I started this investing study seeking to find out why my professionally managed investments are outperformed by unmanaged indices of the stock market (e.g. the DOW). In this chapter, I believe we uncover the dominant reason and the most important single paragraph of his book. With the foundation complete, in the three chapters that follow, we will see Malkiel’s strategy for beating managed funds.

Malkiel’s Rule 7: Pay Yourself Not the Piper

This chapter focuses on the costs of financial services. In his opening paragraph, he makes the point that over the long haul “the sales charges and ongoing expense you pay will hake a dramatic difference in the cumulative value of your portfolio.”  He says that these costs can be about 2% a year.

An illustration of why this matters: If over the long haul your investments make 8% a year (as stocks have done over the long haul), these costs will effectively reduce your net rate of return from 8% to 6%. Now remember the rule of 72. Instead of your money doubling over 9 years, it will take 12 years.  Suppose you invest $1,000 over 40 years. At 8%, this amount will grow to $21,725; at 6%, it comes to $10,286 instead. His conclusion: costs matter.

He warns that many financial services companies obscure their costs. He quotes the former chairman of the Vanguard Companies, “A low-expense ratio is the major reason why a [mutual] fund does well…the surest way to top-quartile returns is bottom-quartile expenses.” He says that most mutual funds turn over their entire portfolio in a year, adding transaction costs to the management expenses they charge.

So you need to look for funds with low expense ratios.  He advises against mutual funds with a load charge. He says the situation it the same with bonds and money-market funds, costs matter.

“Every extra dollar of expense you pay is skimming form your investment capital. Those funds are lost forever.”

So here is the most important paragraph of the book (so far at least) in my opinion:

In rules 8 & 9, I will recommend broad-based stock and bond index funds as the preferred investment vehicles of choice. Of all the funds offered in the market, index funds have the lowest expense ratios. Moreover, index funds mangers are fundamentally “buy and hold” investors. Thus, they avoid the transaction costs that are associated with funds that trade from security to security and regularly turn over the holdings in their portfolios. But even with index funds, expense ratios vary among mutual fund companies. You can be an educated consumer by learning about expense ratios from the Morningstar Mutual Fund Service (www.morningstar.com) and the Securities and Exchange Commission (http://www.sec.gov/investor/tools/mfcc/mfcc-int.htm). Don’t let high fund expenses eat up your retirement funds.

 Finally he says that cost matter in all financial products.

• He cautions against buying insurance via variable annuities and whole life policies as they are in essence mutual funds with a costly insurance wrapper.
• He suggests if one wants to buy stocks directly, to look for a discount broker (but make sure you know what you are doing and you get an honest broker belonging to the Security Investor Protection Program).
• He also has a strong caution against something called a “wrap account” as they cost can be very high.

Next time: Rule Eight: Bow to the Wisdom of the Market

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see my summary.

Malkiel’s Rule 6: Never Forget that Diversity Reduce Adversity

Not only does he recommend holding the different major asset categories (cash, bonds, stocks, real estate), but also diversifying holdings within each category and over time (through dollar cost averaging). He says his advice is not new. Cervantes, in his epic novice Don Quixote, advises that one should not “venture all his eggs in one basket”.

Diversifying in the various investment categories

He includes a few horror stories of people that were doing well invested in what looked like solid investments only to lose much (e.g. Enron stock; internet stocks; Worldcom bonds; etc).

He has a great illustration in his book which is too long to repeat here but that clearly shows that diversification results in much less risk with little reduction in return on your investment. The reason to diversify is fairly simple: as good a deal as individual stock or sector appears, things can change rapidly and unpredictable for a single investment. “By holding a wide variety of stocks, you reduce the risk considerably because economic events don’t affect all companies in the same way and unfavorable company-specific events are likely to be balanced by very favorable events for other companies.”

He recommends investing as many as 100 different stocks to reduce risk. For almost all of us the only practical way to do this is via mutual funds as this is what they do: allow you as an individual investor to own pieces of lots of different stocks.

He does not think most investors need to diversify internationally as there are plenty of good options here and many American companies are global to a significant extent anyway.

He also recommends diversification in bonds (again there are mutual funds for bonds) and real estates investments (via REITs).

Diversification Over Time (dollar cost averaging)

Under his section on “Diversification Over Time” he suggests putting money into the market regularly over time and explains and illustrates something called “dollar cost averaging.” It involve regularly saving (investing) the same amount of money over the long term on, e.g. a monthly or quarterly basis. You do this when stocks are up and when they are down. When stock prices are low, this results in buying more shares; when stock prices are high, you end up buying few shares. He demonstrated that you when you save in this way, you are actually ahead when the market goes down and then returns to its original value verses a market that is constantly going up.

While I won’t take you through the numbers (there are in the book and others as well), here is a great quote he provides by Warren Buffet that helps explain the concept in words:

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

He concludes by warning that dollar cost averaging will not solve all our investment problems. The plan does not protect you if you need to take the money out when the market is down. And there is a time to alter the above. In fact, when the market is down may be the time to buy a few extra shares. The worst thing you can do is to sell when the market is down if you can avoid it.

Next up: Rule 7 – Pay Yourself, Not the Piper (controlling costs)

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see my summary.

Malkiel’s Rule 5: Match Your Asset Mix to Your Investment Personality: How do allocate assets.

Once you have started regular savings, you need to decide how to allocate your savings among the 4 investment categories noted in Basic Point 2 (cash, bond, stocks, real estate).

He starts off with a reminder: remember that risk and return are related.   Over the period 1926 to 2002:

• Cash investments averaged a 3 ½ % return but brought a risk of plus/minus 3%.
• Bonds averaged 5 ½ % return but brought a risk of plus/minus 9%.
• Stocks averaged a 10% return, but brought a risk of plus/minus 21%.

His chapter provides more detail than the table above on the performance the various investment options over time but in the end, he comes to this advice:

3 factors that affect asset allocation:

1)      Time horizon. The longer you have, the more of your money you can have in stocks (for greater earnings). The shorter your time horizon, the more that should be in cash and bonds.

Rule of thumb: your age should dictate the % of your retirement assets in bonds (and I think he intends to include cash). Example, if you are 25, can have 75% in stocks and 25% in bonds and cash. If you are 55 (as I am at this writing), he suggests you have 55% of retirement assets in bonds and other safe investments and no more than 45% in stocks.  An exception: money you are leaving to others that do not immediately need it.

2)      Capacity for risk – you may need to adjust the above general rule if you cannot afford short-term loss (i.e. decrease the % to stocks).

3)      Your temperament – similar to #2, you may need to adjust from the above general rules if you don’t have a temperament that can deal with short term losses. It is better to earn less in safe investments than to bail out of stocks when they take a plunge. “Sell down (stocks in your portfolio) to your sleeping point (where you can sleep at night).” He has a useful table on p 94 that related how much you can stand losing in a bad cycle vs what the percent you can have in stocks. It says, for example, if you cannot take losing more than 20% of your investment value in a bad cycle, you should have not more than 50% of your money in stocks.

Re-balance regularly

With changes in the values of various parts of your portfolio (e.g. stocks vs. bonds), your target mix can/will get out of balance with the target you established. When this occurs, re-allocate your investments to return to the right balance. He suggests rebalancing annually. To the extent possible, do this via new investment money (to reduce costs of moving money around (see Rule 7).

Next up:  Rule 6  – Reducing risk through diversification

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see my summary.

It’s now time to look at saving strategies that reduce taxes, esp. the different types of individual retirement accounts (IRAs). IRAs are our federal government’s encouragement to save for our retirement (and kids/grandkids college costs).  This summary will explore the differences in traditional and Roth IRAs and then overview pension plans. We will look at similar plans to save for college costs for kids and grandchildren and close with Malkiel’s “best” tax strategy

Malkiel’s Rule 4: Stiff Tax Collector

Individual Retirement Accounts (IRA) overview (they come in two basic types – pay attention; as other tax breaks use the same basic approaches).

First, be aware there are three different ways to reduce taxes via these IRAs (each type doing only two of the three benefits):

1)      Reduce taxable income (and typically taxes) when you contribute

2)      Avoid being taxed on the growth in investment value over time (in other investments you have to pay taxes as the investments earn money)

3)      Reduce taxable income (and typically taxes) when you withdraw from your IRAs for retirement.

Here are some things that are applicable to both types:

• Annual limits for IRA deductions (you can do one or the other or both; but in any case, these limits are for the sum): $ 5,000 if under age 50; $6,000 if over 50;
• both you and your spouse can contribute this amount if you having earned at least that much
• this limit is reduced if you earn over a certain amount: $90,000 for married filing jointly.

Traditional IRAs. Here you get benefits 1 & 2 but NOT 3.

1) When you put your money in a Traditional IRA, you reduce your taxable income by that account. The contribution to the IRA is subtracted from your income on line 32 of Form 1040, before computing your adjusted gross income. For example, if you are in a 15% marginal tax bracket as many of us are (i.e. for each additional $1000 of taxable income, you pay an additional $150 in taxes), then you can think of it as the government paying for 15% of the IRA through reduced taxes.  In most states, your taxable income for state purpose is also reduced (in KS, many of us a taxed at a 6% marginal state tax rate).

2) The IRA’s growth in value over time is not taxed.

3) However, when pull the money out of the IRA at retirement, it is reported as income and taxes at that time (currently on line 15b of the Form 1040).

The hitch = you must leave the money in a retirement account until retirement age or suffer 10% penalty.

This is still a significant benefit. As is illustrated in the book, at 8%, your money will grow 3 times as fast with this benefit than not. Even considering taxes at the end, you are way ahead vs saving for retirement without the tax benefit.

Roth IRA – In this case, you get benefits 2 & 3 above but NOT 1.

1) So you do NOT get to deduct the IRA contribution from your taxable income in the year.

2) Your investment grows tax-free

3) You can access your contributions at any time without having to claim it as income and without penalty. To withdraw earnings tax-free (and penalty-free), you will need to be at least 59 ½. But follow these rules and your withdrawals are NOT treated as income as with a traditional IRA [it is reported on your tax filing but it is not taxed].

Which type of IRA is best for you? It depends. There are lots of people willing to help you figure it out. In general, if you have plenty of time until retirement, the Roth is best, esp. if in a lower tax bracket.

Pension plans

Some with employers you can contribute at work to a pension plan (typically called 401k or 403b plans). Even when this is not an option with your employer, you can do it on your own (Keogh or SEP-IRAs). The tax benefits and “hitches” and similar to the traditional IRA above. The advantage of these pension plans is you can contribute greater amounts.

What can you invest in and through whom?

A wide range of investments types: stocks, bonds, mutual funds, CD’s.  He will talk about how to allocate between these choices in Rule 5. There are plenty of places to set these up: banks, securities dealers, insurance companies, mutual funds, etc.  More on this topic later as well (Rule 7 and 9).

Priorities:

1)      Retirement plans where your employer matches your contributions

2)      IRAs and non-matching retirement plans

3)      Roth IRAs (can be above number 2 in some cases)

4)      If you have still more, get some help (he has more advice in his book).

Saving for children/grandchildren’s college with tax advantages

529 plans allow for tax benefits like the Roth IRAs for contributions into funds dedicated for use in college expenses for your children or grandchildren. They have a very liberal in definition of educational expenses (including buying apartments for housing your students or cars as transportation).

Many states provide similar state tax benefits for qualified plans.

I encourage you to NOT put the funds in the names of your children (grandchildren’s) as it may negatively affect financial aid.

Educational Savings Account is another option to explore.

His “Best” tax strategy – Buy your own home. It is a form of forced savings. It has tax advantages as well: interest on your loan and real estate taxes can be deducted [however the tax benefit will only occur to the extent your itemized deductions are greater than the standard deduction you can take: for singles that is $ 5,700 and for a couple this is $ 11,400 in 2010).

He also suggests you avoid over-extending buying a house, i.e. limit your mortgage to 30% of your income.

Next time: Stock, bonds, cash – how much do I put where (asset allocation)?

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see the index page to my full summary.

Murphy’s Law: What can go wrong, will go wrong.
O’Toole’s commentary: Murphy was an optimist.

Rule 3 Don’t Be Caught Empty-Handed: Cash Reserves and insurance

After a short section on why you need cash reserves, this chapter focuses options for where to put the cash, and then concludes for some words on insurance, with a focus on life insurance.

In the chapter, Malkiel provides a helpful overview of the options where your money will be safe, readily assessable and still earn a little return (unfortunately in our day, the return is a very little).

Establishing a Cash Reserve

Many investment advisers say “Cash is trash” as you don’t make much return on it. Yet everyone needs some reserves in safe, liquid investments for life’s surprises, as bad things happened to good people. In addition, you should be fund expected large, future expenditures (college for kids, etc) with short-term investments (e.g. bank CDs) whose maturity matches the date when needed.  Here is a look at his alternatives (and at the very end, what we are using at this writing).

Money-Market Mutual Funds

He believes this is the best instrument for cash reserves. They are safe and have “relatively generous yields” [at his writing of 2003 he was saying 1-5%; at this time (2011) do not expect much].

His list of low-expense money market funds (at the time) included:

• Fidelity’s Spartan Money Market Fund – https://www.fidelity.com/
• TIAA-CREF Money Market fund – https://www.tiaa-cref.org
• USAA money mark fund – https://www.usaa.com
• Vanguard money market – http://vanguard.com/

Minimum purchases listed in his book are $ 2,500 to $20,000.

Below (under CDs), he suggests you go to www.bankrate.com to look at rates. They have them for money market accounts as well. As of 3/27/11, it appears the best rate with no minimum is 1.2%; with several options between 1% to 1.2%.

[Again, see the bottom of the article for what we are using.]

Bank Certificates of Deposit (CDs)

You get these through a bank. They require you to tie up your money for a period of time but can have higher yields (although not much today). Interest earned is subject to taxes.

He suggests you go to www.bankrate.com to look at rates. Best rates as of 3/27/11.

1 year: 1.25%
2 year: 1.5%
3 year: 1.75%

Internet Banks

You can find them included in bankrate.com above. [I think our choice below, ING, is in this category; although it does not show up on bankrate.com.]

Treasury Bills

Know as T-bills. These are backed by the federal government. They have maturities of 4 weeks, 3 months, 6 months, one-year. He says all but the 4-weeks are purchased directly from the government. Earnings are exempt from state and local taxes.

Go to http://treasurydirect.gov/ to purchase. It looks like they are currently (March 2011) paying well under 0.5 % for the shorter term bills.

Tax-exempt Money-Market Funds

See the book for more (as I do not have to worry about this).

Buying Insurance

He says that one is negligent if one does not purchase insurance: auto, home owners, medical, and life insurance. He also recommends disability insurance (which I do not carry, not a bad idea; I built up my sick leave as my disability insurance).

Most of his discussion is on the difference in term and whole life insurance, recommending term (and investing the difference according to the principles in the book).

For term he suggests you consider:

• Renewable term. He says decreasing term will work best for most families with an investment plan as you insurance needs will diminish over time (and as premium rise over time).
• Or level-premium insurance to cover extended period of insurance needs (I have some of this).

For term insurance rates, see http://term4sale.com/. He recommends buying from a firm with no less than an A rating with AM Best.

Variable Annuities

This is another life insurance vehicle, which he recommends avoiding, that combines insurance and investment. He thinks you can do better by getting insurance separate from investing. But if you wish to buy such, he suggests buying directly from TIAA-CREF or Vanguard rather than through an agent.

What we do for our cash funds (including our emergency fund): ING Orange Savings Account. Paying 1% (3/27/2011). They advertise: “No minimum, no fees, no catches”. This has been the case with us. http://home.ingdirect.com/index.html. You open an on-line account and link it to your checking. Then you can transfer money easily from one to the other. We have 8 of them: emergency fund, home improvement, college (almost done!), weddings (one more to go), car purchase/maintain/repair, property tax/propane, vacation, special giving. 6 of the funds get monthly transfers from our checking account, 2 of them get influxes twice a year when I get three paychecks in a month.  I pull from them as needed. It takes about 3 days.

What we do for expected large, future expenditures – Much of this money is in our INGs above.  But based on advice from our financial counselor: we have also been using an account with https://www.ftjfundchoice.com/, their Litman/Gregory Capital Preservation Fund. I am not sure what all is in the fund but it has been returning about 4 – 5% per year. The value does drop some when the DOW goes down but not much. Returns have been good enough for me to keep there. You may have to use an advisor to set this up.

Next time: Stiff the tax collector

The above is from my on-going study on investing, from Malkiel’s  The Random Walk Guide on Investing. For more, see the index page to my full summary.

In investing, risk and return are related.  Risk is the possibility of suffering harm or loss. Some things have little risk, e.g. Treasury bonds. But their return is relatively limited. To induce investors in riskier investments, higher returns must be offered.

He has a table of investment type, historic average annual returns (for the period 1926-2002) and range of annual returns (volatility).

• Cash (including Treasury Bonds) returns on average 3-4%/year with a range of +1% to 9% annually.
• Long-term corporate bonds return on average 6%/year but can range from -5% to +15% annually.
• Common stocks return on average 10%/year but can range from -27% to +52% annually.

While the stock market tends to rise most of the time, he reviews the history of bear (declining) markets. Such declining periods can go on for several years. But eventually, the market comes back and recovers these losses and begins to gain once again. So the market is a good place for long-term investments but can be a poor choice for short-term investments.

Next time: Rule One: Start Saving now, Not Later: Time is Money.

The above is from my on-going study on investing, from Malkiel’s  The Random Walk Guide on Investing.For more, see the index page to my full summary.

From my on-going study on investing, from Malkiel’s  The Random Walk Guide on Investing. For more, see the index page to my full summary.

“While ignorance may be bliss, as the English poet Thomas Gray once wrote, it is not profitable.”

Basic Point Two – Focus on Four Investment Categories

In this section of his book, Malkiel overview the four types of investments to consider (he does not include insurance, which he says should only be used for protection, or collectables included gold):

• Cash – this includes checking accounts and other short term securities that can be turned into cash on short notice and with no risk of loss on principle. This includes short term Treasury bills, short term CDs that can be made to cash without penalty, money market mutual funds. “Every investor needs a cash reserve to meet the various emergencies of life…” More in Rule 3 on how to build this cash reserve.
• Bonds – A long-term IOU from government, industry. Owning bonds make you a creditor of the company. They yield a specific rate of interest. If interest rates rise, bond prices fall. Some bonds are sold at discount and yield their face value at maturity (called zero coupon bonds). Bonds are fixed income investments. High quality bonds are good for retirees. Types of bonds:
  • U.S. Treasury
  • Ginny Mae (Gov’t National Mortgage Association)
  • Sally Mae (Student Loan Marking Association)
  • Municipal (including state and local gov’t)
  • Corporate. Varying quality. Riskier than other bonds so they offer a greater return to attract buyers. Junk bonds are high yielding but the riskiest.
• Common stocks – Owning stock makes you part owner of a company.
  • You can make greater yields if the company does well; but greater risk if not. There is no specific promise of return as in bonds.
  • However, over the long haul, stocks have done well. (average yield is 8-9%/year vs 5-6%/year for high quality bonds).
  • “Bull” (gaining) markets dominate the long history of the stock market. But “bear (loosing) markets can go on for years. So your money in stocks needs to be for long-term objectives (e.g. retirement).
  • He says the stock market is pretty efficient about pricing stocks over the long term.  But once in a while the stock market goes “loony”.  There can be a “herd mentality” where something starts doing well and then everyone wants a piece of the gain so that a particular stock or segment gets overvalued. Eventually, it will come back to reasonable values and those who bought at the end will lose much (e.g. internet, “dot.com” craze).
  • He recommends a simple, low-risk, diversified strategy that will make money and keep us from making mistakes of following the herd. But it will take discipline when others boast of their short-term gains.
• Real estate – besides owning your own home, it can be profitable to invest in commercial real estate.
  • Values of real estate typically rise (and thus the value of this investment) and you also get share in the income of the property.
  • Like stock mutual funds, real estate investment trusts (REITs) allow you to share ownership in real estate with many others. There are differing REITs depending on the segment of property you are interested in.  While they have only been around for 20 years, they look like a place to have some of your investment portfolio.

Next time: Understanding the Risk/Return Relationship

For more, see the index page to my full summary.

From my on-going study on investing, from Malkiel’s  The Random Walk Guide on Investing. For more, see the index page to my full summary.

Basic Point One – Fire Your Investment Adviser

In this chapter he argues that we can do better without investment advisers. These advisers are making money at our expense. They are generally compensated by earning commissions on products they sell us. They make investing seem very complicated so we have to turn to them for advice.  But their products do not return the promised results of beating the market. [As he shows later, 85% of the money managers are beat by the market].

“We will see later that the correct investment strategy is actually to throw a tower over the stock page and buy a lost-cost mutual fund that includes all the stocks and does not trade.”

“Following the advice of these financial “experts” can be hazardous to our wealth.”

2000 Forbes article, “…your average pro on Wall Street has failed to beat the indexes.”

”The way to get rich from investment advice is to sell it.”

“By keeping your savings and investment strategy as simple as possible, you will free up time to do the really important things you want to do with your life such as spending more time with friends and family.”