Copyright©2013byLarryE.Swedroe.Allrightsreserved.ExceptaspermittedundertheUnitedStatesCopyrightActof1976,nopartofthispublicationmaybereproducedordistributedinanyformorbyanymeans,orstoredinadatabaseorretrievalsystem,withoutthepriorwrittenpermissionofthepublisher.

ISBN:978-0-07-180996-2MHID:0-07-180996-1

ThematerialinthiseBookalsoappearsintheprintversionofthistitle:ISBN:978-0-07-180995-5,MHID:0-07-180995-3.

Alltrademarksaretrademarksoftheirrespectiveowners.Ratherthanputatrademarksymbolaftereveryoccurrenceofatrademarked

name,weusenamesinaneditorialfashiononly,andtothebenefitofthetrademarkowner,withnointentionofinfringementofthetrademark.Wheresuchdesignationsappearinthisbook,theyhavebeenprintedwithinitialcaps.

McGraw-HilleBooksareavailableatspecialquantitydiscountstouseaspremiumsandsalespromotions,orfor

useincorporatetrainingprograms.Tocontactarepresentativepleasee-mailusatbulksales@mcgraw-hill.com.

Thispublicationisdesignedtoprovideaccurateandauthoritativeinformationinregardtothesubjectmattercovered.Itissoldwiththeunderstandingthatneithertheauthornorthepublisherisengagedinrenderinglegal,

accounting,orotherprofessionalservice.Iflegaladviceorotherexpertassistanceisrequired,theservicesofacompetentprofessionalpersonshouldbesought.

—FromaDeclarationof

Principlesjointlyadopted

byaCommitteeof

theAmericanBar

Associationanda

CommitteeofPublishers

TERMSOFUSE

ThisisacopyrightedworkandTheMcGraw-HillCompanies,Inc.(“McGraw-Hill”)anditslicensorsreserveallrightsinandtothe

work.Useofthisworkissubjecttotheseterms.ExceptaspermittedundertheCopyrightActof1976andtherighttostoreandretrieveonecopyofthework,youmaynotdecompile,disassemble,reverseengineer,reproduce,modify,createderivativeworksbasedupon,transmit,distribute,disseminate,sell,publishorsublicensetheworkoranypartofitwithoutMcGraw-

Hill’spriorconsent.Youmayusetheworkforyourownnoncommercialandpersonaluse;anyotheruseoftheworkisstrictlyprohibited.Yourrighttousetheworkmaybeterminatedifyoufailtocomplywiththeseterms.

THEWORKISPROVIDED“ASIS.”McGRAW-HILLANDITSLICENSORSMAKENOGUARANTEESORWARRANTIESASTO

THEACCURACY,ADEQUACYORCOMPLETENESSOFORRESULTSTOBEOBTAINEDFROMUSINGTHEWORK,INCLUDINGANYINFORMATIONTHATCANBEACCESSEDTHROUGHTHEWORKVIAHYPERLINKOROTHERWISE,ANDEXPRESSLYDISCLAIMANYWARRANTY,EXPRESSORIMPLIED,

INCLUDINGBUTNOTLIMITEDTOIMPLIEDWARRANTIESOFMERCHANTABILITYORFITNESSFORAPARTICULARPURPOSE.McGraw-Hillanditslicensorsdonotwarrantorguaranteethatthefunctionscontainedintheworkwillmeetyourrequirementsorthatitsoperationwillbeuninterruptedorerrorfree.NeitherMcGraw-Hillnorits

licensorsshallbeliabletoyouoranyoneelseforanyinaccuracy,errororomission,regardlessofcause,intheworkorforanydamagesresultingtherefrom.McGraw-Hillhasnoresponsibilityforthecontentofanyinformationaccessedthroughthework.UndernocircumstancesshallMcGraw-Hilland/oritslicensorsbeliableforanyindirect,incidental,special,punitive,

consequentialorsimilardamagesthatresultfromtheuseoforinabilitytousethework,evenifanyofthemhasbeenadvisedofthepossibilityofsuchdamages.Thislimitationofliabilityshallapplytoanyclaimorcausewhatsoeverwhethersuchclaimorcausearisesincontract,tortorotherwise.

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.