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Copyright©2013byLarryE.Swedroe.Allrightsreserved.ExceptaspermittedundertheUnitedStatesCopyrightActof1976,nopartofthispublicationmaybereproducedordistributedinanyformorbyanymeans,orstoredinadatabaseorretrievalsystem,withoutthepriorwrittenpermissionofthepublisher.
ISBN:978-0-07-180996-2MHID:0-07-180996-1
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Thisbookisdedicatedtofourofthemostimportantpeopleinmylife,my
grandchildren—Jonathan,Sophie,andGracieRosen,andRubyJaneMorris
Contents
Introduction:WhyIWroteThisBook
1.WanttoInvestMoreLikeWarrenBuffett?StartTakingHisAdvice
2.WanttoInvestMoreLikeWarrenBuffett?
StartThinkingLikeHeDoes
3.ShouldYouBeanActiveoraPassiveInvestor?
4.TheNeedtoPlan:ItIsNotOnlyAboutInvestments
5.HowMuchRiskShouldYouTake?TheAssetAllocationDecision
6.HowtoBuildaWell-DesignedPortfolio
7.TheCareandMaintenanceofYourPortfolio
8.ShouldYouHireaFinancialAdvisor?
9.WinningtheGameofLife
Conclusion
30RulesofPrudentInvesting
Notes
Sources
Index
Acknowledgments
Introduction:WhyIWroteThisBook
Eachofmy12booksisaboutwhatIcallthe“scienceofinvesting,”theevidencedemonstratingtheprudent
investmentstrategy.MyOnlyGuidesYou’llEverNeedseriesdealswithstocks,bonds,alternativeinvestments,andthedesigningoftherightfinancialplan.MyWiseInvestingseriesisacollectionofstoriesandanalogiesdesignedtodemonstratethatthewinninginvestmentstrategyisasimple,elegant,andlogicalone.Andbecauseitissosimple,requiringlittle
effort(thoughlotsofdiscipline),itisalsothewinningstrategyinlife.
WhatIhavelearnedfrommyexperiencesisthatnotmanypeoplewilldevotealotoftimetolearnaboutinvestingdespiteitsimportance.Itisdifficulttogetthemtoreada300-pagebookthatcitesdozensofstudies.ThatiswhyIhavewrittenthisbook.
Think,Act,andInvestLikeWarrenBuffettisdesignedtoexplainhowadoptingsomebasicprinciplescanhelpyououtperformthevastmajorityofinvestorsandincreasethechancesofachievingyourfinancialandlifegoals.
Overtheyears,Ihavetalkedtothousandsofpeopleaboutinvesting.Ihavelearnedtherearesome
individualswhocanbesuccessfulinvestorsontheirown.Ifyoubelieveyoufallintothatcategory,Chapter8providesfiveimportantquestionsforyoutoanswerbeforeyoudecidetogoitalone.
Manyothershavefoundgreatbenefitinworkingwithanadvisoryfirm.Forthosewhowanttoconsiderworkingwithanadvisor,
Chapter8alsoprovidesinformationonhowtoperformthoroughduediligenceasyousearchforafiduciaryadvisorwhocantrulyaddvalue,suchasmakingsureyourinvestmentplanispartofanoverallfinancialplanthataddressesestate,tax,andinsuranceissues.
1Wantto
InvestMoreLikeWarrenBuffett?
StartTaking
HisAdvice
Ifinvestorswereasked,“Whodoyouthinkisthegreatestinvestorofourgeneration?,”anoverwhelmingmajoritywouldanswer,“WarrenBuffett.”Iftheywerethenasked,“Shouldyoufollow
theadviceofthepersonyouconsiderthegreatestinvestor?,”youwouldthinkthattheywouldsay,“Yes!”Thesadtruthisthat,whileBuffettiswidelyadmired,themajorityofinvestorsnotonlyfailtoconsiderhisadvicebutalsotendtodoexactlytheoppositeofwhatherecommends.
Todemonstratethetruthofthisstatement,wewill
reviewBuffett’sinvestmentguidanceandseeifpeoplehaveactuallyfollowedit.Wewillreviewhisadviceonthreeissues:
1.Whetheryoushouldinvestinactivelymanagedorpassivelymanagedmutualfunds(suchasindexfunds).
2.Whetheryoushouldlistentomarket
forecasts.
3.Whetheryoushouldtrytotimethemarket.
Activelymanagedfundsattempttouncoverandexploitsecuritiesthemarkethas“mispriced,”buyingthosetheybelieveareundervaluedandavoidingthosetheybelieveareovervalued.Activelymanagedfundsmayalsoattempttotime
investmentdecisionstobemoreheavilyinvestedwhenthemarketisrisingandlesssowhenthemarketisfalling.Incontrast,passivelymanagedfundsarebasicallybuy-and-holdvehiclesthateschewstockpickingandmarkettiming,believingthecostsoutweighthebenefits.Activeinvestorsalsolookto“experts”foraninvestingedge,whilepassiveinvestorsignoresuchadvice.
BeforereviewingBuffett’sadvice,itisimportanttonotethatheknowsthatyoucannotinvestexactlylikehedoes.YoucannotbuyentirecompaniesandincorporatethemintoBerkshireHathaway,norcanyounegotiatespecialdealsduringcrises,whencompaniessuchasGoldmanSachsarewillingtopay“topdollar”tohaveWarrenBuffettinvest.However,you
canfollowhisguidanceabouttherightinvestmentstrategy.AsyoureadBuffett’sadvice,askyourselfifyouhavebeenpracticingwhathepreaches.
Let’sbeginwithBuffett’sadviceonwhichtypeoffundsyoushouldinvestin.
ACTIVEVERSUSPASSIVE
INVESTING
ThefollowingaresomeoftheOracleofOmaha’swordsofadviceonthisimportantdecision:
•“Byperiodicallyinvestinginanindexfund,theknow-nothinginvestorcanactuallyoutperformmostinvestmentprofessionals.”1
•“Mostinvestors,both
institutionalandindividual,willfindthatthebestwaytoowncommonstocksisthroughanindexfundthatchargesminimalfees.Thosefollowingthispatharesuretobeat[emphasismine]thenetresults(afterfeesandexpenses)deliveredbythegreatmajorityofinvestmentprofessionals.Seriously,
costsmatter.”2
•“Overthe35years,Americanbusinesshasdeliveredterrificresults.Itshouldthereforehavebeeneasyforinvestorstoearnjuicyreturns:alltheyhadtodowaspiggybackCorporateAmericainadiversified,low-expenseway.Anindexfundthattheynevertouchedwould
havedonethejob.Insteadmanyinvestorshavehadexperiencesrangingfrommediocretodisastrous.”3
•“Somanyinvestors,brokersandmoneymanagershatetoadmitit,butthebestplacefortheaverageretailinvestortoputhisorhermoneyisinindexfunds.”4
Whatisdifficultformanyinvestorstounderstandisthatindexingworksbecausenotmakinginvestmentdecisions(tryingtopickstocksormutualfundsortryingtotimethemarket)producesbetterresultsthanmakingthem.Ofcourse,nooneonWallStreetwouldeveradmitthat.Remember,WallStreetbenefitsfromthehigherfeesandgreatercommissionsgeneratedbyactivestrategies.
Itneedsyoutoplaythegameofactivemanagementbecausethatisitswinningstrategy.
WenowturntoBuffett’sadviceonwhetheryoushouldpayattentiontoeconomicandmarketforecasts.
THEVALUEOFFORECASTS
ThefollowingisBuffett’sadviceonwhetheryoushouldbepayingattentiontothelatestforecastsfromso-calledeconomicandmarketexperts:
•“Wehavelongfeltthattheonlyvalueofstockforecastersistomakefortune-tellerslookgood.Evennow,Charlie[Munger]andIcontinuetobelievethatshort-termmarketforecastsare
poisonandshouldbekeptlockedupinasafeplace,awayfromchildrenandalsofromgrown-upswhobehaveinthemarketlikechildren.”5
•“Apredictionaboutthedirectionofthestockmarkettellsyounothingaboutwherestocksareheaded,butawholelotaboutthepersondoing
thepredicting.”6
Mostinvestorsfindithardtobelievethattheirlifewouldbebetterwithoutsomuchinformationandthatignoringtheinvestmentnoisewouldimprovetheirperformance.ThisleadstotheconditionIcall“CNBC-itis,”theneedto“tunein.”Whileinvestorsbelievetheyaretuningintovaluableinformation,whattheyare
generallyhearingisnothingmorethanwhatJaneBryantQuinncalls“investmentporn,”andwhatshefeelsare“shamelessstoriesaboutperformancethattickleourprurientfinancialinterest.”7Insteadoftuningin,youshouldbetuningout.
Buffettimploresinvestorstoignoreforecastsbecausetheytellyounothingaboutwherethemarketisheaded.
Researchalsoprovesthis.Thefollowingisabriefsummaryofthatresearch:
•Economists’forecastingskillhasbeenaboutasgoodasguessing.Eventhosewhodirectlyorindirectlyruntheeconomy—suchastheFederalReserve,theCouncilofEconomicAdvisorsandtheCongressionalBudget
Office—haveforecastingrecordsworsethanpurechance.Evenworse,justwhenyouneedtheforecaststobemostaccurate,theyhavebeenthemostwrong.Economistshavenotpredictedtheturningpoints.8
•Therehavebeennoeconomicforecasterswhoconsistentlylead
thepackinforecastingaccuracy.9
•Increasedsophisticationinforecastinghasnotimprovedtheaccuracyofforecasts.10
•Theonlythingthatrelatestoforecastingaccuracyhasbeenfame,andtherelationshiphasbeennegative.Themorefamoustheforecaster,themoreinaccuratethe
forecasts.11
Whydoinvestorspayattentiontoforecasts,ignoringtheevidenceandBuffett’ssageadvice?Myexperiencehasconvincedmethatthisirrationalbehavioriscausedbyanall-too-humanneedtobelievethatthereissomeonewhocanprotectusfrombadthings,suchasbearmarkets.Unfortunately,thereisonlyone“person”who
knowswherethemarketisgoing.IfweaskHim,wewon’tgetananswer,atleastnotinthislifetime.Andinthenextone,itwon’tmatter.ThisiswhywheneverIamaskedaboutmyforecastfortheeconomyorthemarket,myanswerisalwaysthesame:“Mycrystalballisalwayscloudy.”
Whatwehavelearnedisthatwearenoclosertobeing
abletopredictthemarketdespitealltheinnovationsininformationtechnologyanddecadesofacademicresearch.Thenexttimeyouaretemptedtoactonsomeguru’slatestforecast,askyourselfthefollowingquestions:
•IsWarrenBuffettactingonthisexpert’sopinion?
•Ifheisn’t,shouldIbedoingso?
•WhatdoIknowaboutthevalueofthisforecastthatBuffett(andthemarketingeneral)doesn’t?
AuthorCarlRichards,inhisbookTheBehaviorGap,recommendsaskingthreequestionsbeforeyouactonsomeone’sadviceorforecast:12
•IfImakethischangeand
Iamright,whatimpactwillithaveonmylife?
•WhatimpactwillithaveifIamwrong?
•HaveIbeenwrongbefore?
MARKETTIMING
ThefollowingaresomeofBuffett’sadmonitionstothosewhoaretemptedtotime
themarket:
•“Ourfavoriteholdingperiodisforever.”13
•“Ourstay-putbehaviorreflectsourviewthatthestockmarketservesasarelocationcenteratwhichmoneyismovedfromtheactivetothepatient.”14
•“Successininvestingdoesn’tcorrelatewith
IQ.Onceyouhaveordinaryintelligence,whatyouneedisthetemperamenttocontroltheurgesthatgetotherpeopleintroubleinvesting.”15
•“Inactivitystrikesusasintelligentbehavior.”16
Itcanbehardtohearthatthebestcourseofactionduringtoughmarkettimesis
tostaythecourse.Keepingyourheadwhileeveryoneelsearoundyouislosingtheirsisdifficult.Itcanbeevenhardertohearthatmessagerepeatedwhilethingsgofrombadtoworse.However,themessagetostaythecourseisworthrepeatingbecauseitisthebestadvice.Becausethereisnoevidencethattherearegoodforecasters,effortstotimethemarketarehighlyunlikelyto
proveproductive.Thegreatironyisthat
whileinvestorsidolizeBuffett,theyjustdonotlistentohisadvice.Whileinvestorswerepullinghundredsofbillionsoutofthestockmarketinthewakeofthefinancialcrisisof2008,Buffettwasbuying.AndwhileinvestorswereonceagainreactingtotheEuropeancrisisof2011,
withdrawingalmost$100billionfromstockfundsoverthesixmonthsendingOctober2011,BerkshireHathawaywasinvestingalmost$24billioninstocks.Itwasitslargestcommitmentofnewcashinatleast15years.17
Buffettknowsthatadownmarketiswheninvestorsshouldbebuying,notselling.Whilehe
admonishesinvestorsagainstmarkettiming,hedoesadvisethatifyouaregoingtotrytotimethemarket,youshouldbuywheneveryoneelseisfearfulandsellwheneveryoneelseisgreedy.WhatBuffettadvisesisnottosell(asmostindividualsdo)whenexpectedreturnsarethegreatest(becausevaluationsarelow).ThatiswhenBuffettisgenerallyabuyer.Heisnotabuyerbecausehebelieves
hehasaclearcrystalball.Instead,heisbuyingbecauseexpectedreturnsarehigh:“Whetherwe’retalkingaboutsocksorstocks,Ilikebuyingqualitymerchandisewhenitismarkeddown.”18Conversely,thetimetobeasellerisnotwhenvaluationsarelowandexpectedreturnsarehigh.Buffettoffersthisadviceonthesubject:
The most common causeoflowpricesispessimism—sometimes pervasive,sometimes specific to acompany or industry. Wewant to do business insuch an environment, notbecausewelikepessimismbut because we like theprices it produces. It isoptimismthatistheenemyoftherationalbuyer.19
Thetimetobeaselleriswhenthe“coastisclear”andrisksappeartobelow.Thatiswhenvaluationsarehighandexpectedreturnsarelow.Buyinglowandsellinghighisamuchbetterstrategythanthereverse,whichiswhatmostinvestorsdo.
TheappealingthingisthatthereisasimplestrategythatallowsyoutoinvestmorelikeWarrenBuffett,buying
whenvaluationsarelowandexpectedreturnsarehigh,andsellingwhenvaluationsarehighandexpectedreturnsarelow.Allyouneedisthedisciplinetoignoreyouremotionsandadheretoyourinvestmentplan,whichshouldrequireregularrebalancing.Rebalancing,ortheprocessofrestoringaportfoliotoitsoriginalcomposition,isintegraltothewinninginvestmentstrategy.
Itrequiresyoutobuywhathasdonerelativelypoorly(atrelativelylowvaluations)andsellwhathasdonerelativelywell(atrelativelyhighvaluations).However,itisnoteasytomaintainthedisciplinetostaythecoursebecause“CNBC-itis,”andtheemotionsitcauses,oftengetintheway.
2Wantto
InvestMoreLikeWarrenBuffett?Start
ThinkingLikeHeDoes
InorderforyoutolearntoinvestlikeWarrenBuffett,youhavetolearnhowtothinklikehim.Thatiswhatthischapterisallabout.Itprovidesyouwiththree
importantinsightsthatwillhelpyoubecomeBuffett-likeinyourapproachtoinvesting.First,you’lllearntherightwaytothinkaboutbadnews.Next,you’lllearnhowtoavoidthemistakemostinvestorsmakeofengaginginwhatisreferredtoas“stage-one”thinking.Instead,youwilllearntothinkahead,engagingin“stage-two”thinking.Andfinally,you’lllearnnotonlyhowimportant
itistohaveawell-developedplanbutalsohowcriticalitistoadheretoit.
UNDERSTANDHOWTOTHINK
ABOUTBADNEWS
OneofthesecretstoBuffett’ssuccessasaninvestoristhatduringbearmarketsheisabletokeephisheadwhile
everyoneelsearoundhimislosingtheirs.Heunderstandsthatbadnewsdoesn’tmeanstockpriceshavetogolower.Themarketpricealreadyreflectsallpubliclyavailableinformation.Thatmeansthatmarketscanbeexpectedtocontinuetofallonlyiffuturenewsisworsethanalreadyexpected.Ifthenewsisnoworsethanexpected,youwillearnhighreturnsresultingfromthelowvaluations.And
evenifthefuturenewsisnotgoodbutisbetterthanexpected,valuationswillriseastheriskpremiumdemandedbythemarketbeginstofall.That’softenhowbullmarketsbegin.
Itistotallyirrelevanttostockpriceswhethernewsisgoodorbad.Failingtounderstandthisbasictenetcausesinvestorstoreacttothenewsandgetoveren-
thusiasticwhennewsisgoodandpanicwhennewsisbad.Inordertobeasuccessfulinvestor,whatyouneedtounderstandiswhetherthenewsisbetterorworsethanalreadyexpected.Inotherwords,whatmattersisnotwhethernewsisgoodorbadbutwhetherornotitisasurprise.Let’stakealookatanexample.
Theyear2010was
miserableforthecommercialrealestateindustry,asmortgagedefaultsmultiplied.In2008,just1percentofcommercialloansweredelinquent.In2009,thedefaultratejumpedto6percent.In2010,theratejumpedto9percent.Giventhathorriblenews,onewouldexpectthatinvestorsincommercialmortgageswouldhavesufferedgreatly.Despitethedramaticincreasein
defaults,2010wasagreatyearforinvestorsincommercialmortgagesaspricessoared.Forexample,juniorAAA-ratedbondswentfrom30centsonthedollartoalmostpar(or100centsonthedollar).1
Thecontrastbetweentherisingdefaultrateandtherisingvalueofcommercialmortgagesseemsatfirsttobecontradictory.The
explanationisthatpricesrosebecausethedefaultrates,whilebad,werenotnearlyasbadasthemarketexpected.Asaresult,marketpricesrose,reflectingtheprevailingviewthatdefaultlosseswouldnotbesogreatastodamagetheupper(morehighlyrated)tranchesofthesecuritizationladder.
Thebottomlineisthis:ifyouwanttoinvestmorelike
Buffett,youmustunderstandthatsurprisesareamajordeterminantofstockperformance.Becausetheyareunpredictableandinstantlyincorporatedintoprices,youarebestservedbyignoringthenews,becauseactingonitislikelytoprovecounterproductive.
AVOIDSTAGE-
ONETHINKING
OneofthekeystoBuffett’ssuccessasaninvestoristhatheavoidsthetendencytoengageinwhatThomasSowellcalled“stage-one”thinking,aweaknessofmostinvestors.Theyseethecrisisandtherisksbutcannotseebeyondthat.Theirstomachstakeover,theycannotcontroltheiremotions,panicsetsin,
andwell-developedplansareabandoned.
Buffettengagesin“stage-two”thinking.Heexpectsthatacrisiswillleadgovernmentsandcentralbankerstocomeupwithsolutionstoaddresstheproblem.Andthegreaterthecrisis,thegreatertheresponseislikelytobe.Thatallowshimtoseebeyondthecrisis,enablinghisheadtokeep
controloverhisstomachandhisemotions.Thenexttimeyoufindyourselfreactingtoacrisis,askyourself:
•AmIengaginginstage-onethinking?
•DoIknowsomethingthemarketdoesn’t?
•Isthenewsalreadyincorporatedintoprices?
•DoIwanttosellwhen
valuationsarelowandexpectedreturnsarehigh?
•Willgovernmentsandcentralbanksdonothing?Orwilltheyaddresstheproblem?
•HaveIreactedinthepasttosuchevents?Howdidthatturnout?
Mostimportant,youneedtoaskthisquestion:IfIsell
now,howwillIknowwhenitissafetobuyagain?Thisisthebigproblemforthosewhosellduringcrises.
IsThereEveraGreenFlag?Thereisanotherproblemforthosewhoaretemptedbythelatestcrisistosellandwaitforsafertimes.Ifyougotothebeachtoridethewavesandyouwanttoknowifitis
safe,yousimplylooktothelifeguardstand.Iftheflagisgreen,itissafe.Ifitisred,itistoodangeroustotakeachance.Formanyinvestors,themarketoftenlookstoodangerous.Sotheydonotwanttobuy,ortheydecidetosell.
Hereistheproblem.Whilethesurfercanwaitadayortwofortheoceantocalmdown,thereisnevera
greenflagsayingitissafetoinvest.ThemarketsfacedalitanyofproblemsfromMarch9,2009,throughMarch30,2011.Therewasneveragreenlight.Itwasredtheentiretime.Thatiswhyinvestorswerepullingouthundredsofbillionsofdollarsfromthemarket,missingthegreatestrallysincethe1930s,withtheS&P500providingareturnofmorethan100percent.Soifyoudecideto
sell,youarevirtuallydoomedtofailwhileyouwaitforthenextgreenflag.
Evenworseiswhathappenedtosomeinvestorswhothoughttheysawagreenflag.ConsiderthissadtaleofaninvestorwhowatchedtheS&P500fallfromabout1,450inFebruary2007allthewayto752onNovember20,2008.Wornoutbythewaveofbadnews,hesold.
However,heknewtherewasaproblem.Withinterestratesattheirthencurrentlevels,hecouldnotachievehisfinancialgoalswithouttakingrisks.Sohedesignedastrategytogetbackin.Hewouldwaituntilnextyeartoseeifthemarketrecovered.ByJanuary6,2009,theS&P500hadrisenalmost25percentto935.Ofcourse,hehadmissedthatrallywhilehewaitedforthatgreenflag.But
nowhefeltthatitwasonceagainsafetobuy.Unfortunately,byMarch9,2009,theS&P500haddroppedbackallthewayto677.Sohesoldagain,andthemarketbeganitsfiercerally.Inmyopinion,he’llhaveaverydifficulttimereachinghisinvestinggoals.Theproblemisthatonceyousellyouarevirtuallydoomedtofail.Thegreenflagyouarewaitingforwillneverappear.
Never.Buyingwhenvaluationsarehighandsellingwhentheyarelowexplainswhysomanyinvestorshavetakenalltherisksofstocksbuthaveearnedbond-likereturns.
UnderstandingthefallibilityofindividualinvestorsiswhyBuffettofferedthesewordsofwisdom:
•“Themostimportant
qualityforaninvestoristemperament,notintellect.”2
•“Investingissimple,butnoteasy.”3
WhileitissimpletoinvestmorelikeBuffett—youjustneedawell-designedplanandhavethedisciplinetosticktoit—itisnoteasy.Emotions,suchasfearandpanicinbearmarketsand
greedandenvyinbullmarkets,causeevenwell-developedplanstoendupinthetrashheap.Thestomachtakesoverfromthehead…andstomachsdonotmakegooddecisions.
IfyouwanttoinvestmorelikeBuffett,youaregoingtohavetolearntocontrolyouremotions.Thebestwayofpreventingyourstomachfromtakingoveristostop
payingattentiontoforecastersandso-calledexperts.
HAVEAPLANANDSTICKTOIT
WarrenBuffett’sotherpassionisbridge.Heoncesaid:“Iwouldn’tmindgoingtojailifIhadthreecellmateswhoplayedbridge.”Notingthesimilaritybetweenbridge
andinvesting,hestated:“Theapproachandstrategiesareverysimilar.”Headded:“Inthestockmarketyoudonotbaseyourdecisionsonwhatthemarketisdoing,butonwhatyouthinkisrational.”4Withbridge,youneedtoadheretoadisciplinedbiddingsystem.Whilethereisnoonebestsystem,thereisonethatworksbestforyou.Onceyouchooseasystem,
youneedtostickwithit.Similarly,withinvesting,
inordertobesuccessfulyoumusthavea“system,”aplanthatdeterminesyourassetallocationbasedonyouruniqueability,willingness,andneedtotakerisk.Justasthereisnoonebestbiddingsystem,thereisnoonebestassetallocation.However,thereisonethatisrightforyou.Onceyoudevelopyour
plan,andputitinwriting,youneedtosticktoit.HereisBuffett’sadviceonthesubject:“Onceyouhaveordinaryintelligence,whatyouneedisthetemperamenttocontroltheurgesthatgetotherpeopleintotroubleininvesting.”5
INVESTORSWORSHIPBUT
IGNORETHEORACLEOFOMAHA
HavingcompletedourreviewofBuffett’sadvice,itistimenowtoanswerthefollowingquestions:
1.Doyouactonmarketforecasts?
2.Doyoutrytotimethe
market?3.Haveyousoldafter
marketshaveexperiencedbiglosses,onlytothenbuyagainaftertheyhaverecovered?
4.Haveyouadheredtoaninvestmentpolicystatementandyourassetallocation,onlyrebalancingandtaxmanagingasrequired?
If,inansweringthequestionsabove,yourecognizethatyouhavebeenengagingindestructivebehavior,thenyouhavetakenthefirststepontheroadtorecovery.However,becausecrisesarethenorm,youwillcontinuetobetested.Justastherearenoex-alcoholics,justrecoveringones,therearenoex-markettimers,justrecoveringones.Thatexplainswhywhilethereare
tensofmillionsofinvestorswhoidolizetheOracleofOmaha,therearefewindividualinvestorswhoactuallyactinthemarketlikeWarrenBuffett.However,youcanbeoneofthefewifyoumakeupyourmindtodoit.
Buffettknowsthatthewinninginvestmentstrategyisreallysimple.However,healsoacknowledgesthatitis
noteasy,becauseemotionsgetinthewayofbeingabletomaintaindisciplineandadheretoawell-developedplan.
Theremainderofthisbookisdesignedtohelpyouplaythewinner’sgame,providingthesimpleprescriptionsforsuccess.Therestisuptoyou.
3ShouldYouBeanActiveoraPassiveInvestor?
Therearetwocompetingtheoriesaboutinvesting.Theconventionalwisdomisthatmarketsareinefficient;theypersistentlymispriceassets.Ifthatistrue,smart,hardworkingpeoplecanuncoverwhichstocksthemarkethasunder-orovervaluedandmakemoneybyloadinguponundervaluedonesoravoiding(orevenshorting)overvaluedones.Theycanthink,“Intelis
tradingat20,andweshouldloaduponitbecauseitisreallyworth30,”or,“Weshouldavoiditbecauseitisreallyworth10.”Thisiscalledtheartofstockselection.Andifmarketsmispriceassets,smartpeoplecanalsotimethemarket—raisingtheirstockallocationsandgettinginaheadofthebullemergingintothearenaandloweringtheirstockallocationsbeforethebear
emergesfromitshibernation.Thisiscalledtheartofmarkettiming.Together,theymakeuptheartofactivemanagement.
Thecompetingtheoryisthatmarketsareefficient.Hence,thepriceofasecurityisthebestestimateofthecorrectprice.Ifmarketsareefficient,attemptstooutperformthemarehighlyunlikelytoproveproductive,
especiallyafterexpenses.Thisdoesnotmeanitisimpossibletobeatthemarket.Giventhetensofthousandsofprofessionals(andmillionsofindividuals)engagingintheeffort,weshouldexpectsometorandomlysucceedevenoverlongperiodsoftime.
Inordertohavethebestchanceofachievingyourfinancialgoals,youneedtodecidewhichtheoryand
strategyisthemostprudent.Theproblemishowtoknowwhetheranactiveorapassivestrategyisthewisest.Despitethefactthatmoneymaybethethirdmostimportantthinginourlives(notmoneyitself,butwhatmoneyprovides)afterourfamilyandourhealth,oureducationsystemhastotallyfailedtoequipinvestorswiththeknowledgetodeterminetheanswertoourquestion.Unlessyouhave
anMBAinfinance,itislikelythatyouhavenevertakenevenasinglecourseincapitalmarketstheory.
Additionally,youarelikelytogetabiasedanswerfromeitherWallStreetorthefinancialmedia.WallStreetwantsandneedsyoutoplaythegameofactiveinvestingsotheymakemoneybycharginghighfeesforactivemanagementandthrough
commissionsandbid-offerspreadswheneveryoutrade.Thefinancialmediaalsowantsandneedsyouto“tunein.”
THEEVIDENCE
Fortunately,thereisalargebodyofevidenceontheinabilityofactivemanagementtodeliveralpha:
performanceaboveappropriaterisk-adjustedbenchmarks(suchascomparingtheperformanceofasmall-capfundtoasmall-capindex,nottotheS&P500Index).AstheCarlRichardssketchshows,theweightofevidenceisheavilyinfavorofpassiveinvesting.Thefollowingareshortsummariesofthevolumesofacademicresearchontheeffortsofindividual
investors,mutualfunds,andpensionplanstogeneratealpha.Remember,ifmarketsareinefficient,weshouldseeevidenceofthepersistentabilitytooutperformappropriaterisk-adjustedbenchmarks.Andthatpersistenceshouldbegreaterthanrandomlyexpected.
IndividualInvestorsWebeginwithexploringthe
evidenceontheperformanceofindividualinvestors.Itclearlydemonstratesthatindividualsareplayingaloser’sgame,enrichingonlythepurveyorsofproductsandservices.Thefollowingisasummaryoftheevidence:
•Thestocksthatbothmenandwomenboughtsubsequentlyunderperformed,andthestockstheysold
outperformedaftertheyweresold.1
•Bothmenandwomenunderperformedmarketandrisk-adjustedbenchmarks.2
•Thosewhotradedthemostperformedtheworst.3
•Themoreconfidentpeoplewereintheirabilitytoeitheridentify
mispricedsecuritiesortimethemarket,theworsetheresults.4
•Menproducedsimilargrossreturnstowomen.However,menearnedlowernetreturnsastheirgreaterturnovernegativelyimpactedresults.5
•Singlewomenproducedbetternetreturnsthantheirmarried
counterparts,presumablybecausetheywerenotinfluencedbytheiroverconfidentspouses.6
•Demonstratingthatmoreheadsarenotbetterthanone,theaverageinvestmentclublaggedabroadmarketindexbyalmost4percentperyear.Adjustingforrisk,theperformancewas
evenworse.Andclubswouldhavebeenbetteroffnevertradingduringtheyear.7
•Demonstratingthatintelligencedidnottranslateintohigherreturns,theMensa(thehighIQsociety)investmentclubunderperformedtheS&P500Indexbyalmost13percentperyearfor15
years.8
Exacerbatingtheproblemisthatinvestorsareunawareofhowpoorlytheyaredoing.Astudyonthesubjectfoundinvestorsoverestimatedtheirownperformancebyanastounding11.5percentayear.Andthelowerthereturns,theworseinvestorswerewhenjudgingtheirrealizedreturns.Whilejust5percentbelievedtheyhad
experiencednegativereturns,therealitywasthat25percentdidso,andmorethan75percentunderperformedtherelevantbenchmark.9
ActivelyManagedMutualFundsThefollowingisabriefsummaryoftheevidenceontheinabilityofactivelymanagedfundstodeliveroutperformance:
•Therehasbeennoevidenceoftheabilitytopersistentlygenerateoutperformancebeyondwhatwouldberandomlyexpected.Thepastperformanceofactivemanagersisnotprologue.10
•Expensesreducedreturnsonaone-for-onebasis(eachdollarspentreducedreturnsby
approximatelythesameamount)andexplainedmuchofthepersistentlong-termunderperformanceofmutualfunds.11
•Turnoverreducedpretaxreturnsbyalmost1percentofthevalueofthetrade.12
•Initsownstudy,Morningstarfoundthatexpenseratioswerea
betterpredictorthanitsstarratings.Simplyrankingbyexpensesproducedsuperiorresults—thelowestcostfundstendedtoproducethehighestreturns.13
Thebottomlineisthatthecostsofsecurityselectionandmarkettimingproveadifficulthurdletoovercome.Anddespitewhatmostpeoplebelieve,evenlong
periods(suchas10oreven15years)ofsuperiorperformancedonothavepredictivevalue;wecannotdifferentiatebetweenskillandluck.Onereasonforthisisthatsuccessfulactivemanagementcontainstheseedsofitsowndestruction:thehurdlestogeneratingalphaincreaseastheamountofassetsundermanagementincrease.Thisisanimportantcontributortothelackof
persistentperformance,eveninthepresenceofskill.14
ThisbodyofevidenceislikelywhatledBuffetttodrawthisconclusion:
By periodically investinginanindexfundtheknow-nothing investor canactually outperform mostinvestmentprofessionals.15
PensionPlansItseemslogicaltobelievethatifanyonecouldbeatthemarket,itwouldbethepensionplansofU.S.companies.Whyisthisagoodassumption?Let’sconsider:
•Pensionplanscontrollargesumsofmoney,givingthemaccesstothebestandbrightest
portfoliomanagers.
•Plansdonothiremanagerswitharecordofunderperformance.
•Mostpensionplanshireprofessionalconsultantstohelpthemperformduediligenceininterviewing,screening,andultimatelyselectingtheverybestmanagers.Theseconsultantsemployarmiesof
talentedpeoplewho,youcanbecertain,havethoughtofeveryconceivablescreen.
•Theirfeesaremuchlowerthanthefeesindividualinvestorspay.
•Becausepensionplansareexemptfromtaxation,theydonothavetheburdenoftaxestopaythatindividualsmustovercome.
Here’stheevidenceontheperformanceofpensionplans:
•Plansponsorshiredinvestmentmanagerswhohadoutperformed.However,theoutperformancedidn’tcontinue,asthepost-hiringexcessreturnswereindistinguishablefromzero.Ifplansponsorshadstayedwith
thefiredinvestmentmanagers,theirreturnswouldhavebeengreaterthanthoseactuallydeliveredbythenewlyhiredmanagers.
•Therewasnoevidencethenumberofmanagersbeatingtheirbenchmarkswasgreaterthanpurechance.16
Studiesonthe
performanceofcorporate401(k)planshavefoundthesametypeofevidence:thereisnoabilitytoidentifyaheadoftimethefewactivefundsthatwilloutperformtheirappropriatebenchmarks.17Asyoucansee,theevidenceisoverwhelmingthatpassiveinvestingisthewinner’sgame.Activemanagementistheloser’sgamebecausetheoddsofwinningaresolow
thatitisnotprudenttotry.Inadditiontotheevidence,NobelLaureateWilliamSharpeprovideduswithasimpleandelegantproofofwhyactivemanagementmustbe,inaggregate,aloser’sgame.18
THEARITHEMETICOF
ACTIVE
INVESTING
Themarketismadeupofonlytwotypesofinvestors:activeandpassive.Assumethat70percentofinvestorsareactiveand30percentofinvestorsarepassive.Alsoassumethemarketreturns10percent.(Theoutcomeisthesameregardlessofthepercentagesused.)Onapre-expensebasis,passive
investorsmustearn10percent.Whatrateofreturn,beforeexpenses,musttheactivemanagers,inaggregate,haveearned?Becausethesumofthepartsmustequalthewhole,collectively,activemanagersmustalsohaveearned10percent.Thefollowingequationsshowthemath:
Itdoesnotmatterwhatpercentagesofmarketshareyouuse;theoutcomeisthesame.Thereasonisthatallstocksmustbeownedbysomeone.Ifoneactiveinvestoroutperformsbecauseheoverweightedthetop-performingstocks,anotheractiveinvestormusthaveunderperformedbyunderweightingthoseverysamestocks.Inaggregate,onapre-expensebasis,active
investorsearnthesamemarketrateofreturnasdopassiveinvestors.Thisholdstruenomatterwhatassetclassortypeofmarket.
THEMATHISALWAYSTHE
SAME
If,insteadofusingthetotalstockmarket,wesubstituted
anyotherindexorassetclass,wewouldcometothesameconclusion.Thatexposesthemyththatactivemanagementworksin“inefficient”assetclasseslikesmall-capandemergingmarketstocks.
Thesamethingistrueforbullandbearmarkets.Ifthemarketloses10percent,theVanguardTotalStockMarketFundwillalsolose10percentonapre-expensebasis.In
aggregate,somustactiveinvestors.Themathdoesnotchangeforbullorbearmarkets.
Sofar,wehavebeendiscussinggross(beforeexpenses)returns.Unfortunately,youdonotearngrossreturns;youearnreturnsnetofexpenses.Togettothenetreturns,theonlykindyougettospend,wemustsubtractallcosts:
•Expenses:theoperatingexpensesofthefund
•Tradingcosts:thefund’scostsofbuyingorsellingsecurities
•Bid-offerspreads:thedifferencebetweentheaskingprice(thepriceyoupaywhenyoubuy)andthebidprice(thepriceyoureceivewhenyousell)
•Brokeragecommissions
•Marketimpact:theadditionalcostsincurredwhiletransactinglargeblocksofstock,resultingfromchangesinpricebeforethefullamountisboughtorsold
•Costofcash:thedifferencebetweenthereturnsearnedwhilesittingincashandwhatwouldhavebeenearned
iffullyinvested
Becauseactivefundshavehigherexpensesineachcategory,thecostofimplementingapassivestrategywillbelessthanthatofanactiveone.Thus,inaggregate,passiveinvestorsmustearnhighernetreturnsthanactiveinvestors.Themathematicalfactscannotbedenied.Activemanagementis,inaggregate,anegative
sum(loser’s)game.Theevidenceis
overwhelmingthatthesurestwaytowinthegameofactivemanagementistorefusetoplay.Thus,thewinningstrategyistoadoptapassiveinvestmentstrategy.Youcandothatbyinvestinginindexmutualfunds,suchasthoseofVanguard,CharlesSchwab,andFidelity.Youcanalsoconsiderinvestingin
exchange-tradedfunds(ETFs)—suchasiSharesandSPDRs—whichareessentiallymutualfundsthattradeonexchangesthroughoutthedaylikestocks.
Anotheroptionarethepassivelymanagedfunds(which,thoughpassive,arenotindexfunds)offeredbyfundfamiliessuchasBridgeway,Dimensional
FundAdvisors,Invesco(throughitsPowerSharesfunds),andWisdomTree.Well-designed,passivelymanagedfundscanaddvalueoversimilarindexfundsbymaximizingthebenefitsofindexing(suchaslowcost,broaddiversification,lowturnover,andtaxefficiency)whileminimizingsomeofthenegatives(suchasforcedturnover,whichincreasestradingcostsandcreatestax
inefficiencies).Nowthatyouknowthe
rightstrategy,let’sturnourattentiontothedevelopmentofafinancialplan.
4TheNeedto
Plan:ItIsNotOnly
AboutInvestments
Wouldyoutakeatriptoaplaceyouhaveneverbeenwithoutaroadmap,directions,oraGPS?Wouldyoustartabusinesswithoutspendinglotsoftimeandenergythoroughlyresearchingthatbusinessandthenwritingawell-designedplan?Theanswersexplainwhytheoldandwisesayingholdstrue:thosewhofailtoplan,plantofail.
Despitethewisdomofthisstatement,thevastmajorityofinvestorsbegintheirinvestmentjourneywithoutaplan,specifically,aninvestmentpolicystatement(IPS)layingouttheplan’sobjectivesandtheroadmaptoachievingthem.Onereasonsofewinvestorshaveawell-developed,written,andsignedplan(whatyoushouldconsideracontractbetweenyouandyourself)is
thatWallStreetandthemediadonotreallywantyoutohaveone.Thewinningstrategyforthemisthelosingstrategyforyou.
Itisimportanttounderstandthataplanisnecessaryinordertomakerationaldecisionsaboutinvestments.Youcannotproperlyevaluateanyinvestmentwithoutconsideringhowitsaddition
affectstheriskandexpectedreturnofyourportfolio,andthustheoddsofachievingtheplan’sobjectives.
AFinancialPlanMustBeaLivingDocumentJustasabusinessplanmustbereviewedregularlytoadapttochangingmarketconditions,anIPSandafinancialplanmustbelivingdocuments.Ifanyofyour
plan’sunderlyingassumptionschange,theIPSshouldbealteredtoadapttothechange.Life-alteringevents(suchasabirthordeathinthefamily,amarriageordivorce,alargeinheritance,orapromotionorjobloss)canaffecttheplanindramaticways.Thus,theIPSshouldbereviewedwheneveramajorlifeeventoccurs.
Marketmovementscan
alsoleadtochangesinyourassumptions.Bullmarketsmaymeanyou’reaheadofyourgoals,allowingyoutotakelessrisk.But,bullmarketsalsolowerexpectedfuturereturns,meaningthosestillfarfromtheirgoalsmayhavetotakemorerisk.(Thisdoesnotmeanyoushouldtakemorerisk.Analternativeistolowerthegoal.)Thereverseistrueofbearmarkets.Agoodpolicyisto
reviewtheIPSanditsassumptionsonanannualbasis.
BeforewritinganIPS,youshouldthoroughlyreviewyourfinancialandpersonalstatus.Youshouldconsidernotonlyyourpersonalfinancialsituationbutalsosuchfactorsas
•Thestabilityofyourjob
•Whethertheriskofyour
jobishighlycorrelatedwithyourstocksholdings
•Yourinvestmenthorizon
•Yourtoleranceforrisk
•Theneedforemergencyreserves
Keepinmindthatyourinvestmenthorizonextendswellbeyondyourplannedretirementdate.Anditmay
evenextendbeyondyourdeathifyouareinvestingonbehalfofyourheirs.
Youshouldalsoconsideryourneedtotakerisk.Haveyoualreadysavedenough?Ifso,whycontinuetakingrisk?Fartoomanyinvestorsfailtounderstandthatthestrategytogetrich(takerisks)isentirelydifferentfromthestrategytostayrich(minimizerisks,diversifytherisksyoutake,
anddon’tspendtoomuch).Itisalsoimportantto
understandthatit’snotenoughtohaveonlyawell-developedinvestmentplan.Itneedstobeincorporatedintoanoverallfinancialplanthatalsoaddressesestateandtaxplanningissues,aswellasriskmanagementissuessuchastheneedforlife,health,disability,long-termcare,personalliability,and
longevityinsurance.Itshouldalsoincorporateaplanforwhentobegintakingsocialsecurity.Finally,yourcharitableintentionsshouldbeaddressed.
Awell-developedplanshouldalsoaddresssuchissuesasobjectivesfortransferringwealthandyourvaluestofamilymembers.Thiscanbeincorporatedintowhatiscalledafamilywealth
missionstatement.Youshouldconsiderhavingyourchildren(andtheirspouses,ifany)involvedinyourestateplan,includingreadingyourwillandunderstandingyourintentionswithrespecttoyourpropertyuponyourdeath.Theyshouldalsoknowthefamily’snetworth.Andtheyshouldgettoknowyouradvisors(yourattorney,accountant,andfinancialadvisor).
Itisalsoimportanttodevelopacontingencyplanincaseyourportfoliofailstodeliverthereturnsthatyourplananticipated.Youshouldputinwritingwhatactionsyouwilltakeifabearmarketleadstotherebeinganunacceptablechanceofyourplanfailing.Youdonotwanttofindyourselfinasituationwhereyourportfolioislikelytorunoutofassetsorjeopardizeanimportant
legacygoal.Yourplanshouldlistthe
specificactions.Theseactionsmightincludedelayingretirementorreturningtotheworkforce,reducingcurrentspending,reducingthefinancialgoal,sellingahome,ormovingtoalocationwithalowercostofliving.
ThewrittenIPSshouldincludealistofyourspecific
goals,suchastheamountyouplantoaddtoyourportfolioeachyear,theamountofassetsyouaretryingtoaccumulatebyacertaindate,whenyouplantobeginwithdrawalsfromtheportfolio,andthedollaramountyouplanonwithdrawingeachyear.Thiswillallowyoutotrackprogresstowardthegoal,makingappropriateadjustmentsalongtheway.
ThenextstepindevelopingyourIPSistospecifyyourassetallocation,orthemakeupofyourportfolio.TheIPSshouldincludeaformalassetallocationtableidentifyingboththetargetallocationforeachassetclassandtherebalancingtargetsintheformofminimumandmaximumtoleranceboundaries.AwrittenIPSservesasaguidepostand
helpsprovidethedisciplineneededtoadheretoastrategyovertime.Developingthatassetallocationplanisthesubjectofthenextchapter.
5HowMuchRiskShouldYouTake?TheAssetAllocation
Decision
There’snooneplanthat’srightforeverybody.Theamountofriskyoushouldtakeandthemakeupofyourportfoliodependsentirelyonyouruniqueabilityandwillingnessandneedtotakerisk.Let’sbeginwithtakinga
lookattheabilitytotakerisk.
THEABILITYTOTAKERISK
Thelongeryourinvestmenthorizon,themoreriskyoucantake.Thisisbecauseyouhaveagreaterabilitytowaitoutabearmarket.Inaddition,thelongertheinvestmenthorizon,themorelikely
stockswillprovidehigherreturnsthanbonds.Thefollowingtablecanhelpserveasaguidelinetohelpyoudeterminehowtodivideyourassetsbetweenriskierstocksandsaferbonds.
Besidesyourinvestmenthorizon,youshouldalsoconsideryourlaborcapital.Wecandefinelaborcapitalas
thepresentvalueoffutureincomederivedfromlabor.Itisanassetthatdoesnotappearonanybalancesheet.Itisalsoanassetthatisnottradablelikeastockorabond.Thus,itisoftenignored,atpotentiallygreatrisktotheindividual’sfinancialgoals.Thereareseveralimportantpointstoconsideraboutyourlaborcapital.
First,whenweareyoung,humancapitalisatitshighestpoint.Itisalsooftenthelargestassetindividualshavewhentheyareyoung.Asweageandaccumulatefinancialassets,andthetimewehaveremaininginthelaborforcedecreases,theamountofhumancapitalrelativetofinancialassetsshrinks.Thisshiftovertimeshouldbeconsideredintermsoftheassetallocationdecision.
Second,weneedtoconsidernotonlythemagnitudeofourhumancapitalbutalsoitsvolatility.Somepeople(suchastenuredprofessorsandgovernmentemployees)havestablejobs.Theirlaborincomeismuchlikeabond.Otherpeople(suchascommissionedsalesmenandconstructionworkers)havelaborincomethatismorevolatileand,thus,actsmorelikestocks.Your
assetallocationshouldincorporatetheseimportantpoints.
Third,youshouldconsiderthesignificanceofhumancapitalasapercentageoftotalassets.Ifhumancapitalisasmallpercentageofthetotalportfolio(becausetherearelargefinancialassets),thevolatilityofthehumancapitalanditscorrelationtofinancialassets
becomeslessofanissue.Fourth,toavoidhaving
toomanyeggsinonebasket,youshouldavoidinvestinginassetsthathaveahighcorrelationwithyourhumancapital.Unfortunately,fartoomanypeoplefollowPeterLynch’sadviceto“buywhatyouknow.”Theresultisthattheyinvestheavilyinthestocksoftheiremployers.Thisisamistakeontwo
fronts.Thefirstisthatitisahighlyundiversifiedinvestment.Thesecondisthattheinvestmentislikelytohaveahighcorrelationwiththeperson’shumancapital.EmployeesofsuchcompaniesasEnronandWorldComfoundouthowcostlyamistakethatcanbe.
Fifth,humancapitalcanbelostbecauseoftworisksthatneedtobeaddressedby
meansotherthanthroughinvestments.Thefirstisthepossibilityofdisability.Thisriskcanbeaddressedbythepurchaseofdisabilityinsurance.Theotherriskisthatofmortality.Thatissuecanbeaddressedwiththepurchaseoflifeinsurance.Theseissueshighlighttheimportanceofintegratingyourinvestmentplanintoanoverallestate,tax,andriskmanagementplan.
Thereisonemoreimportantissueweneedtoconsiderabouttheabilitytotakerisk:theneedforliquidity.Theneedforliquidityisdeterminedbytheneedfornear-termcashrequirementsaswellasthepotentialforunanticipatedcallsoncapital.Agoodruleofthumbistohaveareservetocoversixmonthsofordinaryexpenses.
THEWILLINGNESSTO
TAKERISK
Thewillingnesstotakeriskisdeterminedbywhatcouldbecalledthe“stomachacid”test.Askyourselfthisquestion:Canyoustickwithyourinvestmentstrategywhenmarketscrash?Successfulinvestment
managementdependsonyourabilitytowithstandperiodsofstressandovercomethesevereemotionalhurdlespresentduringbearmarketsliketheonesexperiencedin1973-1974,2000-2002,and2008.Thus,itisimportantnottotakemoreriskthanyourstomachcanhandle.Andbesides,lifeistooshortnottoenjoyit.
Thefollowingtable
providesaguidelineforyoutoconsider.Themaximumtolerablelossisindependentofthetimeframe.
THENEEDTOTAKERISK
Theneedtotakeriskisdeterminedbytherateofreturnrequiredtoachieveyourfinancialobjectives.Thegreatertherateofreturnneeded,themoreriskyouneedtotake.However,youshouldalsomakesureyoudistinguishbetweenrealneedsanddesires.Theseare
verypersonaldecisions,withnorightanswers.However,thefewerthingsthatfallintotheneedscolumn,thelowertheneedtotakerisk.Conversely,themorethingsthatfallintotheneedscolumn,themoreriskonewillhavetotake.
THEMAKEUPOFTHEPORTFOLIO
Oncewehaveaddressedthekeyissuesofability,willingness,andneedtotakerisk,weneedtodecideonthemakeupoftheportfolio.Volumesofresearchhavefoundthatthevastmajorityoftheriskandexpectedreturnofyourportfolioaredeterminedbyitsassetallocation,meaningthepercentofyourportfoliodevotedtospecificassetclasses.Morespecifically,it’s
determinedbytheexposuretowhatarecalledriskfactors.Riskierassetshavehigherexpected(notguaranteed)returns.Ifthehigherreturnswereguaranteed,therewouldbenorisk.Webeginourdiscussionwiththebroadcategoryofstocks.
StocksInorderofimportance,thefirstdecisionistodetermine
howmuchofanallocationyouwillhavetoriskierstocksversusbonds.Sincestocksareriskierthanbonds,theyprovidegreaterexpectedreturns.
ThenextdecisioninvolvesdividingupyourstockallocationamongU.S.stocks,internationalstocks(thestocksofotherdevelopedcountries),andemerging-marketstocks.Withinthose
threestockcategories,youcandivideyourallocationsfurtherintosmall-caporlarge-capandvalueorgrowth.
Similartothewaystockshavehigherexpectedreturnsthanbondsbecausetheyareriskier,small-capandvaluestockshavehigherexpectedreturnsthantheirlarge-capandgrowthcounterparts.However,thosehigher
expectedreturnscomewithadditionalrisk.Inotherwords,thehigherexpectedreturnsofsmall-capandvaluestocksarenotafreelunch;theyarecompensationforacceptingincrementalrisk.
Inadditiontoprovidinghigherexpectedreturns,small-capandvaluestocksprovideanotherbenefit:theyhelptodiversifyyour
portfolio.Thereasonforthisisthatsomeoftherisksofsmall-capstocksandofvaluestocksareunique.Wecanseethatwhenwelookatcorrelationsofreturns—thedegreetowhichthehistoricalreturnsoftheseassetclasseshaveatendencytovarytogether.From1927through2011,thecorrelationofthesmall-cappremiumtotheequitypremiumhasbeenonlyabout0.4.The
correlationofthevaluepremiumtotheequitypremiumhasonlybeenabout0.1.Andtherehasbeenvirtuallynocorrelationofthesmall-cappremiumtothevaluepremium.Thelowcorrelationsshowthatthesmall-cappremiumandthevaluepremiumareindependent(unique)riskfactors.Thatmakesthemgooddiversifiersoftherisksofstocksingeneral.Wecan
seethebenefitofdiversificationbyexaminingthereturnsofthreeassetclassesfortheyears1998and2001.
In1998,whiletheS&P500Indexrosealmost29percent,small-capstocks(asrepresentedbytheCRSP6-10Index)lostabout2percentandsmall-capvaluestocks(asrepresentedbytheFama-FrenchSmallValueIndexex
utilities)lost10percent.Therelativeperformancesreversedin2001.WhiletheS&P500Indexlost12percent,small-capstocksgainedalmost18percentandsmall-capvaluestocksgainedover40percent.
Nowconsideraportfoliothatownedanequalamountofeachassetclass.In1998,itwouldhaveearnedabout5percent.In2001,itwould
haveearnedabout15percent.Diversifyingacrossallthreeassetclasseswouldhaveprovidedamuchsmootherridethanifyouhadinvestedallyoureggsinanyofthethreebaskets.Sincenoonehasdemonstratedtheabilitytodetermineaheadoftimewhichassetclasswilldowellwhen,thewinningstrategyistodiversifyyourrisks.Similarexamplescouldbeshownforinternationaland
emergingmarketstocks.Thebottomlineisthatsincediversificationistheonlyfreelunchininvesting,youmightaswelleatalotofit.
BondsBondshavetworiskfactors:term(numberofyearstomaturity)anddefault(credit).Thelongerthetermtomaturityandthelowerthecreditrating,thegreaterthe
riskandexpectedreturns.Soyouneedtodecidehowmuchyouwillallocatetohigh-qualityversuslower-qualitybonds,andhowmuchyouwillallocatetoshort-termandintermediate-termbondsversuslong-termbonds.
Beforeyoutacklethetypeofbondstoown,itiscriticalthatyouunderstandtherolebondsshouldplayinaportfolio.Thecentralroleof
bondsinaportfolioshouldbetodampentheriskoftheoverallportfoliotoanacceptablelevel,whichmeansyoushouldminimizerisksinyourbondholdings.Thatmakestheinvestmentdecisionsimple.AbasicruleofthumbistolimityourholdingstoFDIC-insuredCDsandthesafestbonds,thosethatcarrythefullfaithandcreditoftheU.S.government,andhighlyrated
(AAA/AA)municipalbonds.Ifyouchoosetoowncorporatebonds(whichentailmorecreditrisk),thehistoricalevidencesuggeststhatyoulimityourholdingstothosewithremainingmaturitiesofthreeyearsorlessandtobondsthathaveinvestment-graderatings(aratingthatindicatesthatthebondhasarelativelylowriskofdefault).Theseguidelinessimplifyyourdecision.
AlternativeInvestmentsThesearchforbetterperforminginvestmentstypicallyleadsinvestorstoconsiderwhatareoftencalledalternativeinvestments.Thistermisgenerallyusedtodescribeinvestmentsbeyondthefamiliarcategoriesofstocksandinvestment-gradebonds.Thecategoryincludessuchinvestmentsasrealestate,commodities(e.g.,
preciousmetals,oilandgas,andwheat),privateequity,venturecapital,hedgefunds,junkbonds,emergingmarketbonds,convertiblebonds,preferredstocks,andso-calledstructuredinvestmentproducts.AcommonelementofalternativeinvestmentsisthatWallStreettypicallymakesalotofmoneyasthepurveyorsoftheseproducts.Thegoodnewsisthat,withtheexceptionofrealestate
andcommodities,theacademicresearchdemonstratesthatyoushouldnotevenconsiderowninganyoftheotheralternatives.Youcertainlydonotneedthemtodevelopawell-diversifiedportfolioortoachieveyourgoals.
Thetwoalternativesworthconsideringarerealestateandcommodities.Realestateisagooddiversifierof
therisksofbothstocksandbonds.Andyoucaninvestinrealestatebyowninganindexfund(suchasVanguard’sREITIndexFund)thatinvestsinabroadspectrumofpubliclytradedrealestateinvestmenttrusts(REITs).Similarly,commoditiesareagooddiversifieroftherisksofstocksandbonds.AndtherearegoodmutualfundandETFalternativesforinvesting
incommodityindexes(thebestwaytoaccessthisassetclass).
Wenowturnourattentiontotheassetlocationdecision,orthebestplacestoholdyourvariousinvestmentstogainataxadvantage.Whatshouldbeyourpreferenceforholdingyourvariousinvestmentsinyourtaxable(individual,communityproperty,trust,etc.)andtax-
advantagedaccounts,suchasIRA,401(k),or403(b)plans?
THEASSETLOCATIONDECISION
Whenfacedwithachoiceofplacingassetsineithertaxableortax-advantagedaccounts,taxableinvestorsshouldhaveapreferencefor
holdingstocks(versusbonds)intaxableaccounts.However,beforeinvestinganytaxabledollars,investorsshouldalwaysfirstfundtheirRothIRAordeductibleretirementaccounts.Andbecausetax-advantagedaccountsarethemosttax-efficientinvestmentaccounts,youshouldalwaystakecompleteadvantageofyourabilitytofundthem.Theoneexceptionistheneedtoprovideliquidityfor
unanticipatedfundingrequirements.
IfyouinvestineitherREITsorcommodities,becausetheyaretax-inefficientinvestments,thepreferenceshouldordinarilybetoholdtheseinvestmentsintax-advantagedaccounts.Ifyoucannotdoso,youshouldconsiderpassingontheirdiversificationbenefits.
Onceyoudecideonyour
assetallocationyouwillneedtoalsodecideonwhetheryoushouldinvestinmutualfundsorindividualsecurities.
MUTUALFUNDSORINDIVIDUALSECURITIES?
Whenimplementingyourplan,youwillhavetodecidebetweeninvestingin
individualsecuritiesandusingmutualfundsandETFs.Tomaketherightchoice,youneedtobeabletodistinguishbetweentwoverydifferenttypesofrisk:goodriskandbadrisk.Goodriskisthetypeyouarecompensatedfortaking.Forexample,youcannotdiversifyawaytherisksofinvestinginstocksnomatterhowmanyyouown.Thecompensationyoureceivefortakingtherisks
comesintheformofgreaterexpectedreturns.
Ontheotherhand,badriskisthetypeforwhichthereisnosuchcompensation.Thus,itiscalleduncompensatedorunsystematicrisk.Oneexampleofbadoruncompensatedriskistheriskoftheindividualcompany(suchasEnronorLehmanBrothers).Therisks
ofindividualstockownershipcanbeeasilydiversifiedawaybyowningindexfundsthatbasicallyownallthestocksinanentireassetclass/index.Thesevehicleseliminatethesingle-companyriskinalow-costandtax-efficientmanner.
Youcanalsodiversifyassetclassriskbybuildingagloballydiversifiedportfolio,allocatingfundsacross
variousassetclasses:domestic,international,andemergingmarkets;large-capandsmall-cap;valueandgrowth;andrealestateandcommodities.
Becausetheseriskscanbediversified,themarketdoesnotcompensateinvestorsfortakingsuchrisks.Thesameistrueofstayingwithinasingleassetclass.Thisiswhyinvestingin
individualcompaniesandonlyoneorafewassetclasseshasmoreincommonwithspeculatingthanitdoeswithinvesting.Investingmeanstakingcompensatedrisk.Speculatingistakinguncompensatedrisk.Otherexamplesofuncompensatedriskareinvestinginsectorfunds(suchashealthcareortechnology)andindividualcountryfunds(otherthanaU.S.totalstockmarketfund).
Prudentinvestorsrecognizethedifferencebetweenspeculatingandinvesting.Theytakeonlyrisksforwhichtheyarecompensated.Thus,whenitcomestoinvestinginriskyassets,theonlyvehiclesyoushouldconsideraremutualfunds.Thisadviceappliestoallriskyassets,notjuststocks,butcorporatebondsaswell.
WithbondsbackedbythefullfaithandcreditoftheU.S.government,thelackofcreditriskmeansyoucanbuyindividualbondsandsavetheexpenseofamutualfund.Ontheotherhand,mutualfunds,inadditiontoprovidingthebenefitsofdiversification,alsoprovidethebenefitofconvenience,includingtheautomaticreinvestmentofinterest.Thatbenefitisatleastworthconsidering.
Wenowturntodemonstratingthebenefitsofbuildingagloballydiversifiedportfolio.
6HowtoBuild
aWell-DesignedPortfolio
AsdiscussedinChapter5,diversificationistheonlyfreelunchininvesting.Unfortunately,mostinvestorsfailtotakeadvantageofthis“all-you-can-eat”opportunitybecausetheydonotbuildwell-diversifiedportfolios.Instead,theyholdaportfoliothatconsistsofjustahandfulofstocks.Theydosobecausetheymakemistakes,suchasbeingoverconfidentintheirinvestmentskills.Theyalso
tendtoconfusethefamiliarwiththesafe,causingthemtoconcentratetheirholdingsincompaniestheyarefamiliarwith,particularlythestockoftheiremployer.Thistendencytypicallyresultsinminimalexposuretointernationalstocks.
Becausemostinvestorshavenotstudiedfinancialeconomicsorreadfinancialeconomicjournals,orbooks
onmodernportfoliotheory,theydonothaveanunderstandingofhowmanystocksareneededtobuildatrulydiversifiedportfolio.ToeffectivelydiversifytherisksofjusttheassetclassofU.S.large-capstocks,youwouldhavetoholdaminimumof50stocks.ForU.S.small-capstocksthefigureismuchhigher.Onceyouexpandyourinvestmentuniversetoincludeinternationalstocks,it
becomesobviousthattheonlywaytoeffectivelydiversifyaportfolioisthroughtheuseofmutualfunds.
However,evenwhenindividualsinvestinmutualfunds,theytypicallydonotdiversifyeffectivelybecausetheymakethemistakeofthinkingthatdiversificationisaboutthenumberoffundstheyown.Instead,itisabout
howwellone’sinvestmentsarespreadacrossdifferentassetclasses.Forexample,aninvestorwhoowns10differentactivelymanagedU.S.large-capfundsmaybelievethatheiseffectivelydiversified.Whileitistruethateachfundwilllikelyhavesomedifferentiationinitsholdingsfromtheothers,collectively,alltheinvestorhasdonehasbeentocreateanexpensive“closet”index
fund.Thereasonforthisisthatitislikelythatthereturnofhisportfolio,beforeexpenses,willapproximatethereturnofanS&P500Indexfund.Afterexpenses,theoddsaregreatitwillunderperform.
EvenmanyindividualswhoinvestinindexfundsgetitwrongbecausetheylimitthemselvestofundsthatmimiceithertheS&P500
IndexoratotalU.S.marketindex.Attheveryleast,theyshouldalsoincludeasignificantallocation(30to50percent)toaninternationalfund,suchasVanguard’sTotalInternationalStockIndexFund.
MODERNPORTFOLIOTHEORYAT
WORK
Thenextstepistoshowyouhowsimpleitistobuildamoreeffective,globallydiversifiedportfolio.Manyinvestorsthinkthatdiversificationmeansowningenoughmutualfunds.However,thekeyisspreadingthemacrossassetclasses.Afterall,10differentlarge-capgrowthfundsstill
meanyouonlyhaveexposuretooneassetclass.
Wewillbeginwithaportfoliothathasaconventionalassetallocationof60percentstocksand40percentbonds.Thetimeframewillbethe37-yearperiod,1975-2011.Thisperiodwaschosenbecauseitisthelongestforwhichwehavedataontheindexesweneed.Whilemaintainingthe
same60percentstock/40percentbondallocation,wewillthenexpandourinvestmentuniversetoincludeotherstockassetclasses.
Step1:Wecreateaportfoliothatconsistsofjusttwoinvestments:theS&P500Indexforthestockallocationandfive-yearTreasurynotes(thehighest-qualityintermediate-termbond)for
thebondportion.Wewillseehowtheportfolioperformedifonehadthepatiencetostaywiththisallocationfrom1975through2011andrebalancedannually.Wewillthendemonstratehowtheportfolio’sperformancecouldhavebeenmademoreefficientbyincreasingitsdiversificationacrossassetclasses.Wedosoinfoursimplesteps.
Portfolios are shown forillustrative purposes only.Indexes are not availablefor direct investment.Their performance doesnot reflect the expensesassociated with themanagement of an actualportfolio, nor do indexesrepresent results of actualtrading.
Portfolio1
1975–2011
Bychangingthecompositionofthecontrolportfolio,wewillseehowwecanimprovetheefficiencyofourportfolio.Toavoidbeingaccusedofdatamining,wewillalterourallocationsby
arbitrarily“cuttingthingsinhalf.”
Step2:WebeginbydiversifyingourstockholdingstoincludeanallocationtoU.S.small-capstocks.Therefore,wereduceourallocationtotheS&P500Indexfrom60to30percentandallocate30percenttotheFama/FrenchSmallCapIndex.(TheFama-Frenchindexesmeasurereturnsusing
theacademicdefinitionsofassetclasses.Notethatutilitieshavebeenexcludedfromthedata.)
Portfolio2
1975–2011
Step3:Next,wediversifyourdomesticstockholdingstoincludevaluestocks.Weshifthalfofour30percentallocationintheS&P500Indextoalarge-capvalueindexandhalfofour30percentallocationofsmall-capstockstoasmall-capvalueindex.
Portfolio3
1975–2011
Step4:Ournextstepisto
shifthalfofourstockallocationtointernationalstocks.Forexposuretointernationalvalueandinternationalsmall-capstockswewilladda15percentallocationtoboththeMSCIEAFEValueIndexandtheDimensionalInternationalSmallCapIndex.
Portfolio4
Step5:Theeffectofthechangeshasbeentoincrease
thereturnontheportfoliofrom10.6percentto12.4percent—anincreaseof17percentinrelativeterms.Thisoutcomeiswhatweshouldhaveexpectedtoseeasweaddedriskiersmall-capandvaluestockstoourportfolio.Thus,wealsoneedtoconsiderhowtheriskoftheportfoliowasimpactedbythechanges.Thestandarddeviation(ameasureofvolatility,orrisk)ofthe
portfolioincreasedfrom10.8percentto11.8percent—anincreaseof8percentinrelativeterms.Whilereturnsincreased17percent,volatilityincreasedjust8percent.
Thereisonemoreassetclasswewanttoconsiderincludinginaportfolio.Aswediscussedearlier,commoditiesdiversifysomeoftherisksofinvestingin
stocks.Theyalsodiversifytherisksofinvestinginbonds.Therefore,wewilladda4percentallocationtotheGoldmanSachsCommodityIndex,reducingeachofour4domesticstockallocationsby0.5percentandboththeinternationalstockallocationsby1percent.
Portfolio5
1975–2011
Mostinvestorsthinkofcommoditiesasriskyinvestments.However,youwillnotethattheadditionofcommoditiestotheportfolioactuallyreducedthevolatilityoftheportfolio,andreduceditbytwicethereductionin
theportfolio’sreturn.Whereastheportfolio’sreturnfellby0.3percent,itsstandarddeviationfellby0.6percent.Relativelyspeaking,theportfolio’sreturnfell2percentwhileitsvolatilityfellby5percent.This“diversificationbenefit”iswhyyoushouldconsiderincludingasmallallocationtocommoditiesinyourportfolio.
Thenetresultofallofourchangesisthatweincreasedthereturnoftheportfolioby1.5percent,from10.6to12.1percent—anincreaseof15percentinrelativeterms.Atthesametime,thevolatilityoftheportfolioincreasedjust0.4percent,arelativeincreaseof4percent.
LOWERINGTHE
PORTFOLIORISK
Youhavenowseenthepowerofmodernportfoliotheoryatwork.Yousawhowyoucanaddrisky(and,therefore,higherexpectedreturning)assetstoaportfolioandincreasethereturnsmorethantheriskswereincreased.Thatisthebenefitofdiversification.However,thereisanotherwayto
considerusingthisknowledge.Insteadoftryingtoincreasereturnswithoutproportionallyincreasingrisk,wecantrytoachievethesamereturnwhileloweringtheriskoftheportfolio.Totryandachievethisgoal,weincreasethebondallocationto60percentfrom40percentanddecreasetheallocationstoeachofthestockassetclassesandtocommodities.
Portfolio6
1975–2011
ComparedwithPortfolio1,Portfolio6achievedahigherreturnwithfarlessrisk.Portfolio6provideda0.3percenthigherreturn,10.9percentversus10.6percent—arelativeincrease
of3percent.Itdidsowhileexperiencing2.9percentlowervolatility,7.9percentversus10.8percent—arelativedecreaseof27percent.
PLAYINGTHEWINNER’SGAME
Throughthestep-by-stepprocessdescribedabove,it
becomesclearthatoneofthemajorcriticismsofpassiveportfoliomanagement—thatitproducesaveragereturns—iswrong.Therewasnothing“average”aboutthereturnsofanyoftheportfolios.Certainlythereturnsweregreaterthanthoseoftheaverageinvestorwithasimilarstockallocation,beitindividualorinstitutional.
Passiveinvestingdelivers
market,notaverage,returns.Anditdoessoinarelativelylow-costandtax-efficientmanner.Theaverageactivelymanagedfundproducesbelow-marketresults,doessowithgreatpersistency,anddoessoinatax-inefficientmanner.
Byplayingthewinner’sgameofacceptingmarketreturns,youwillalmostcertainlyoutperformthevast
majorityofbothindividualandinstitutionalinvestorswhochoosetoplaytheactivegame.Thereisonlyonecaveat.Youmustlearntothinkofyourselfakintoapostagestamp.Thelowlypostagestampdoesonlyonething,butitdoesitexceedinglywell:itstickstoitsletteruntilitreachesitsdestination.Youmuststicktoyourinvestmentplanuntilyouachieveyourfinancial
goals.Youronlyactivitiesshouldberebalancing,managingfortaxes,andadjustingtheplaniftheunderlyingassumptionschange.Andthatisthesubjectofournextchapter.
7TheCareandMaintenance
ofyourPortfolio
Justasagardenmustundergoregularcareandmaintenance,regularmaintenancemustbeperformedonaninvestmentportfolio.Otherwise,youwilllosecontroloverthemostimportantdeterminantofriskandreturns:yourportfolio’sassetallocation.Thatmakesrebalancingoneofthetwoimportantitemsontheportfoliomaintenanceagenda.Theotheristax
management.Wewilldiscussboth,beginningwithrebalancing.
REBALANCING
Rebalancingrestorestheportfoliotoyourdesiredriskprofile,theoneyouwroteinyourIPS.Withoutregularlyrebalancingaportfolio,youwillfindthat“styledrift”will
occur.Inrisingmarkets,yourportfoliowillbecomemoreaggressiveasyourstockholdingsbecomeabiggerpercentageofyourportfolio.Withoutrebalancing,yourstockallocationwilltypicallybeincreasingwhenvaluationsarehigherand,thus,expectedreturnsarelower.Infallingmarkets,thereverseistrue.Yourstockallocationwilltypicallybedecreasingwhenvaluationsarelowerand,
thus,expectedreturnsarehigher.Thatdoesnotsoundlikeanintelligentapproach.
BuyLowandSellHighTherebalancingprocessissimple,thoughnoteasy.Thisisbecauseemotionscangetintheway.Rebalancingallowsyoutoreduceyourallocationintheassetclassesthatperformedrelativelythebest(sellinghigh)and
increasethepositionintheassetclassesthatperformedrelativelypoorly(buyinglow).Isn’titeveryinvestor’sdreamtobuylowandsellhigh?
Anotherbenefitofrebalancingisthatovertimeitwillproduceabonus—theportfolio’sannualizedreturnwillexceedtheweightedaverageoftheannualizedreturnsofthecomponent
assetclasses.Thisisreferredtoasadiversificationreturn,or“rebalancingbonus.”Andthemorevolatiletheassetclassesarewithintheportfolio,andthelowertheircorrelations,thegreatertheeffectofrebalancing.Thereasonisthatwhenyourebalanceyouwillbebuyingatlowerlowsandsellingathigherhighs.
Animportantdecisionto
makeishowtodeterminetherebalancingparameters.Thefollowingwillprovideyouwithareasonableruleofthumbtoconsider.
The5/25PercentRuleRebalancingmaycausetransactionfeestobeincurred,anditmayalsohavetaximplications.Therefore,itshouldbedoneonlywhenevernewfundsare
availableforinvestmentorwhenyourassetallocationhasshiftedsubstantiallyoutofalignment.Areasonableruleofthumbistousea5/25percentruleinanassetclass’sallocationbeforerebalancing.Thatis,rebalancingshouldoccuronlyifthechangeinanassetclass’sallocationisgreaterthaneitheranabsolute5or25percentoftheoriginaltargetallocation,whicheverisless.
Forexample,let’sassumeanassetclasswasgivenanallocationof10percentoftheportfolio.Applyingthe5percentrule,onewouldnotrebalanceunlessthatassetclass’sallocationhadeitherrisento15percentorfallento5percent.However,usingthe25percentrule,onewouldreallocateifithadrisenorfallenbyjust2.5percenttoeither12.5or7.5percent.
Inthiscase,the25percentfigurewasthegoverningfactor.Ifonehada50percentasset-classallocation,the5/25percentrulewouldcausethe5percentfiguretobethegoverningfactorsince5percentislessthan25percentof50percent,whichis12.5percent.Inotherwords,onerebalancesifeitherthe5percentorthe25percenttestindicatestheneedtodoso.
Whilerebalancingshouldbedonebasedonrisk(asdescribedabove),notonthecalendar,ifyouaredoingityourself,keepitsimpleandapplythe5/25percenttestatleastquarterly.Youshouldbesurethatthetestisappliedatallthreelevels:
•Thebroadlevelofstocksandbonds
•Thelevelofdomestic
andinternationalassetclasses
•Themorenarrowlydefinedindividualasset-classlevel(suchasemergingmarkets,realestate,small-cap,value,andsoon).
Forexample,supposeyouhadsixstockassetclasses,eachwithanallocationof10percent,resultinginastock
allocationof60percent.Ifeachstockclassappreciatedsothatitthenconstituted11percentoftheportfolio,norebalancingwouldberequiredifyouonlylookedattheindividualasset-classlevel(the5/25percentrulewasnottriggered).However,lookingatthebroaderstockclasslevel,weseethatrebalancingisrequired.Withsixstockassetclasses,eachconstituting11percentofthe
portfolio,thestockassetclassasawholeisnowat66percent.Theincreasefrom60to66percenttriggersthe5/25percentrule.Thereversesituationmayoccurwherethebroadassetclassesremainwithinguidelinesbuttheindividualclassesdonot.Onceagain,justaswiththemodelportfolios,the5/25percenttestisjustaguideline.Youcancreateyourownguidelinefor
rebalancingforrisk.Thedisciplinetheprocessprovidesismoreimportantthanthepercentagesyouchoose.
TheIPSAssetAllocationandRebalancingTableYourIPSshouldincludeanassetallocationandrebalancingtable.Thetableshouldincludeboththetargetlevelsforeachassetclassand
theminimumandmaximumlevelstowhichtheallocationswillbeallowedtodrift.Somedriftshouldbeallowedtooccur,becauserebalancinggenerallyinvolvescosts,includingtransactionfeesandtaxesintaxableaccounts.
SampleRebalancingTableUsing5/25Rule
TheRebalancingProcessIntheaccumulationphase,
therearetwowaystorebalance.Thefirstistosellwhathasdonerelativelywellinordertobuywhathasdonerelativelypoorly.Thesecondistousenewcashtoraisetheallocationsoftheassetclassesthatarebelowtargetedlevels.Acombinationofthetwostrategiescanbeused.Utilizingnewcashispreferred;itreducestransactionscosts,andit
reducesoreliminatesthecapitalgainsthataregeneratedwhensellingappreciatedassetsintaxableaccounts.Inthewithdrawalphase,investorscansellwhathasdonerelativelywell.
Astrategytoconsideristohavedistributionspaidincash,ratherthanautomaticallyreinvested,andusethecashtorebalance.However,youshould
considerthesizeoftheportfolioandanytransactioncoststhatmightbeincurred.Forsmallaccountswheretransactioncostsarepresent,thismightnotbeagoodstrategy.Herearesomeotherrecommendationsontherebalancingprocess:
•Considerifincrementalfundswillbecomeavailableinthenearfuture(suchasatax
refund,aperformancebonus,proceedsfromasale,ordividends).Ifcapitalgainstaxeswillbegeneratedbyrebalancing,itmightbeprudenttowaituntilthenewcashisavailable.
•Considerdelayingrebalancingifitgeneratessignificantshort-termcapitalgains.Thesizeofthegain
shouldbeamajorconsideration:thelargerthegain,thegreateristhebenefitofwaitingtoreceivethemorefavorabletreatmentthatlong-termgainsreceive.Alsoconsiderhowlongitwillbebeforeadditionalfundscanbegeneratedtorebalance.
•Ifsignificantcapitalgainstaxesare
generated,considerrebalancingtoonlytheminimum/maximumtolerancerangesratherthanrestoringallocationstothetargetlevels.
Wenowturntotheotherimportantmaintenanceitem:taxmanagement.
TAX
MANAGEMENT
Whilethewinningstrategyistouseapassiveinvestmentstrategy,passivelymanagingthetaxableportionoftheportfoliowithoutregardtotaxesisamistake.Aninvestorcanimprovetheafter-taxreturnsofaportfoliobyproactivetaxmanagement.Taxmanagementinvolvesthefollowingactions:
•Choosethemosttax-efficientvehicles.
•Sellfundswithlossesthroughouttheyear—wheneverthevalueofthetaxdeductionsignificantlyexceedsthetransactioncosts—andimmediatelyreinvesttheproceedsinamannerthatavoidsthewash-salerule(whichwouldcausethetaxdeductiontobe
disallowed).Awashsaleoccurswhenyousellsecuritiesatalossandthenbuyorcontracttobuysubstantiallyidenticalsecuritieswithin30days.Portfoliosshouldbecheckedregularly(atleastquarterly)todetermineifthereareopportunitiestoharvestlosses.Waitinguntiltheendoftheyearto
performtax-lossharvestingisamistake,becauselossesthatmightexistearlyintheyearmaynolongerexistbytheendoftheyear.
•Sellthehighestcost-basislotsfirsttominimizegainsandmaximizelosses.Asof2012,custodiansarerequiredtotrackthisinformationforyou.
•Ingeneral,neverwillinglyrealizeshort-termgains.Instead,waituntilthegainsqualifyaslongterm.Notethatifyourstockallocationiswellabovetarget,youmaywishtooverridethissuggestion,weighingtherisksofan“excessive”allocationtostocksversusthepotentialtaxsavings.Anothercommon
exceptionisifyouhavepriorcapitalgainslossesthatcanoffsetthesegains.
•Tradearounddividenddates.Sharesofafundshouldnotbepurchasedjustpriortothedateofrecordfordividendpaymentstoshareholders.Notethattheex-dividenddateisnotthesameasthedate
ofrecord.Thedateofrecordisthedatewhenyoumustbeonthecompany’sbooksasashareholdertoreceivethedividend.Theex-dividenddateisthedateaftertherecorddatewhenthedividendis“separated”(thepaymentismade)fromthefund.Thefundthentradesatalowerprice,netofdividends.
Dependingonthesizeofthedistributionthatisexpected,youshouldnotconsiderbuyingwithin30to60daysoftheex-dividenddate.
•Tradearoundyear-enddistributions.Mostfundsmakedistributionsonceayear,usuallyinDecember.Somefundsmakethemmorefrequently,and
sometimestheymakespecialdistributions.Checktoseeiftherearegoingtobelargedistributionsthatwillbetreatedaseitherordinaryincomeorshort-termgains.Ifyouareconsideringbuyingafundaroundthetimeofthedistribution,itmaymakesensetowaituntilaftersuchadistributionhasbeenpaidout,
therebyavoidinghavingtopaytaxonthetaxableportionofthosegainsonyourincometaxreturn.Ifyouareconsideringsellingafund,youmightbenefitfromsellingthefundbeforetherecorddate.Bydoingso,theincreaseinthenetassetvaluewillbetreatedaslong-termcapitalgains,andtaxeswillbeatthelowerlong-termrate.If
thefundmakingthelargepayoutissellingforlessthanyourtaxbasis,considersellingthefundpriortothedistribution.Otherwise,youwillhavetopaytaxesonthedistribution,despitehavinganunrealizedlossonthefund.Also,considerthepotentialdistributionfromanyreplacementfundsoyoudon’t
exacerbatetheproblem.
Wenextturntothequestionofwhetheryoushouldbeado-it-yourselfinvestororhireanadvisor.
8ShouldyouHirea
FinancialAdvisor?
Whetherwearetalkingabouthomerepairsorinvesting,individualscanbecategorizedintotwobroadgroups:thosewhohireprofessionalsandthe“do-it-yourselfers”—thosewhodonotwanttopayprofessionalsforsomethingtheybelievetheycandojustaswell.Ofcourse,somewhobelongtothedo-it-yourselfgroupwouldbebetteroffhiringprofessionals.Onereasonis
thatifsomethingisnotdonerightthefirsttime,thecostofcorrectingerrorscanfarexceedthecostofaprofessionaltodoitrightinthefirstplace.Anotheristhatwhileyoucanrecoverfrommakingamistakewhiletryingtofixaleakyfaucet,thedamagedonebyfinancialerrorscantakeyearstorecoverfromandcanevenbeirreversible.
Ifyouareconsideringbeingado-it-yourselfinvestor,askyourselfthefollowingfivequestions:
1.DoIhavealltheknowledgeneededtodevelopaninvestmentplan,integrateitintoanoverallestate,tax,andriskmanagement(insuranceofalltypes)plan,andthenprovidetheongoingcareand
maintenancethatisrequired?
2.DoIhavethemathematicalskillsneeded?Ithelpstohaveknowledgethatgoeswellbeyondsimplearithmetic,includingadvancedknowledgeofprobabilitytheoryandstatistics,suchascorrelationsandthevariousmomentsof
distribution(suchasskewnessandkurtosis).
3.DoIhavetheabilitytodeterminetheappropriateassetallocation,onethatprovidesthegreatestoddsofachievingmyfinancialgoalswhilenottakingmoreriskthanIhavetheabilityandwillingnesstotake?Animportantpartof
theplanningprocessincludestheuseofaMonteCarlosimulator(asophisticatedretirementplanningprogram)toestimatetheoddsofachievingyourfinancialgoalsundervariousassetallocations,saving,andspendingassumptions.Requiredassumptionsincludeexpectedreturnsofassetclasses,
expectedstandarddeviationsofassetclasses,andexpectedcorrelationsamongassetclasses.Therearemanyoftheseprogramsavailable,severalofwhichhaveseriousflaws.Andbecauseoftheircomplexity,itiseasytomakemistakes.
4.DoIhaveastrongknowledgeoffinancial
history?Oneneedstobeawareofhowoftenstockshaveprovidednegativereturns,howlongbearmarketshavelasted,andhowdeeptheyhavebeen.Thosewhodonotknowtheirhistoryarelikelytorepeatpastmistakes.
5.DoIhavethetemperamentandtheemotionaldiscipline
neededtoadheretoaplaninthefaceofthemanycrisesIwillalmostcertainlyface?Areyouconfidentthatyouhavethefortitudetowithstandaseveredropinthevalueofyourportfoliowithoutpanicking?Willyoubeabletorebalancebacktoyourtargetallocations(keepingyourheadwhilemost
othersarelosingtheirs),buyingmorestockswhenthelightattheendofthetunnelseemstobeatruckcomingtheotherway?ThinkbacktohowyoufeltandactedaftertheeventsofSeptember11,2001,andduringthefinancialcrisisthatbeganin2007.Experiencedemonstratesthatfearoftenleadstoparalysis,
or,evenworse,panickedsellingandtheabandonmentofwell-developedplans.Whensubjectedtothepainofabearmarket,evenknowledgeableinvestorswhoknowwhattodofailtodotherightthingbecausetheyallowemotionstotakeover,overridingwhattheirbrainsknowisthecorrectactiontotake.
ThisresultsinwhatCarlRichardscalls“thebehaviorgap.”Thetermisusedtodescribethefailureofinvestorstoearnthesamereturnasthatearnedbytheveryfundsinwhichtheyinvest.Askyourself:HaveIalwaysdonetherightthing?Havemyreturnsmatchedthoseofmyinvestments?
Ifyouhavepassedthistest,youarepartofasmallminority.Thisbookprovidesyouwithnotonlythewinningstrategyofbroadglobaldiversificationandpassiveinvestingbutalsoguidanceonhowtoconstructaportfoliotoaddressyouruniquecircumstances.Andthebook’sconclusioncontainsmylistofthe30RulesofPrudentInvestingthatwillhelpyouachieve
yourgoals.Ifyouareinterestedinlearningmoreabouthowtodevelopanoverallfinancialplanthatistailoredtoyouruniquesituation,readTheOnlyGuideYou’llEverNeedfortheRightFinancialPlan.
Alternatively,youmayrecognizethatyoudonothavetheknowledge,temperament,ordisciplinetosucceedonyourown.And
evenifyoudecidethatyoumeettheserequirements,youmayrecognizethatagoodfinancialadvisoryfirmcanaddvalueinmanyways,includingfreeingyoutofocusyourattentiononthemostimportantthingsinyourlife,suchastimespentwithfamily,friends,ormeaningfulendeavors.Thus,youmayplaceagreatervalueonthattimethanthecostspentonadvice.Itisachoiceabout
findingtherightbalanceinyourlife.
Ifyoudecidetohireafinancialadvisoryfirm,thatchoicewillbeoneofthemostimportantdecisionsyouwillevermake,becauseitwillhavethegreatestimpact.Thus,itiscriticalthatyougetitright.Hereisvaluableadvice:therearethreecriteriathatshouldbeabsoluteswhensearchingfortheright
advisor.Thesecriteriaare
•Afiduciarystandardofcare
•Advicebasedonscience(evidencefrompeer-reviewedjournals),notopinions
•Investmentplanningthathasbeenintegratedintoanoverallfinancialplan
AFIDUCIARYSTANDARDOF
CARE
Therearetwostandardsofcarethatfinancialprofessionalsoperateunder:fiduciaryandsuitability.Underafiduciarystandard,thefinanceprofessionalmustalwaysactinyourbestinterests.Underasuitability
standard,thefinanceprofessionalonlyhastobuyproductsthataresuitable.Theydon’tnecessarilyhavetobeinyourbestinterest.Thereisnoreasonwhyyoushouldsettleforanythinglessthanafiduciarystandard.Andthereisnoreasonyoushouldeverworkwithanadvisororfirmnotpreparedtomeetthisstandard.Thebottomlineisthis:youmustbeconvincedthattheguiding
principleoftheadvisororfirmisthatadviceofferedissolelyinyourbestinterest.
Thereareseveralthingsyoucandoinyourduediligencetogiveyouthebestchancetoreceiveunbiasedadvice.First,requirethattheadvisoryfirmserveasafee-onlyadvisor,whichavoidstheconflictsthatcommission-basedcompensationcancreate.Withcommission-
basedcompensation,itcanbedifficulttoknowiftheinvestmentorproductrecommendedbytheadvisoristheonethatisbestforyouortheonethatgeneratesgreatercompensationfortheadvisor.Avoidingcommissioned-basedcompensationhelpstoensurethattheadviceyoureceiveisclient-centric;theonlythingbeing“sold”isadviceandsolutionstoproblems,not
products.Second,youneedtomake
surethatallpotentialconflictsofinterestarefullydisclosed.Alongwithaskingquestions,youshouldreviewthefirm’sFormADV—adisclosuredocumentsettingforthinformationaboutthefirm’sadvisors,itsinvestmentstrategy,feeschedules,conflictsofinterest,regulatoryincidents,
andmore.Carefulduediligencehelpsminimizetheriskofanexpensivemistake.
Third,youshouldrequirethatthefirm’sadvisorsinvesttheirpersonalassets(includingthefirm’sprofit-sharingand/orretirementplan)basedonthesamesetofinvestmentprinciplesandinthesameorcomparablesecuritiesthattheyrecommendtotheirclients.
Althoughyoushouldexpecttoseeassetallocationsdifferentfromthosethatarebeingrecommendedtoyou(aseachinvestorhashis,ownuniquecircumstances),theinvestmentvehiclesshouldbethesame.
EVIDENCE-BASEDADVICE
Youshouldconsiderworkingonlywithafirmwhoseinvestmentstrategyandadviceisbasedonthescienceofinvesting,notonopinions.Todemonstratethewisdomofthisadvice,considerthefollowingsituation.Youarenotfeelingwell.Youmakeanappointmenttovisitadoctoryourfriendhasrecommended.Thedoctor’sjobistodiagnosetheproblemandrecommendtreatment.
Afterathoroughexam,heturnsaroundtohisbookshelfandreachesforthelatestcopyofPreventionmagazine.Beforehearinghisadviceyouareprobablyalreadythinkingitistimetogetasecondopinion.Therefore,youmakeanappointmentwithanotherdoctor.Afterherexam,shereachesforacopyoftheNewEnglandJournalofMedicine.Atthispoint,youarefeelingmuchbetterabouttheadvice
youareabouttoreceive.ThefinancialequivalentsoftheNewEnglandJournalofMedicinearesuchpublicationsastheJournalofFinance.Theadvisoryfirmshouldbeabletociteevidencefrompeer-reviewedjournalssupportingtheirrecommendations.YoushouldnotbegettingyouradvicefromthefinanceequivalentsofPrevention,suchasInvestor’sBusiness
DailyorBarron’s.
INTEGRATEDFINANCIALPLANNING
Becauseplanscanfailforreasonsthathavenothingtodowithaninvestmentplan,itiscriticalthattheadvisoryfirmyouchoosewillintegrateaninvestmentplanintoan
overallestate,tax,andriskmanagementplan.
Awell-developedfinancialplanincludesadetailedanalysisoftheneedfor
•Lifeinsurance,forreplacingincome,payingestatetaxesand/ortransferringwealthtoheirsoracharity
•Disabilityinsurance,incaseyoucan’twork
•Longevityinsurance,tocovertheriskofrunningoutofmoneybecauseyoulivelongerthanexpected,ariskthatcanbehedgedthroughthepurchaseofapayoutannuity
•Long-termcareinsurance,toprotectagainstcarecosts
drainingyourassets
•Propertyandcasualtyinsurance,suchasforhomes,cars,andboatsandagainstfloodsandearthquakes
•Personalliabilityinsurance,includinganumbrella(excessliability)policy
Itisimportanttounderstandthatplanscanfail
evenwhenestateplanningisdonewell.Forexample,fartoooftenindividualspayforhigh-poweredattorneystodevelopwell-thought-outestateplansonlytohavethetrustscreatedeithergototallyunfundedorbefundedwiththewrongtypeofassets.Sometrustsaredesignedtogeneratestablecashflowsandshouldbefundedwithsafebonds.Othersaredesignedwithagrowth
objectiveinmindandshouldbefundedprimarilywithstocks.
Estateplanscanalsoderailyoubecausethebeneficiarieshavenotbeenproperlynamed(resultingfromafailuretoupdatedocumentstoaddresslifeeventssuchasdivorceordeath)orbecausethetypeormethodofassetdistributionisinappropriate(forinstance,
directingassetstobedistributeddirectlytoabeneficiarywithdemonstratedcreditor,bankruptcy,orfinancialmanagementissues).Thisisanotherexampleofwhyafinancialplanmustbealivingdocument,onethatisreviewedonaregularbasis.
Itisalsocriticaltounderstandthatestateplanscanfaildespitethebest
effortsoftop-notchprofessionaladvisors.Unfortunately,itisnotuncommonforestatestolosetheirassetsandforfamilyharmonytosplinterfollowingthetransitionoftheestate.Thisoccursbecausebeneficiariesareunprepared,theydonottrustoneanother,andcommunicationsbreakdown.Whilegreatattentionistypicallypaidtopreparingtheassetsfortransitiontothe
beneficiaries,verylittle,ifany,attentionisbeingpaidtopreparingthebeneficiariesfortheassetstheywillinherit.Agoodadvisoryfirmcanaddgreatvaluebyhelpingtoprepareandeducatebeneficiariesforthewealththeywillinherit.
Therearemanyotherwaysagoodfinancialadvisoryfirmcanandshouldaddvalue.Thefollowingisa
partiallist:
•Retirementplanning,includingcashwithdrawalstrategies.Choosingthemostefficientamountandaccountfromwhichassetsshouldbewithdrawnaswellasthesequencingcanmakeabigdifferenceinafter-taxresults.Anothercriticallyimportant
decisioniswhentobegintakingsocialsecurity.
•Regular,ongoingcommunications,especiallyduringtimesofcrisis.Educationprotectsyoufromhavingyouremotionstakecontrolofyourportfolio.
•Ongoingeducationaboutinnovationsinfinance.Theknowledgeofhow
marketsworkadvancesonapersistentbasis.Thus,youshouldbesurethatthefirmhasthedepthofresourcestostayontopofthelatestresearch.
•Theabilitytoanalyzecomplexfinancialproducts,helpingyouavoidpurchasingcostlyproductsthataremeanttobesold,notbought.
•Disciplinedcost-andtax-effectiverebalancingandtaxmanagementthatarenotdrivenbythecalendarbutbyhowtheportfolio’sassetsareperforming.
•Collegefunding.
•Selectinginvestmentsfor529plans,401(k),403(b),andotheremployerplans.
•Giftingtoheirsandcharitiesinthemosteffectivemanner.
•Homepurchaseandmortgagefinancingdecisions.
•Themanagementandultimatedispositionoflargeconcentratedpositionswithlow-costbasis(typicallythestockofyouremployerorstockthathasbeen
inherited).
•Separateaccountmanagementofbondportfolios,eliminatingtheexpenseofamutualfund,whilemaximizingtaxefficiencyandafter-taxreturns.
•Ongoingperformancetracking,measuringtheprogressversusyourplanandrecommendingadjustmentsthatare
necessarytopreventfailure.
•Actingasan“insurancepolicy”intheeventofadeathofafamilymemberwhoisresponsibleformanagingfinancialmatters.
Clearly,nooneadvisorcanbeanexpertinalloftheseareas.Therefore,when
choosingafirm,besurethatithasateamofexpertswhocanhelpaddresseachoftheseareas.Youshouldalsomakesurethatthefirm’scomprehensivewealthmanagementservicesareprovidedbyindividualswhohavethePFS(personalfinancialspecialist),CFP(certifiedfinancialplanner),orothercomparabledesignations.NotethatthePFScredentialisgrantedto
CPAswhohavedemonstratedtheirknowledgeandexpertiseinpersonalfinancialplanning.Andoncethesedesignationsaregranted,theymustbemaintainedthroughrequiredprofessionaldevelopmenttokeepthemcurrent.
Itisalsoimportanttobeclearthatthefirmwilldeliverahighlevelofpersonalattentionanddevelopstrong
personalrelationships.Thisshouldbepartofyourduediligenceprocessasyoucheckthefirm’sreputationwithotherlocalprofessionals(suchasCPAsandattorneys)andclientreferences.
Anotherpartofyourinvestigationshouldbeaskingtheadvisorhowheorshespendstimeatwork.Youmightask:“Canyoupleasetellmeaboutyouraverage
day?”Whatyouarelookingforisanadvisorwhospendsthemajorityofhisorhertimesolvingclient’sconcernsaboutsuchissuesas
•Makingsmartdecisionsaboutmoney
•Minimizingincome,gift,andestatetaxes
•Transferringassetstothenextgeneration
•Protectionfromthirdpartiesunjustifiablytakingtheirassets
•Interestinmakingsignificantcharitablegifts
Yourinvestigationshouldincludesharingallofyourconcernswiththeadvisor.Theobjectiveistodevelopadeepunderstandingofhowtheadvisorcanhelpyou
addresstheseconcernsandensurethatyouareconfidentyouhaveahighleveloftrustintheadvisor,hisorhersupportteam,andtheadvisoryfirmasawhole.
Thereisonelastpointweneedtocover.Asisthecasewiththechoiceofinvestmentvehicles,withchoiceofinvestmentadvisorscostsmatter.Butwhatreallymattersisthevalueadded
relativetothecost.Thelowestcostinvestmentvehiclemaynotbethebestchoice.Rememberthatwhilegoodadvicedoesn’thavetobeexpensive,badadvicealmostalwayswillcostyoudearly,nomatterhowlittleyoupayforit.
Thechoiceofafinancialadvisorisoneofthemostimportantdecisionsyouwillevermake.Thatiswhyitis
soimportanttoperformathoroughduediligence.Thebottomlineisthatyouwanttobesurethatthefirmyouchooseisonewherethescienceofinvestingmeetstruewealthmanagementandthattheservicesaredeliveredinahighlypersonalmanner.
9WinningtheGameofLife
AswediscussedinChapter3,thereisanover-whelmingbodyofevidencedemonstratingthatpassive
investingistheprudentinvestmentstrategy.Passiveinvestingalsoallowsyoutowinthefarmoreimportantgame:thegameoflife.Thefollowingtaledemonstratesthewisdomofthatstatement.
AnexpertintimemanagementwasinvitedtospeaktoanMBAclass.Afterabriefintroductionshereacheddownandproducedaverylargemasonjarandsetit
onatableinfrontofher.Shethenreacheddownagainandproducedaboxfilledwithbigrocks.Sheproceededtoremovetherocksfromtheboxandcarefullyplacedthem,oneatatime,intothejar.Whennomorerockswouldfitinsidethejar,sheaskedtheclass,“Isthisjarfull?”Everyoneyelled,“Yes.”Shethenreachedunderthetable,pulledoutabucketofgravel,dumped
somein,andshookthejar.Thiscausedpiecesofgraveltoworkthemselvesdownintothespacesbetweenthebigrocks.Shecontinuedthisprocessuntilnomoregravelcouldbeplacedintothejar.Shethenaskedtheclass,“Isthejarfull?”Onestudent,gettingtheidea,answered,“No.”Shethenreachedunderthetable,broughtoutabucketofsand,andstarteddumpingthesandintothejar.
Thesandbegantofillthespacesbetweentherocksandthegravel.Shecontinueduntilnomoresandcouldfitintothejar.Oncemoresheasked,“Isthisjarfull?”Thistimeeveryoneshouted,“No!”Shethengrabbedapitcherofwaterandpoureduntilthejarwasfilledtothebrim.Shethenaskedtheclass,“Whatisthemoralofthestory?”Aneagerstudentraisedhishandandsaid,“Themoralofthe
storyisthatnomatterhowfullyourscheduleis,youcanalwaysfitinonemoremeeting!”
Thespeakerreplied,“Nicetry,butthatisnotthemoralofthestory.Thetruththisillustrationteachesusisthatifyoudonotputthebigrocksinfirst,youcannevergetthemin.”Toeachofus,the“bigrocks”meansomethingdifferent,butatthe
core,thebigrocksarethosethingsthatprovidetherichestmeaningtoourlives.
Asapassiveinvestor,whenIcomehomefrommybusyday,Igettositdownwithaglassofwineandaskmywifeaboutherdayandhowmykidsandgrandchildrenaredoing.BecauseIdidnotspendmytimetryingtobeatthemarket,Ialsogottocoach
myyoungestdaughter’ssoftball,soccer,andbasketballteams.Ialsoreadabout70bookseachyear,docommunityservice,playtennis,andfocusontheotherbigrocks,thereallyimportantthingsinmylife.
Investorsfollowinganactivemanagementstrategyspendmuchoftheirpreciousleisuretimewatchingthelatestbusinessnews,studying
thelatestcharts,readingfinancialtradepublications,andsoon.Whattheyarereallydoingisfocusingonthegravel,thesand,andthewater.Therefore,eveniftheyareamongtheveryfewwhoaresuccessfulatthegameofactiveinvesting,the“price”ofsuccessmaybethattheylosethefarmoreimportantgameoflife.
Thequestionforyouto
consideris,whatarethebigrocksinyourlife?Isthebigrockinyourlifetryingtogenerateextrareturnsthroughactivemanagementstrategiesthatrequireyouto“invest”largeamountsofyourtime?Orarethebigrocksinyourlifetimespentwithyourlovedones,yourfaith,youreducation,yourdreams,aworthycause,orteachingormentoringothers?Ifyoudonotalreadyknowtheanswer,
perhapsthisstorywillhelpyoufindit.
Shortlyaftermyfirstbookwaspublishedin1998,Ireceivedacallfromadoctor.Hehadbeeninpracticejustafewyears.Hehadawifeandayoungchild,withanotherchildontheway.Hehadgottencaughtupintheeuphoriaofthebullmarketandtheadventofdaytrading.Hehadseenmanyofhis
doctorfriendsgeneratelargeprofitsfromtradingstocks,andhethoughtheshouldgetinonthiseasymoney.
AfterputtinginhistypicallongdayhewouldheadstraightforhiscomputerandtheInternet.Hespenthoursstudyingchartsandinvestmentreportsandfollowingthechatboards.Withinafewmonthshehadturnedhissmallinvestment
stakeintoabout$100,000.Unfortunately,hiswifenolongerhadahusband,andhischildnolongerhadafather.Hewasnowmarriedtohisinvestments.Hiswifebegantoseriouslyquestiontheirmarriage.Luckily,withinafewmonthshehadlostallhisprofits.
Fortunately,thedoctorrealizedthathisoriginalgainswerelikelyamatterofluck
andthathehadbeenabeneficiaryofabullmarket.Moreimportant,herecognizedthathewasnotpayingattentiontohisfamily.Whendiscussingthiswithafriend,hisfriendsuggestedthathereadTheOnlyGuidetoaWinningInvestmentStrategyYou’llEverNeed.Afterdoingsohecalledtothankmeforhelpinghimfindthewinner’sgameininvesting,butmoretothe
point,forhelpinghimfindthewinner’sgameinlife.Fromthenonheknewtofocusonthebigrocksinhislife.
Thefollowingisanothertruestory.Aboutoneyearaftermyfirstbookwaspublished,ImetRickHill.RickwasasophisticatedinvestorwithanMBAfromWharton,UniversityofPennsylvania.Rickhadabout
30yearsofexperienceinfinancialmanagement.Aftermeetingwithoneofmypartners,andhavingreadmybook,Rickbecameaclient.Eventually,RickjoinedBuckinghamAssetManagementasafinancialadvisorsothathecouldhelpothersenjoythebenefitsofpassiveinvesting.Uponjoining,herelatedthisstory.
Ricktoldmethatheused
tospendmanyhourseverydayreadingfinancialpublications,researchingstocks,andwatchingthefinancialnews.Andthiswasafterspendingalongdayattheoffice.Afteradoptingtheprinciplesofmodernportfoliotheory,theefficientmarketshypothesis,andpassiveinvesting,hefoundthathenolongerneededtodothosethings.Herecognizedthathehadbeenpayingattentionto
whatwasnothingmorethannoiseandthatitonlydistractedhimfromthewinner’sgame.
Rickandhiswifesatdownandcalculatedthatbyadoptingapassiveinvestmentapproachhehadactuallyrecapturedsixweeksperyearofhislife!It’sonethingtospendsixweeksayearinproductiveactivities.However,Rickhadrealized
thattheactivitiesinwhichhewasengagedwerecounterproductivebecauseoftheexpensesandtaxesincurredwhenhewasimplementinganactivestrategy.And,thatdidn’tincludeplacingavalueonthemostpreciousresourcehehad:time.Heonlyhadalimitedamountofitanddidnotwanttospenditonless-than-optimalactivities.
Conclusion
IbecamethedirectorofresearchforBAMAdvisorServicesbecauseIwantedtoteachinvestorstheknowledgenecessarytomakeprudentinvestmentdecisions.Throughmywritingsandinteractionswithinvestors,I
believeIhaveaccomplishedthatobjective—thoughthereisalotmoreworktodo.
ThegreatestpleasureIhavereceivedfrommyeffortsisthatmanyreadershavetoldmethatthegreatestvaluetheyreceivedfrommybooksisthatthequalityoftheirliveshasbeenimproved.Armedwiththeknowledgeofhowmarketswork,andwithawell-developedfinancial
plantailoredtotheiruniquesituation,theyareabletoignorethenoiseofthemarketandtheinvestmentpanderingofWallStreetandfocusonthe“bigrocks”intheirlives.
IsharedwithyouthebenefitsofindexingandpassiveinvestingbecauseIfeeltheyprovidethemostprudentsolutionforallinvestors.Itishowyoureceivemarketreturnsina
low-costandtax-efficientmanner,providingyouwiththegreatestlikelihoodofachievingyourgoals.Adoptingthisapproachalsofreesyoufromcombingthroughfinancialpublications,allowingyoutospendyourpreciousfreetimeinmeaningfulactivitieswiththoseyoulove,thusenrichingyourlife.
Finally,itisimportantto
rememberthatdespitewhatWallStreetandthefinancialpresswantyoutobelieve,investingwasnevermeanttobeexciting.Instead,itisaboutachievingyourfinancialgoalswiththeleastamountofrisk.Togiveyourselfthebestchanceofachievingthatobjective,besuretofollowmy30RulesofPrudentInvesting.
30RulesofPrudentInvesting
Whilewesearchfortheanswerstothecomplexproblemofhowtolivealongerlife,therearesimple
solutionsthatcanhaveadramaticimpact.Forexample,itwouldbehardtofindbetteradviceonlivinglongerthan:donotsmoke,drinkalcoholinmoderation,eatabalanceddiet,getatleastahalfanhourofaerobicexercisethreetofourtimesaweek,andbuckleupbeforedriving.Theideathatcomplexproblemscanhavesimplesolutionsisnotlimitedtothequestionoflivinga
longerlife.Ihavespentalmost40
yearsmanagingfinancialrisksfortwofinancialinstitutionsaswellasadvisingindividualsandmultinationalcorporationsonthemanagementoffinancialrisks.Basedonthoseexperiences,Ihavecompiledalistofrulesthatwillgiveyouthegreatestchanceofachievingyourfinancial
goals:
1.Donottakemoreriskthanyouhavetheability,willingness,orneedtotake.Plansfailbecauseinvestorstakeexcessiverisks.Therisksshowupunexpectedly,whichleadstotheabandonmentofplans.Whendevelopingyourplan,consideryour
horizon,stabilityofincome,abilitytotoleratelosses,andtherateofreturnrequiredtomeetyourgoals.
2.Neverinvestinanysecurityunlessyoufullyunderstandthenatureofalloftherisks.Ifyoucannotexplaintheriskstoyourfriends,youshouldnotinvest.Fortuneshave
beenlostbecausepeopledidnotunderstandthetypeofriskstheyweretaking.
3.Themorecomplextheinvestment,thefasteryoushouldrunaway.Complexproductsaredesignedtobesold,notbought.Youcanbesurethecomplexityisdesignedinfavoroftheissuer,nottheinvestor.
InvestmentbankersdonotplaySantaClausandhandoverhigherreturnsbecausetheylikeyou.
4.Riskandreturnarenotnecessarilyrelated;riskandexpectedreturnarerelated.Iftherewerenorisk,therewouldnotbehigherexpectedreturns.
5.Ifthesecurityhasahighyield,youcanbesuretherisksarehighevenifyoucannotseethem.ThehighyieldisliketheshinyapplewithwhichtheevilqueenenticesSnowWhite.Investorsshouldneverconfuseyieldwithexpectedreturn.SnowWhitecouldnotseethepoisoninsidetheapple.Similarly,
investmentrisksmaybehidden,butyoucanbesuretheyarethere.
6.Awell-designedplanisnecessaryforsuccessfulinvesting,butyoumustalsohavethedisciplinetostaythecourse,rebalance,andtax-manageasneeded.Unfortunately,mostinvestorshaveno
writtenplan.Andemotionssuchasgreedandenvyinbullmarketsandfearandpanicinbearmarketscancauseevenwell-designedplanstobediscarded.
7.Investmentplansmustbeintegratedintowell-designedestate,tax,andrisk-management
(insuranceofallkinds)plans.Thebestinvestmentplanscanfailbecauseofeventsunrelatedtofinancialmarkets.Forexample,thebreadwinnerdieswithoutsufficientlifeinsuranceorsuffersanaccidentandhasinsufficientliability,disability,orlong-term-careinsuranceinplace.
8.Donottreatthehighlyimprobableasimpossibleorthehighlylikelyascertain.Investorsassumethatiftheirhorizonislongenough,thereislittletonorisk.Theresultistheytaketoomuchrisk.Takingtoomuchriskcausesinvestorswithlonghorizonstobecomeshort-terminvestors.
Stocksareriskynomatterthehorizon.Andremember,justbecausesomethinghasnothappened,doesn’tmeanitcannotorwillnot.
9.Theconsequencesofdecisionsshoulddominatetheprobabilityofoutcomes.Webuyinsuranceagainstlow-probabilityevents(such
asdeath)whentheconsequencesofnothavingtheinsurancecanbetoogreat.Similarly,investorsshouldinsuretheirportfolios(byhavinganappropriateamountofhigh-qualitybonds)againstlow-probabilityeventswhentheconsequencesofnotdoingsocanbetoogreattoeven
contemplate,letaloneaccept.
10.Thestrategytogetrichisentirelydifferentfromthestrategytostayrich.Onegetsrichbytakingrisks(orinheritingtheassets).Onestaysrichbyminimizingrisks,diversifying,andnotspendingtoomuch.
11.Theonlythingworse
thanhavingtopaytaxesisnothavingtopaythem.The“too-many-eggs-in-one-basket”problemoftenresultsfromholdingalargeamountofstockwithalowcostbasis.Largefortuneshavebeenlostbecauseoftherefusaltopaytaxes.
12.Thesafestportinaseaofuncertaintyis
diversification.Portfoliosshouldincludeappropriateallocationstotheassetclassesoflarge-capandsmall-cap,valueandgrowth,realestate,internationaldevelopedmarkets,emergingmarkets,commodities,andbonds.
13.Diversificationisalwaysworking;
sometimesyou’llliketheresultsandsometimesyouwon’t.Onceyoudiversifybeyondpopularindexes(suchastheS&P500),youwillbefacedwithperiodswhenapopularbenchmarkindexoutperformsyourportfolio.Thenoiseofthemediawilltestyourabilitytoadheretoyourstrategy.
14.Thepricesofallstockandriskybondassets(suchashigh-yieldbondsandemergingmarketbonds)tendtofallduringfinancialcrises.Yourplanmustaccountforthis.
15.Itisn’tenoughtofindmispricedsecurities.Youhavetomakemoneyafteraccountingforthe
costs.The“historybooks”arefilledwithinvestorswhotriedtoexploit“mispricings,”onlytofindthatthecostsexceededanybenefits.
16.Stockinvestingisapositivesumgame;expensesmakeoutperformingthemarketanegativesumgame.Risk-averse
investorsdonotplaynegativesumgames.Andmostinvestorsareriskaverse.Useonlylow-cost,tax-efficient,andpassivelymanagedinvestments.
17.Owningindividualstocksandsectorfundsismoreakintospeculatingthaninvesting.Themarketcompensatesinvestors
forrisksthatcannotbediversifiedaway,liketheriskofinvestinginstocksversusbonds.Investorsshouldn’texpectcompensationfordiversifiablerisk—theuniquerisksrelatedtoowningonestock.Prudentinvestorsacceptriskonlyforsituationsinwhichtheywillbecompensatedwithhigherexpected
returns.
18.Takeyourriskswithstocks.Theroleofbondsistoprovidetheanchortotheportfolio,reducingoverallportfoliorisktotheappropriatelevel.
19.Beforeactingonseeminglyvaluableinformation,askyourselfwhyyoubelievethat
informationisnotalreadyincorporatedintoprices.Onlyincrementalinsighthasvalue.Capturingincrementalinsightisdifficultbecausetherearesomanysmart,highlymotivatedanalystsdoingthesameresearch.IfyouhearrecommendationsonCNBC,fromyourbroker,orreadthemin
Barron’s,themarketalreadyknowstheinformationitisbasedon.Ithasalreadybeenincorporatedintopricesandhasnovalue.
20.Thefivemostdangerousinvestmentwordsare“Thistime,itisdifferent.”Gettingcaughtupinthemaniaofthe“newthing”iswhy“thesurestwayto
createasmallfortuneistostartoutwithalargeone”isacliché.
21.Themarketcanremainirrationallongerthanyoucanremainsolvent.Bubblesdooccur.However,whiletheyeventuallyburst,theycangrowlargerandlastlongerthanyourresources.
22.Ifitsoundstoogoodtobetrue,itis.Whenmoneymeetsexperience,theexperiencegetsthemoneyandthemoneygetstheexperience.Theonlyfreelunchininvestingisdiversification.
23.Neverworkwithacommission-basedinvestmentadvisor.
Commissionscreatethepotentialforbiasedadvice.
24.Onlyworkwithadvisorswhowillprovideafiduciarystandardofcare.Thatisthebestwaytobesuretheadviceprovidedisinyourbestinterest.Thereisnoreasonnottoinsistonafiduciarystandard.
25.Separatetheservicesoffinancialadvisor,moneymanagers,custodian,andtrustee.Thisminimizestheriskoffraud.
26.Sinceweliveinaworldofcloudycrystalballs,astrategyiseitherrightorwrongbeforeweknowtheoutcome.Ingeneral,luckyfoolsdo
nothaveanyideatheyarelucky.Evenwell-designedplanscanfail,becauserisksthatwereacceptedoccur.Andrisksthatwereavoidedbecausetheconsequencesoftheirmaterializingwouldbetoogreattoacceptmaynotoccur.
27.Hopeisnotaninvestmentstrategy.
Baseyourdecisionsontheevidencefrompeer-reviewedacademicjournals.
28.Keepadiaryofyourpredictionsaboutthemarket.Afterawhile,youwillconcludethatyoushouldnotactonyour“insights.”
29.Thereisnothingnewininvesting,justtheinvestmenthistory
youdonotknow.Theknowledgeoffinancialhistorywillenableyoutoanticipaterisksandincorporatethemintoyourplan.
30.Goodadvicedoesnothavetobeexpensive;butbadadvicealwayscostsyoudearly,nomatterhowlittleyoupayforit.Smartpeopledonotchoose
thecheapestdoctororthecheapestCPA.Costsmatter,butitisthevalueaddedrelativetothecostoftheadvicethatultimatelyismostimportant.
Thefollowingisnotonlythemostimportantmessageinthebook,butisafittingending.Whileitisatragedythatthevastmajorityofinvestorsunnecessarilymiss
outonmarketreturnsthatareavailabletoanyoneadoptingapassiveinvestmentstrategy,thetrulygreattragedyisthattheyalsomissoutontheimportantthingsinlifeinpursuitofwhatIcallthe“HolyGrailofOutperformance.”Myfondestwishisthatthisbookhasledyoutothewinner’sgameinbothinvestingand,farmoreimportant,life.
Notes
ChapterOne1.1993BerkshireHathawayAnnualReport.
2.1996BerkshireHathawayAnnualReport.
3.2004BerkshireHathawayAnnualReport.
4.Ibid.5.JamesAltucher,TradeLikeWarrenBuffett(NewYork:Wiley,2005).
6.MarkSellers,“CouldStocksStillBeUndervalued?”February18,2004,http://news.morningstar.com/articlenet/article.aspx?id=104110
7.Newsweek,August7,1995.
8.WilliamSherden,TheFortuneSellers(NewYork:Wiley,1998).
9.Ibid.10.Ibid.11.PhilipE.Tetlock,Expert
PoliticalJudgment(Princeton,NJ:PrincetonUniversityPress,2006).
12.CarlRichards,TheBehaviorGap(NewYork:Penguin,2012).
13.1988BerkshireHathawayAnnualReport.
14.1991BerkshireHathawayAnnualReport.
15.BusinessWeek,June25,1995.
16.1996BerkshireHathawayAnnualReport.
17.DanKadlec,“WarrenBuffettIsBuying.IsItTimetoCelebrate?”Time,November09,
2011,http://moneyland.time.com/2011/11/09/warren-buffett-is-buying-is-it-time-to-celebrate/
18.2008BerkshireHathawayChairman’sLetter.
19.1990BerkshireHathawayChairman’sLetter.
ChapterTwo1.FloydNorris,“The
Upside?ThingsCouldBeWorse,”NewYorkTimes,
December23,2010,http://www.nytimes.com/2010/12/24/business/24norris.html?ref=business
2.Adam’sSmith’s“MoneyWorld”show,June20,1988,http://www.lestout.com/article/business/business-news/warren-buffet-advice-during-a-crisis.html
3.CliffordAsness,“RubbleLogic:WhatDidWeLearnFromtheGreat
StockMarketBubble?,”FinancialAnalystsJournal,November/December2005.
4.http://www.buffettcup.com/Default.aspx?tabid=69
5.BusinessWeek,June25,1999.
ChapterThree1.BradBarberandTerrance
Odean,“BoysWillBeBoys:Gender,OverconfidenceandCommonStockInvestment,QuarterlyJournalofEconomics,February2001.
2.Ibid.3.BradBarberandTerrance
Odean,“DoInvestorsTradeTooMuch?”AmericanEconomicReview,December1999.
4.Ibid.5.WilberG.Lewellen,
RonaldC.Lease,andGaryG.Schlarbaum,“PatternsofInvestorStrategyandBehaviorAmongIndividualInvestors,”JournalofBusiness,501977,pp.296–333.
6.Ibid.7.BradBarberandTerrance
Odean,“TooMany
CooksSpoiltheProfits,”FinancialAnalystsJournal,January/February2000.
8.SmartMoney,June2001.9.MarkusGlaserandMartin
Weber,“WhyInexperiencedInvestorsDoNotLearn:TheyDon’tKnowTheirPastPortfolioPerformance,”July2007.
10.MarkCarhart,“On
PersistenceinMutual-fundPerformance,”JournalofFinance,March1997.
11.Ibid.12.Ibid.13.RusselKinnel,“How
ExpenseRatiosandStarRatingsPredictSuccess,”MorningstarAdvisor,August10,2010.
14.JonathanB.Berk,“Five
MythsofActiveManagement.”
15.1993BerkshireHathawayAnnualReport.
16.AmitGoyalandSunilWahal,“TheSelectionandTerminationofInvestmentManagementFirmsbyPlanSponsors,”May2005.
17.EdwinJ.Elton,MartinJ.Gruber,andChristopherR.Blake,“Participant
ReactionandthePerformanceofFundsOfferedby401(k)Plans,”JournalofFinancialIntermediation,May2006.
18.WilliamSharpe,“TheArithmeticofActiveManagement,”TheFinancialAnalystsJournal,January/February1991,pp.7–9.
Sources
Thefollowingarethesourcesfordatacontainedinthetext:
Standard & Poor’s fordata on the S&P 500Index and the S&PGSCI. Used withpermission.
Kenneth R. French andthe Center for Researchin Security Prices at theUniversity of Chicagofor data on the variousFama-French series.Usedwithpermission.
Morgan Stanley for dataon the MSCI indexes.www.msci.com Usedwithpermission.
Barclays for data on theBarclays CapitalIntermediateGovernment/CreditIndex. Used withpermission.
Index
Pleasenotethatindexlinkspointtopagebeginningsfromtheprintedition.Locationsareapproximateine-readers,andyoumayneedtopagedownoneormoretimesafterclickingalinktogettothe
indexedmaterial.Activeinvesting,4–7,27–39,
115–118Advisors(seeFinancial
advisors)Aggregaterateofreturn:forindexfundsandassetclasses,38
forstockmarket,36–37Alternativeinvestments,59–
60Assetallocation,55–64
fordo-it-yourselfinvestors,96–97
andfinancialplanning,45–46
5/25percentrulein,83–86andinvestmenthorizon,50
andinvestmentpolicystatements,45–46
ininvestmentstrategy,22–23
BAMAdvisorServices,121
Barron’s,103Bearmarkets,16,37,45,53–
54Beatingthemarket,28BehaviorGap(Carl
Richards),The,10BerkshireHathaway,4,12Bonds:assetallocationin,58–59corporate,59,635/25percentrulefor,85andinvestmenthorizon,50
mutualfundsvs.,63–64portfoliodiversificationwith,76–78
intaxableaccounts,61Bridgeway,39BuckinghamAsset
Management,117Buffett,Warren:onactivevs.passiveinvesting,5–6
onforecasts,7,8onindexfunds,33oninvestmentstrategies
andbridge,22investorbehaviorandadviceof,3–4
onmarkettiming,11–12practicesandstrategiesof,4–5,24
stage-twothinkingby,18–19
onsuccessfulinvestors,11,21,23
Bullmarkets,37,42–43Buy-and-holdstrategies,4(SeealsoPassive
investing)
Capitalgains,88–92Casualtyinsurance,104Charitablegiving,44,107CharlesSchwab,38Closetindexfunds,68–69CNBC-itis,8,13Commercialmortgages,17Commissions:andactivemanagement/investing,6,29
offinancialadvisors,101,132
andnetreturns,38Commodities,57–61,74–76Compensation:offinancialadvisors,101,132
fortakingrisk,62,63,130–131
CongressionalBudgetOffice,8
Corporatebonds,59,63Costbasis,90
CouncilofEconomicAdvisors,8
CRSP6–10Index,57
DimensionalFundAdvisors,39
DimensionalInternationalSmallCapIndex,73–78
Diversification:acrossassetclasses,57–58withalternativeinvestments,60
ofassetclassrisk,62–63
ofassetsandhumancapital,52
withindexfunds,62andmodernportfoliotheory,69–76
andportfoliodesign,67–69
andportfoliorisk,76–78forprudentinvesting,129–130
withsmall-capandvaluestocks,56
andwealthmanagement,
44Duediligenceinvestigations
(ofadvisors),100–101,108–110
Efficientmarkettheory,28Enron,52Estateplanning,44–45,104–
105ETFs(exchange-traded
funds),38Europeanfinancialcrisis
(2011),12Evidence-basedinvestment
strategies,102–103,133Exchange-tradedfunds
(ETFs),38Expectedreturns:andassetriskfactors,55buyingandsellingbasedon,12–13
and“good”risk,62inprudentinvesting,126–127
ofstocks,55,56
Fama-FrenchUSindexes,
57,71–78Fee-onlyadvisors,101Fees,6,29,34Fiduciarystandardofcare,
100–102,132Financialadvice:andactivevs.passiveinvesting,5–7
fromWarrenBuffett,3–13fromfinancialadvisors,102–103
andinvestmentpracticesvs.strategies,4–5
andinvestorbehavior,3–4Financialadvisors,xii,95–
110fiduciarystandardofcarefor,100–102,132
prudentinvestingwith,132
Financialcrisis(2008),12Financialplanning,41–46integrated,103–110,127–128
andprudentinvesting,127–128
5/25percentrule,83–86Five-yearTreasurynotes,
70–78FormADV,101401(k)plans,35
Globallydiversifiedportfolios,62–63
GoldmanSachsCommodityIndex,74–78
Grogan,Kevin,99
Hill,Rick,117–118
HolyGrailofOutperformance,134
Humancapital,51–52
Indexfunds:aggregaterateofreturnfor,37
WarrenBuffetton,5–6,33
closet,68–69diversificationwith,69netresultsof,5–6inpassivestrategies,38–
39realestate,60andriskofindividualstocks,62
Indexing,121–122(SeealsoPassiveinvesting)
Individualretirementaccounts(IRAs),61
Insurance,103–104Integratedfinancialplanning,
103–110,127–128Internationalstocks,55–565/25percentrulefor,85
portfoliodiversificationwith,67,73
Invesco,39Investmentclubs,31Investmentpolicystatements
(IPSs),41–46,86–87Investment-graderatings,
bond,59Investor’sDaily,103IPSs(seeInvestmentpolicy
statements)IRAs,61iShares,38
JournalofFinance,102
Laborcapital,50–53Large-capstocks,68Lifeinsurance,52,103Life-alteringevents,42Lim,Tiya,99Longevityinsurance,103Long-termcapitalgains,92Long-termcareinsurance,
104Lynch,Peter,52
Maintenance,portfolio(seePortfoliomaintenance)
Marketbubbles,132Marketforecasts,valueof,
7–10Markettiming,4,10–13Modernportfoliotheory,69–
76Moneymanagers,132MonteCarlosimulation,96Morningstar,32Mortgages,17,107MSCIEAFEValueIndex,
73–78Munger,Charlie,7Mutualfunds,4,32–33,63–
64,130–131
OnlyGuidetoaWinningInvestmentStrategyYou’llEverNeed,The(Swedroe),117
OnlyGuideYou’llEverNeedfortheRightFinancialPlan,The(Swedroe,Grogan,&Lim),99
Passiveinvesting:activeinvestingvs.,5–7,27–29,38–39
ofmutualfunds,4,39asprudentinvesting,121–122
rateofreturnfor,35–36,78–79
andtimemanagement,115–118
Pensionplans,33–34Personalliabilityinsurance,
104
Portfoliodesign,67–79Portfoliomaintenance,45,
46,81–92Propertyinsurance,104Prudentinvesting:compensationfortakingriskin,63
passiveinvestingas,121–122
(Seealso30RulesofPrudentInvesting)
Quinn,JaneBryant,8
Ratings,bond,58–59Realestate,investingin,59–
60Realestateinvestmenttrusts,
60,61REITIndexFund,60REITs,60,61Retirementplanning,105–
106Return(s):average,78forclosetindexfunds,69correlationsofstock,56–
57diversification,83fordiversifiedportfolio,74,76,77
gross,30,35–36forindexfundsinrecenthistory,6
market,78andpassivevs.activeportfoliomanagement,78–79
probabilityof,128rateof,36–38,54
weightedaverageof,83(SeealsoExpectedreturns)
Richards,Carl,10,29,98Risk,49–54,62–63,74–76,
126–127,130–131RothIRAs,61
Sharpe,William,35Short-termcapitalgains,90Short-termmarketforecasts,
7Small-capstocks:
expectedreturnsof,56independenceofriskfactorsfor,57
portfoliodiversificationwith,56–57,71–72
Sowell,Thomas,18S&P500Index:closetindexfundreturnsvs.,69
correlationsofsmall-capandvaluestockwith,57
inportfoliodiversification
example,70–78rallyof(2009–2011),19–21
returnsforinvestmentclubvs.,31
SPDRs(Standard&Poor’sdepositaryreceipts),38
Speculating,investingvs.,63,130–131
Stage-onethinking,18–21Stage-twothinking,18–19Standard&Poor’s500Index
(seeS&P500Index)
Standard&Poor’sdepositaryreceipts(SPDRs),38
Stayingthecourse,11,13Stock(s),45–58diversificationwith,67–685/25percentrulefor,85international,55–56,67(SeealsoInternationalstocks;Small-capstocks)
Stockmarket:aggregaterateofreturnfor,35–36
predicting,7Suitabilitystandardofcare,
100Swedroe,LarryE.,99,117
Taxdeductions(forlosses),89–90
Taxmanagement,89–92,106
Taxableaccounts,61,89–92Tax-advantagedaccounts,61Tax-deductibleretirement
accounts,61
Taxes:andassetallocation,61capitalgains,88,89forpensionplans,34andprudentinvesting,129
Tax-lossharvesting,89–90Thinkingprocesses(of
investors),15–2430RulesofPrudent
Investing,99,122,125–134
Timemanagement,113–118TotalInternationalStock
IndexFund,69Tradingcosts,37Transactioncosts,87–88Treasurynotes,70–78Trustees,132Trusts,fundingof,104
Uncertainty,diversificationand,129
Uncompensatedrisk,62,63Unsystematicrisk,62Upmarkets,styledriftin,82
Valuestocks,56,57,72Vanguard,38,60,69Volatility:ofassets,83ofdiversifiedportfolio,75–77
ofhumancapital,51
Washsales,90Wealth,transferof,44–45Wealthmanagement,44,129Weightedaverageofreturns,
83
WisdomTree,39WorldCom,52
Year-enddistributions,91–92
Acknowledgments
Foralltheirsupportandencouragement,IwouldliketothanktheprincipalsofBAMAdvisorServices:AdamBirenbaum,ErnestClark,MadalineCreehan,TheliaEagan,BobGellman,EdGoldberg,JoeGoldberg,
MontLevy,VladimirMasek,AlSears,BertSchweizerIII,BrentThomasandBrendaWitt.
Thanksalsogotothosewhoreadearlydraftsofthisbookandmadesignificantcontributions:WendyCook,EricEss,MikeGoing,KevinGrogan,Jo-AnnGallerstein,MattHall,StephenHigh,ScottLucia,andAlexMadlener.
AndaspecialthankstoCarlRichardsforputtingmyvisiontopaperontheillustrationinChapter8,aswellasprovidingtheotherillustrations.
RCBalabanistheeditorofmyblogatCBSNews.com,aswellastheco-authorofInvestmentMistakesEvenSmartInvestorsMake.Ifyouenjoyedthisbook,RCdeservesmuchofthecredit.
Theusualcaveatofanyerrorsbeingmyowncertainlyapplies.
IalsothankmyagentSamFleischmanforallhiseffortsovertheyearsandforgettingmestartedasanauthor.Iamforevergratefulforhissupportandfriendship.
Iespeciallythankmywife,Mona,theloveofmylife.Walkingthroughlifewithherhastrulybeena
graciousexperience.
AbouttheAuthor
LarryE.SwedroeisaprincipalandtheDirectorofResearchfortheBAMAlliance.Hehasalsoheld
executive-levelpositionsatPrudentialHomeMortgage,Citicorp,andCBS.SwedroefrequentlyspeaksatfinancialconferencesthroughouttheyearandwritestheblogWiseInvestingatCBSNews.com.