) is the expense ratio, which is the mutual fund company's total annual cost for things like advertising and managing the fund. The company pa.s.ses these costs on to investors.

Other costs are subtler; you have to look to find them. For instance, funds are required to reveal their portfolio turnover rates-how often they buy and sell securities (that's the technical term for stocks and bonds)-in the prospectus, but they don't list the costs there. Whenever the fund buys and sells securities, it has to pay commissions and taxes, just as you and I would. Studies show that a 100% annual turnover rate, which is around the average for mutual funds, adds about 1% to the cost of the fund.

Altogether, mutual-fund costs typically run about 2% annually. So for every $1,000 you invest in mutual funds, $20 gets taken out of your return each year. This may not seem like much, but as you'll see in the next section, 2% is huge when it comes to investments. (For more on the importance of costs, see Keep Costs Low Keep Costs Low.) TipTo find how much your mutual fund is costing you, pull out the fund's prospectus. (If you can't find your copy, go to your fund company's website and download it.) For help deciphering the prospectus, check out http://tinyurl.com/GRS-prospectus.

With more than 10,000 mutual funds to choose from, how do you decide which one to buy? The costs of the different funds can help you narrow the field.

The way a fund is managed plays a big role in its costs. Mutual funds can be either actively or pa.s.sively managed. Actively managed funds try to beat the market and earn above-average returns. Some succeed and some don't, but as a whole, all actively managed funds earn the market average. Pa.s.sively managed funds (called index funds), on the other hand, try to match the performance of a specific benchmark, like the Dow Jones Industrial Average or S&P 500 stock-market indexes. As you'll learn in the next section, this makes them a great long-term investment.

Index funds Because index funds try to match an index and not beat it, they don't require much intervention from the fund manager, which makes their costs much lower than those of actively managed funds. In The Little Book of Common Sense Investing The Little Book of Common Sense Investing (Wiley, 2007), John Bogle writes that the average actively managed fund has a total of about 2% in annual costs, whereas a typical pa.s.sive index fund's costs are only about 0.25%. (Wiley, 2007), John Bogle writes that the average actively managed fund has a total of about 2% in annual costs, whereas a typical pa.s.sive index fund's costs are only about 0.25%.

Although this 1.75% difference in costs between actively and pa.s.sively managed mutual funds may not seem like much, there's a growing body of research that says it makes a huge difference in long-term investment results. Other advantages of index funds include diversification (see Mutual Funds Mutual Funds) and tax efficiency. And because index funds have a low turnover rate-as described on Mutual Funds Mutual Funds-they don't generate as much tax liability.

NoteExchange-traded funds (or ETFs) are basically index funds that you can buy and sell like stocks (instead of going through a mutual fund company). To learn more about the subtle differences between index funds and ETFs, head to http://tinyurl.com/YH-etfs.

In Unconventional Success: A Fundamental Approach to Personal Investment Unconventional Success: A Fundamental Approach to Personal Investment (Free Press, 2005), David Swensen writes, "Fully 95% of active investors lose to the pa.s.sive alternative, dropping 3.8% per annum to the Vanguard 500 Index Fund results." In other words, people who own index funds have typically earned almost 4% more each year than those who own actively managed funds. (This long article offers a good summary of the arguments for using index funds: (Free Press, 2005), David Swensen writes, "Fully 95% of active investors lose to the pa.s.sive alternative, dropping 3.8% per annum to the Vanguard 500 Index Fund results." In other words, people who own index funds have typically earned almost 4% more each year than those who own actively managed funds. (This long article offers a good summary of the arguments for using index funds: http://tinyurl.com/dowie-index.) By owning index funds, you can beat the returns of nearly everyone you know. But to do this, you can't let yourself get caught up in cla.s.sic investing mistakes like those described in the next section. The key to successful investing-whether you own index funds or not-is overcoming bad behavior.

NoteIf you're a math whiz and want to see all the calculations and proofs behind why index funds do better than actively managed funds, pick up a copy of Bogle's book or take a look at this short (but dense) paper from Stanford professor William Sharpe: http://tinyurl.com/sharpe-rocks.

Being on Your Best Behavior Investing isn't rocket science; it's easy to understand the methods for reaping good returns. The biggest barrier to making those methods work is human nature. Research shows that when it comes to investing, you are your own worst enemy. In fact, according to the Quant.i.tative a.n.a.lysis of Investor Behavior www.qaib.com) from the research firm Dalbar, Inc., the returns earned by the average investor lag far behind the returns earned by the market as a whole.

Here's a specific example: During the 20-year period ending in 2008, the S&P 500 index returned an average of 8.35%, but the average person who invested in stock-market mutual funds only earned 1.87%, which puts him behind even the rate of inflation (2.89%). In other words, the average investor has underperformed the market by nearly 6.5% over the past 20 years. This "behavior gap"-the difference between overall market returns and individual investors' returns-is devastating to any hope of long-term financial success.

TipFor more about the gap between investor returns and investment returns, visit BehaviorGap.com, where you can download "The Behavior Gap: A Snapshot" (www.behaviorgap.com/the-lab/), which takes a closer look at this phenomenon.

Why do investors underperform the market? Part of the problem is that so many of the mutual funds out there are actively managed. When you pay somebody else to manage your money in one of those funds, you're giving up 12% of your return right from the start.

Psychology and emotions play a huge role, too. Investors tend to be overconfident-they think they know more than everyone else. But according to the 2009 edition of Dalbar Inc.'s study, investors only make the best choice 42% of the time, meaning they're wrong more often than they're right.

Though it can be tough, the best thing you can do to improve your odds of long-term investment success is to admit that you're not likely to beat the market. Your best bet is to try to match the market, and you'll learn ways to do that on Common-Sense Investing Common-Sense Investing. But first, let's look at how to overcome common behavioral barriers that cost the typical investor 6.5% per year.

NoteA study published in the February 2001 issue of The Quarterly Journal of Economics The Quarterly Journal of Economics ( (http://tinyurl.com/PDF-gender) found that men trade 45% more often than women-leading to annual returns 1.4% lower. (And single men are even worse, earning annual returns 2.3% less than single women.) The reason? Overconfidence.

Know Your Goals As you learned in Chapter2 Chapter2, goals are an important part of your financial life, and investing is no exception. One way to reduce mistakes is to invest with a purpose. If you know why you're investing and have a long-term plan, it's easier to avoid making rash decisions that can lower your returns.

Financial advisers suggest you create an investment policy statement, or IPS, which is simply your target a.s.set allocation (see the Note below) and instructions to yourself for how to set and maintain it.

Notea.s.set allocation is the way your money is divided among your different investments; it's just a fancy way of saying "the things you've invested in." The cla.s.sic example is the basic 60/40 split: 60% invested in stocks and 40% in bonds. To learn more about a.s.set allocation, read the SEC's "Beginner's Guide to a.s.set Allocation" at http://tinyurl.com/SEC-a.s.sets. You can learn more here: http://tinyurl.com/GRS-alloc.

In other words, your IPS is a blueprint for your investments. It's a plan to help you build your future. An IPS helps you stay on course instead of trying to take shortcuts (by doing things like chasing hot stocks) or panicking when things fall apart (like during 2008's market crash). By keeping your goals in mind, you can avoid making financial mistakes.

It's easy enough to draft your own investment policy statement. A good place to start is Morningstar's step-by-step guide to creating an IPS (http://tinyurl.com/mstar-ips), which includes a free downloadable worksheet to get you started. If you want help and can afford it, pay a fee-only financial planner to help you develop an IPS. ("Fee-only" means you pay the planner directly and she doesn't get commissions for selling you stuff. For more on hiring a financial planner, see How to open a Roth IRA account How to open a Roth IRA account.) You can also find info on setting investment goals in Chapter2 Chapter2 of of Personal Investing: The Missing Manual Personal Investing: The Missing Manual.

Think Long Term Short-term returns aren't an accurate indicator of long-term performance. What a stock or fund did last year doesn't tell you much about what it'll do during the next decade.

Over the short term, index funds are, by definition, average (see Index funds Index funds). But a funny thing happens the longer you hold onto them: They begin to float to the top of the stack. That's because the "hot" funds don't stay hot year after year-they cool down. So while index funds are usually in the middle of the pack in any given one-year period, they s.h.i.+ne over the long term.